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CandleFocus Glossary Editor
The degree of financial leverage (DFL) is an important metric used to analyze the financial risk of a company. It indicates how sensitive a company’s earnings per share (EPS) is to changes in its operating income—the higher the DFL, the more volatile its EPS is. By analyzing DFL, investors can get an idea of how much risk a company is taking by using borrowed capital to finance its activities.
The most commonly used leverage ratio is the debt-to-equity ratio. This is calculated by dividing a company’s total debt by its total equity. A company with a debt-to-equity ratio of 1 or higher is considered to be highly leveraged, and a company with a ratio greater than 1 is considered to be very highly leveraged. Companies with a high degree of financial leverage are typically more vulnerable to economic downturns and interest rate fluctuations than those with lower degrees of financial leverage.
However, it’s not just the debt-to-equity ratio that should be considered when analyzing a company’s degree of financial leverage. Other key ratios that should be considered are the debt-to-assets ratio, the current ratio and the quick ratio. By looking at these ratios together, a more comprehensive picture of how leveraged a company is can be obtained.
Different sectors of the economy will have different degrees of leverage. For example, companies in the banking sector are likely to have higher degrees of financial leverage than companies in the manufacturing sector, since banks rely heavily on debt-funded financing. As well, the degree of financial leverage for companies operating in the same sector can vary depending on their size, age, and financial structure.
Overall, the degree of financial leverage is a key factor for investors when evaluating a company’s financial risk. By analyzing the various ratios that make up the degree of financial leverage, investors can get an indication of how heavily a company relies on borrowed capital to finance its activities. This, in turn, will provide key insight into the company’s exposure to risk and how vulnerable it may be to changes in the market.
The most commonly used leverage ratio is the debt-to-equity ratio. This is calculated by dividing a company’s total debt by its total equity. A company with a debt-to-equity ratio of 1 or higher is considered to be highly leveraged, and a company with a ratio greater than 1 is considered to be very highly leveraged. Companies with a high degree of financial leverage are typically more vulnerable to economic downturns and interest rate fluctuations than those with lower degrees of financial leverage.
However, it’s not just the debt-to-equity ratio that should be considered when analyzing a company’s degree of financial leverage. Other key ratios that should be considered are the debt-to-assets ratio, the current ratio and the quick ratio. By looking at these ratios together, a more comprehensive picture of how leveraged a company is can be obtained.
Different sectors of the economy will have different degrees of leverage. For example, companies in the banking sector are likely to have higher degrees of financial leverage than companies in the manufacturing sector, since banks rely heavily on debt-funded financing. As well, the degree of financial leverage for companies operating in the same sector can vary depending on their size, age, and financial structure.
Overall, the degree of financial leverage is a key factor for investors when evaluating a company’s financial risk. By analyzing the various ratios that make up the degree of financial leverage, investors can get an indication of how heavily a company relies on borrowed capital to finance its activities. This, in turn, will provide key insight into the company’s exposure to risk and how vulnerable it may be to changes in the market.