Before we move on to the comprehensive
question on Degree
of Financial Leverage - Debt/Equity Capital Structure
- Indifference EBIT, it is important to know
what all these terms mean. That's the goal of this tutorial.
Return on Equity
Return on Equity is an accounting
ratios formula that measures the profitability of a company.
The formula is:
| Return
on Equity = Net Income / Shareholder's
Equity |
For example, if the net income of
a corporation for 2006 is $1 million while the value of
the total common shares outstanding is $12 million, then
ROE:
Return on Equity = 1 million / 12
million
Return on Equity = 8.33%
8.33% means the shareholders of the
corporation are getting a return of 8.33% for every dollar
they invest into the corporation. Return on Equity formula
helps in comparing the profitability of different corporations
in the same line of business or industry.
Degree of Financial Leverage
Degree of Financial Leverage measures
the amount of risk a company takes up when it borrows
more debt (and increases the debt portion of its capital
structure). The formula for Degree of Financial Leverage
is:
| Degree
of Financial Leverage = |
Earnings Before
Interest & Taxes (EBIT)
Earnings Before Taxes (EBT) |
To illustrate Degree of Financial
Leverage, lets do a hypothetical question. Imagine there
are 3 firms, Firm A, Firm B and Firm C. Each one has an
interest expense of $12000 in the year 2006. The Earnings
Before Taxes for each firm is given below in the table.
Can you calculate the Degree of Financial Leverage using
this data?
Interest Expense = $80,000 x 15%
= $12000
| |
Firm A |
Firm B |
Firm C |
| EBIT |
25000 |
50000 |
75000 |
| EBT (EBIT
- Interest Expense) |
25000 - 12000
= 13000 |
50000 - 12000
= 38000 |
75000 - 12000
= 63000 |
| Degree of Financial
Leverage (EBIT / EBT) |
25000 / 13000
= 1.92 |
50000 / 38000
= 1.32 |
75000 / 63000
= 1.19 |
Out of the Firm's A, B and C, which
is more riskier? This riskiness is measured by the Degree
of Financial Leverage. Since the Degree of Financial Leverage
for Firm A is 1.92 which is higher
than that of Firm B (1.32) and C (1.19), this means Firm
A is much more riskier than Firm B & C.
Degree of Financial Leverage is very
helpful in comparing various firms and the riskiness of
their capital structures in a particular industry.
Capital Structure
The term capital structure means
the amount of debt (bonds) + equity (common + preferred
shares) that a corporation has that makes up its capital
structure. Go here for a complete tutorial on capital
structure.
