## Financial Leverage (FL)

### Meaning

Financial leverage measures the relationship between EBIT and EPS. It is the use of funds carrying a fixed cost in order to increase earnings per share — i.e., using funds on which the company pays a limited (fixed) return.

FL is caused by Fixed Financial Cost = Interest + Preference Dividend.
It involves using funds obtained at a fixed cost in the hope of increasing the return to equity (common) shareholders.
This concept is also known as "Trading on Equity".

### Formulas (DFL — interchangeable with "FL")

Formula 1 — General:

$$DFL = \frac{\%\ Change\ in\ EPS}{\%\ Change\ in\ EBIT}$$

Formula 2 — when Preference Shares are issued:

$$DFL = \frac{EBIT}{EBIT - Interest - \dfrac{PD}{(1 - tax)}}$$

(The preference dividend is grossed up by (1 − tax) because PD is paid out of after-tax profits.)

Formula 3 — when no Preference Shares are issued:

$$DFL = \frac{EBIT}{EBT}$$

### Exam tip

ICAI sometimes uses Formula 3 even when preference shares exist. So when preference shares are present you may use either Formula 2 or Formula 3 — state your assumption.

Worked example

### Example 1

DFL with only debt (no preference shares): EBIT ₹2,00,000; Interest ₹50,000.

EBT = 2,00,000 − 50,000 = ₹1,50,000.

DFL = EBIT ÷ EBT = 2,00,000 ÷ 1,50,000 = 1.33.

Interpretation: a 10% change in EBIT → 13.3% change in EPS.

### Example 2

DFL with preference shares (Formula 2): EBIT ₹2,00,000; Interest ₹50,000; Preference Dividend ₹30,000; tax 40%.

Grossed-up PD = 30,000 ÷ (1 − 0.40) = 30,000 ÷ 0.60 = ₹50,000.

DFL = 2,00,000 ÷ (2,00,000 − 50,000 − 50,000) = 2,00,000 ÷ 1,00,000 = 2.

⚠️ Common exam mistakes

Not grossing up preference dividend by (1 − tax) in Formula 2 — PD is an after-tax appropriation.
Subtracting preference dividend directly (without the (1−tax) adjustment) from EBIT.
Confusing financial leverage (EBIT↔EPS, financial risk) with operating leverage (Sales↔EBIT).
Forgetting that interest is the fixed financial cost in the simple (no-preference) Formula 3 = EBIT/EBT.
Assuming Formula 2 is mandatory when preference shares exist — ICAI also accepts Formula 3; note the approach.

Reference:

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