Investors are primarily concerned with two things, return and risk. Higher returns require a greater degree of risk. The risk is justified by the amount of revenue and profit that can be generated from the degree of financial leverage. As a general rule, when returns are higher than the costs associated with obtaining funds (financial leverage), a company can expect to see an increase in profits.
Review the DFL formula at a high level. The degree of financial leverage is the percent change in net income given a change in operating income. The exact formula is DFL = operating income ÷ (operating income - interest - (preferred dividends ÷ (1 - tax rate)).
Define the variables. For our example, let's assume a company has $1 million in total sales. Operating costs (variable and fixed) are $500,000. Annual interest expense is $100,000, and preferred dividends are $10,000 per year. The tax rate is 33 percent.
Calculate operating income or EBIT. EBIT equals sales ($1 million) - operating costs ($500,000). EBIT equals $500,000.
Divide preferred dividends by 1 - tax rate. Preferred dividends ($10,000) divided by (1 - .33) or .67 equals $14,925.37.
Calculate DFL. The final equation should be: $500,000 ÷ ($500,000 - $100,000 - $14,925.37) = 1.3.