Financial Leverage: Understanding the Risk Level of Corporations A and B
DFL can be calculated using two formulas:
DFL Formula 1:
DFL = EBIT / (EBIT - interest)
This formula shows the ratio of a company's EBIT to the difference between EBIT and interest expenses. A higher DFL indicates that a company is more leveraged and has a higher risk level.
DFL Formula 2:
DFL = % change in net income / % change in EBIT
This formula compares the percentage change in net income to the percentage change in EBIT. It helps assess how sensitive a company's earnings are to changes in operating income.
Now, let's look at Corporations A and B:
Corporation A has a DFL of 1.75, which means that its interest expenses represent approximately 43% of its EBIT. This indicates that Corporation A is less leveraged and has a lower risk level compared to Corporation B.
On the other hand, Corporation B has a DFL of 83, implying that its interest expenses make up around 98.8% of its EBIT. This high DFL suggests that Corporation B is heavily leveraged and carries a higher risk level than Corporation A.
In conclusion, Corporation B is at a much higher risk level than Corporation A due to its extremely high degree of financial leverage. It is important for investors to consider DFL when assessing the riskiness of an investment in a company.