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DegreeOfFinancialLeverageDFL

Degree Of Operating Leverage - DOL

What is a 'Degree Of Operating Leverage - DOL'

The degree of operating leverage (DOL) is a leverage ratio that summarizes

the effect a particular amount of operating leverage has on a company's
earnings before interest and taxes (EBIT) over a period of time. Operating
leverage involves using a large proportion of fixed costs to variable costs in
the operations of the company. The formula is as follows:

BREAKING DOWN 'Degree Of Operating Leverage - DOL'

CalculatingDegreeofFinancialLeverage

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The higher the degree of operating leverage, the more volatile and
unpredictable the EBIT figure is relative to a given change in sales, assuming
all other variables remain constant. The DOL ratio is useful as it helps analysts determine the effects
of a given level of operating leverage on the earnings potential of a company. This ratio can also be
used to help company decision-makers determine the most appropriate level of operating leverage
to maximize the company's EBIT.

Degree of Operating Leverage Formula

The formula for the DOL takes into account two variables. They are:
1) The percentage change in EBIT from time period one to time period two
2) The percentage change in sales from time period one to time period two
The formula is then, DOL = % change in EBIT / % change in sales
EBIT can be calculated by taking the sales revenue and subtracting the operating expenses.

Example Calculation

Assume Company X has $500,000 in sales in year one and $600,000 in sales in year two. For year one,
the company's operating expenses were $150,000, while in year two, the operating expenses were
$175,000. To calculate the DOL, the EBIT for each year must first be calculated. In this example, the
EBIT values are:
Year one EBIT = $500,000 - $150,000 = $350,000
Year two EBIT = $600,000 - $175,000 = $425,000
Next, the percentage change in the EBIT values and the percentage change in the sales figures are
calculated as:
% change in EBIT = $425,000 / $350,000 - 1 = 21.43%
% change in sales = $600,000 / $500,000 -1 = 20%
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Lastly, the DOL ratio is calculated as:

DOL = 21.43% / 20% = 107.14%
Net operating income is the income remaining after fixed-cost payments are made by a company,
irrespective of sales. If the DOL of a company is high, this means a relatively small increase in sales
can have a large effect on net operating income. Calculating DOL can help in decision-making, which
may prevent large losses to a company based on smaller changes in sales.

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A ratio that measures the sensitivity of a companys earnings per share (EPS) to fluctuations in its
operating income, as a result of changes in its capital structure.
structure. Degree of Financial Leverage (DFL)
measures the percentage change in EPS for a unit change in earnings before interest and taxes
(EBIT), and can be mathematically represented as follows:

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DFL can also be represented by the equation below:

The ratio shows that the higher the degree of financial leverage, the more volatile is EPS. Since
interest is a fixed expense, leverage magnifies returns and EPS, which is good when operating
income is rising, but it can be a problem during tough economic times when operating income is
under pressure.

BREAKING DOWN 'Degree Of Financial Leverage - DFL'

Consider the following example to illustrate the concept. Assume hypothetical company BigBox has
operating income or EBIT of $100 million in Year 1, with interest expense of $10 million, and has 100
million shares outstanding. (For the sake of clarity, lets ignore the effect of taxes for the moment.)
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