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Debt Financing/Financial Leverage Question From Wiley

Wiley Debt Financial leverage

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#1 jeremiah89

jeremiah89

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Posted 14 January 2014 - 10:53 AM

Greetings all,

 

I have a question that I need some clarification on. Here is the pertinent information:

 

Budget income information:

 

Forecast 1: Sales - 3 million; Expenses - (2.8 million); Operating Income (EBIT): $200,000; EPS: $.20.

 

Forecast 2: Sales 3.15 million; Expenses - (2.85 mllion); Operating Income (EBIT: $300,000; EPS: $1.20

 

It's asking me to calculate financial leverage and Wiley says that the formula is: % change in EPS / % change in EBIT. So my question is this: why do we use EBIT (Earnings BEFORE Interest...) to calculate financial leverage (i.e. how much debt is built into the capital structure)? It seems to me that the only way to accurately know a company's financial levage would be to use earnings AFTER interest (because that will tell us how expensive their debt is).

 

I've read that another version of this formula is: % change in EPS / (% change in EBIT minus Interest).........and that formula makes so much more sense to me. But the standard EBIT number that has not deducted interest is making no sense to me.

 

What am I missing?