Which of the following mathematical expressions is used to compute the degree of financial leverage at a particular level of earnings before interest and tax (EBIT)? Assume that the preferred stockholders receive no dividends.
A) Earnings before interest and tax ÷ Earnings per share (EPS)
B) Gross profit ÷ Earnings before interest and tax
C) Sales ÷ (Earnings before interest and tax - Interest)
D) Earnings before interest and tax ÷ (Earnings before interest and tax - Interest)
E) (Earnings before interest and tax - Interest - Taxes) ÷ Number of shares

Question

Quizplus · Accepted Answer

The degree of financial leverage is calculated by dividing earnings before interest and taxes (EBIT) by EBIT minus interest. This gives an indication of how much a company's net income will fluctuate with changes in EBIT, and represents the level of financial risk associated with a company's capital structure. Option A is incorrect because EPS is not a relevant factor in calculating the degree of financial leverage. Option B is incorrect because gross profit does not account for interest or taxes. Option C includes sales in the calculation, which is not relevant to calculating the degree of financial leverage. Option E uses taxes and number of shares, which are also not relevant in calculating the degree of financial leverage.

Which of the Following Mathematical Expressions Is Used to Compute