What does the Degree of Financial Leverage indicate?

The Degree of Financial Leverage (DFL) specifically measures the sensitivity of a company's earnings per share (EPS) to changes in its operating income, which is influenced by the company's capital structure—particularly its use of debt. By employing debt, a company can potentially enhance returns on equity for its shareholders due to the effects of leveraging.

When a company has a higher degree of financial leverage, it is more reliant on borrowed funds to finance its operations and growth prospects. Although using debt can increase returns when business performance is strong, it also amplifies risk since fixed interest payments must be met irrespective of the company's earnings. Thus, understanding DFL is crucial for assessing how leveraged a company is and the associated risks involved, reinforcing the idea that it is fundamentally about reliance on debt rather than equity or other aspects.

In contrast, the other options do not accurately reflect what DFL indicates. For instance, reliance on equity would imply a lower financial risk since equity does not require fixed repayments. Similarly, the concepts of the risk of capital loss and the proportion of cash reserves pertain to different financial metrics and considerations, which do not capture the essence of financial leverage.