Combined Leverage

Combined leverage examines the total effect of both operating and financial leverage on a company's risk and potential returns. It provides a comprehensive view of how changes in sales translate into changes in earnings per share (EPS).

Core Concepts

• Operating Leverage: Impact of fixed operating costs on EBIT.
• Financial Leverage: Impact of fixed financial charges on EPS.
• Combined Leverage: The combined effect of both types of leverage on EPS sensitivity to sales changes.
• Total Risk: The risk associated with the combined use of operating and financial leverage. It represents the potential for significant swings in EPS due to changes in sales.

Measuring Combined Leverage: Degree of Combined Leverage (DCL)

The Degree of Combined Leverage (DCL) quantifies the overall impact of leverage on a company's profitability.

• DCL Definition: The percentage change in EPS for a given percentage change in sales. It is the product of DOL and DFL.
• Formula: DCL = DOL * DFL

An alternative formula is:

• Contribution Margin / EBIT I

Formula interpretation

This equation provides for percentage change in EPS due to percentage change in sales.

If the degree of operating leverage of a firm is 6, its financial leverage is 2.5 the combined leverage is 15 or 6 * 2.5. Meaning the firm can expect for a 1% sales change, there will be 15% return on EPS. Also combined leverage could go in both directions, if there is a sales increase or sales decrease.

Interpreting the DCL

• High DCL: A high DCL indicates that a small change in sales will result in a large change in EPS. This creates significant potential for increased profits during sales growth but also for substantial losses during sales declines.
• Low DCL: A low DCL suggests that EPS is less sensitive to changes in sales, resulting in more stable but potentially lower returns.

Managing Total Risk: Balancing Operating and Financial Leverage

The DCL helps companies manage their overall risk profile by balancing operating and financial leverage. A company can adjust its financing policy to compensate for changes in operating leverage, and vice versa. Total risk can be managed, but it could vary depending on how it is managed.

• Increased Operating Leverage: If a company invests in riskier assets, increasing its operating leverage, it may need to decrease its financial leverage (by using more equity financing) to keep total risk constant.
• Decreased Operating Leverage: If a company has low fixed costs (low operating leverage), it may be able to afford a more highly leveraged financial plan (more debt) to increase its potential EPS gains without substantially increasing total risk.

Usefulness of DCL

DCL is particularly useful for:

• Assessing the Overall Impact of Leverage: Provides a comprehensive measure of the impact of both operating and financial decisions.
• Choosing Financial Plans: Helps in evaluating the risk and return trade-offs of different financing alternatives for new investments.
• Maintaining Risk Profile: Enables companies to adjust their capital structure in response to changes in operating leverage to maintain a consistent risk profile.

Example: Combining Operating and Financial Leverage

Suppose:

• A company's Degree of Operating Leverage (DOL) = 2
• The same company's Degree of Financial Leverage (DFL) = 3 The company's Degree of Combined Leverage (DCL) = 2 x 3 = 6 Interpretation: This means that for every 1% change in sales, the company's earnings per share (EPS) will change by 6%. A 10% increase in sales will result in a 60% increase in EPS, while a 10% decrease in sales will result in a 60% decrease in EPS.

Conclusion

Combined leverage provides a valuable framework for understanding the overall impact of fixed costs (both operating and financial) on a company's profitability and risk. By carefully managing both operating and financial leverage, companies can optimize their financial performance and maintain a risk profile that aligns with their strategic goals.