Degree of Combined Leverage

The Degree of Combined Leverage (DCL) is a financial metric that evaluates the sensitivity of a company’s earnings before interest and tax (EBIT) to the changes in sales, which demonstrates the impact of both operating and financial leverage. Essentially, it provides a comprehensive measure of leverage by combining operating leverage (DOL) and financial leverage (DFL).

Understanding Leverage

Leverage in finance refers to the use of various financial instruments or borrowed capital—like debt—to increase the potential return on investment. There are two primary types of leverage:

1. Operating Leverage: This refers to the extent to which a company uses fixed costs in its operations. A company with high operating leverage will see a significant change in EBIT with small changes in sales because its fixed costs are relatively large.
2. Financial Leverage: This pertains to the use of debt in the company’s capital structure. Companies with high financial leverage have high levels of debt and thus high-interest obligations. Changes in EBIT will cause larger changes in net income due to the fixed cost of interest.

Calculating Degree of Combined Leverage

The formula for the DCL:

[ \text{DCL} = \frac{\% \text{Change in EPS}}{\% \text{Change in Sales}} ]

Or alternatively:

[ \text{DCL} = \text{DOL} \times \text{DFL} ]

Where:

• DOL (Degree of Operating Leverage): Measures the percentage change in EBIT for a given percentage change in sales.
• DFL (Degree of Financial Leverage): Measures the percentage change in net income for a given percentage change in EBIT.

Detailed Formula Breakdown

1. Degree of Operating Leverage (DOL): [ \text{DOL} = \frac{\% \text{Change in EBIT}}{\% \text{Change in Sales}} ] [ \text{DOL} = \frac{\text{Sales} - \text{Variable Costs}}{\text{Sales} - \text{Variable Costs} - \text{Fixed Costs}} ]

2. Degree of Financial Leverage (DFL): [ \text{DFL} = \frac{\% \text{Change in Net Income}}{\% \text{Change in EBIT}} ] [ \text{DFL} = \frac{\text{EBIT}}{\text{EBIT} - \text{Interest Expenses}} ]

Combining DOL and DFL gives the Degree of Combined Leverage:

[ \text{DCL} = \text{DOL} \times \text{DFL} ] [ \text{DCL} = \left( \frac{\text{Sales} - \text{Variable Costs}}{\text{Sales} - \text{Variable Costs} - \text{Fixed Costs}} \right) \times \left( \frac{\text{EBIT}}{\text{EBIT} - \text{Interest Expenses}} \right) ]

Practical Implications

Significance for Investors

For investors, understanding the DCL of a company offers deeper insights into how various levels of sales will impact earnings:

• Higher DCL: Indicates that the company’s earnings are more volatile and sensitive to changes in sales. This is typically seen in companies with high fixed costs and significant debt levels, potentially increasing financial risk but also the potential for higher returns.
• Lower DCL: Demonstrates that the company has lesser sensitivity to change in sales, implying more stable earnings. Such companies may have lower fixed costs and debt levels, suggesting lower financial risk and generally lower returns.

Business Strategy

Corporations must carefully balance their operating and financial leverage:

• High Operating Leverage: May be beneficial during periods of stable or increasing sales as it magnifies earnings. It, however, can be risky during downturns.
• High Financial Leverage: Can amplify returns on equity but at the cost of increased financial risk and potential insolvency during low earnings periods.

Practical Example

Consider a company XYZ with the following details:

• Fixed Costs: $100,000
• Variable Costs per unit: $20
• Sales price per unit: $50
• Units Sold: 10,000
• Interest Expenses: $30,000

Calculate DOL and DFL:

• Contribution Margin per Unit: $50 - $20 = $30
• Total Contribution Margin: 10,000 units * $30 = $300,000
• Operating Income (EBIT): $300,000 - $100,000 = $200,000

[ \text{DOL} = \frac{\text{Total Contribution Margin}}{\text{Total Contribution Margin} - \text{Fixed Costs}} = \frac{300,000}{300,000 - 100,000} = \frac{300,000}{200,000} = 1.5 ]

[ \text{DFL} = \frac{\text{EBIT}}{\text{EBIT} - \text{Interest Expenses}} = \frac{200,000}{200,000 - 30,000} = \frac{200,000}{170,000} \approx 1.176 ]

[ \text{DCL} = \text{DOL} \times \text{DFL} = 1.5 \times 1.176 \approx 1.764 ]

This means that for every 1% change in sales, the EPS of XYZ is expected to change by approximately 1.764%.

Conclusion

The Degree of Combined Leverage is a vital metric for understanding a company’s financial health and risk profile. By analyzing DCL, investors and management can make more informed decisions about the engineering of their cost structures and capital to navigate the volatile nature of business environments. As such, it is an integral part of financial analysis, risk management, and strategic planning within corporate finance.