Degree of Combined Leverage (DCL)
Degree of combined leverage is the combination of both operational and financial leverage. It tells the impact of change in sale to the earning per share (EPS). DCL shows us the best combination of operational and financial leverage that is used in the company. It shows the balance between operational risk and financial risk.
Operational risk (DOL) is the analyzing of company operating income (EBIT) due to change in sale. Financial risk (DFL) is the analying of company EPS change due to change in operating income.
A higher level of DCL means the company is facing a higher risk due to a huge impact of sales on earning. One percent decrease in sales can reduce the higher percentage of earning per share (EPS). The profit is very low due to a high fixed cost, so the company needs to increase sales to make good profit. Any change in sales will have significant impact on profit.
On the other hand, a low DCL means the company is having a low risk. Even there is a change in sales, the EPS will not get a huge impact due to a lower sensitivity.
Degree of Combined Leverage Formula
Degree of Combined Leverage Example
Base on the financial statement of company A, we could find the following information:
| Describe | Amount |
|---|---|
| Sale | 1,000,000 |
| Total Variable Cost | 500,000 |
| Total Fixed Cost | 300,000 |
| Interest | 100,000 |
Please calculate the degree of combined leverage
Contribution margin = 1,000,000 – 500,000 = 500,000
EBIT = 1,000,000 – 500,000 – 300,000 = 200,000
DCL = (500,000/200,000) * [200,000/ (200,000-100,000)] = 5 times
It means that if the sale decreases 1%, the EPS will decrease by 5 %. Earning per share will change 5 times of the sale movement.
What is the Degree of Financial Leverage?
Degree of Financial leverage is a financial ratio that measures the sensitivity in fluctuations of a company’s overall profitability to the volatility of its operating income caused by changes in its capital structure. In general, the degree of financial leverage will be higher for companies with a higher proportion of debt in their capital structure.
This is because interest payments on debt are fixed, meaning that they will not fluctuate along with changes in operating income.
As a result, a company with a high degree of financial leverage may find itself in financial difficulty if its operating income decreases.
However, if its operating income increases, the company will see a greater boost to its profitability due to the fixed interest payments on its debt. For this reason, companies must carefully consider their use of debt when making decisions about their capital structure.
Financial leverage is the use of debt to finance the purchase of assets. When used wisely, leverage can be a powerful tool to help grow your business. By using borrowed money to purchase assets, you can increase your return on investment without having to put up any additional capital of your own.
Leverage can also help you to expand your business more quickly than you could if you were relying solely on equity financing. Of course, financial leverage is not without its risks. If the value of your assets decreases, you may find yourself unable to meet your financial obligations. As a result, it is important to carefully consider the risks and rewards of leverage before taking on any debt.
What is Degree of Operating Leverage?
The degree of operating leverage (DOL) is a financial ratio that measures the sensitivity of a company’s earnings before interest and taxes (EBIT) to changes in revenue. A higher degree of operating leverage indicates that a company’s EBIT is more sensitive to changes in revenue. This ratio is used to assess the riskiness of a company’s business model.
A company with a high degree of operating leverage is said to be riskier because a small decrease in revenue can have a large impact on profits. However, a company with a low degree of operating leverage is less risky because it can still generate profits even if revenue decreases. The degree of operating leverage is calculated by dividing a company’s EBIT by its revenue.
A company with an EBIT of $10 million and revenue of $100 million would have a DOL of 10. This means that for every 1% decrease in revenue, EBIT would fall by 10%.
Interpretation
- The higher the DOL, the more sensitive EBIT is to changes in sales. A high DOL can be advantageous because it means that a company can generate a large amount of EBIT with only a small increase in sales. However, it can also be risky because a small decrease in sales can result in a large decrease in EBIT. Therefore, companies with a high DOL must carefully manage their business operations to avoid declines in sales that could lead to losses.
- A firm has a low degree of operating leverage if a small change in sales results in a proportionately small change in earnings before interest and taxes (EBIT). In other words, the company’s earnings are not very sensitive to changes in sales. A low degree of operating leverage is often seen as a desirable characteristic because it indicates that the company will be able to continue earning a profit even if sales decline. However, it is important to note that a low degree of operating leverage can also indicate that the company is not growing very rapidly.
- The higher the ratio, the greater the risk that the company will default on its debt obligations. A company with a high degree of financial leverage is more likely to suffer from cash flow problems and unable to meet its financial obligations. If the company’s income decreases, the risk of default increases.
- A low degree of financial leverage indicates that a company has less debt and is, therefore, less risky. This is because a company with less debt is more able to cover its interest payments and other expenses if sales decline. A low degree of financial leverage also gives a company more flexibility in how it uses its cash flow.
