Combined Leverage

This leverage shows the relationship between a change in sales and the corresponding variation in taxable income. If the management feels that a certain percentage change in sales would result in percentage change to taxable income they would like to know the level or degree of change and hence they adopt this leverage. Thus, degree of leverage is adopted to forecast the future study of sales levels and resultant increase/decrease in taxable income. This degree establishes the relationship between contribution and taxable income.

Example:

It should be observed that the leverage is ascertained from a particular sales point. When different levels of sales are adopted, different degrees of composite leverages are obtained. When the volume of sales increases, fixed expenses remains same, the degree of leverage falls. This happens because of existence of fixed charges in the cost structure.

Significance of Operating and Financial Leverage:

These two leverages are used to know the impact on earnings per share and the price-earning ratio. As the financial leverage is more effective on EPS, it is popularly used than operating leverage. The different combination of debt to equity helps the management to maximise the earnings to the equity shareholders. This helps the management to achieve wealth maximisation in the long run.

Continuous increase in the size of the debt increases the financial risks. The majority of earnings will directly goes to meet the interest cost on borrowings. It adversely affects the overall performance of the organisation. Hence, he should evaluate the different mix of capital involving financial risk to the firm.

Operating leverage is based on the principle of marginal costing, where BEP can be calculated at different level of sales. Any increase of sales beyond BEP sales will yield higher operating profit, (fixed cost remain constant). Any change in sales due to the change in operating cost results in higher operating profits. Therefore, operating leverage is said to be “First phase Leverage” which magnifies the profit due to change in sales volume.

The financial leverage is said to be a “Second phase Leverage” as it starts off at the point where the operating leverage stops. These two leverages are properly blended to have profit maximisation and wealth maximisation which are the two objectives of financial management.

Formula:

Combined leverage considers both financial leverage and operating leverage to assess the overall risk and impact on a company’s earnings. The combined leverage can be calculated using the degree of combined leverage (DCL) or the combined leverage ratio.

1. Degree of Combined Leverage (DCL):

DCL = DOL × DFL

Where:

• DOL is the Degree of Operating Leverage.
• DFL is the Degree of Financial Leverage.

The degree of combined leverage provides a measure of how sensitive a company’s earnings per share (EPS) is to changes in sales.

2. Combined Leverage Ratio:

Combined Leverage Ratio = % Change in EPS / % Change in Sales​

The combined leverage ratio is another way to express the combined impact of operating and financial leverage on earnings per share.

These formulas help assess how changes in sales can affect a company’s profitability, factoring in both its operating structure (operating leverage) and financing structure (financial leverage). A higher degree of combined leverage means that a company’s earnings are more sensitive to changes in sales, both positively and negatively.

It’s important to note that while leverage can enhance returns, it also introduces additional risk. Therefore, understanding the combined leverage is crucial for effective risk management and financial decision-making. Companies need to strike a balance between leveraging to maximize returns and maintaining financial flexibility to navigate potential challenges.