 # Degree of Combined Leverage, DCL By Yuriy Smirnov Ph.D.

## Introduction

The degree of combined leverage (DCL) is a ratio that summarizes the effect of both operating and financial leverage. This ratio shows the percentage change in earnings per share (EPS) caused by a 1% change in sales. The higher its value, the more vulnerable a company is for a decrease in sales.

## Low vs. high combined leverage

The combined leverage summarizes the effect of fixed operating costs and fixed financial costs on a company’s earnings per share (EPS). That ratio is a measure of the total risk of a business because it includes both operating risk and financial risk.

A high value DCL ratio means that a large proportion of a company’s total costs are fixed, and incremental sales will result in a higher incremental EPS. Other things being equal such companies have to generate more sales to cover their total fixed costs.

A smaller proportion of fixed operating and financial costs will result in a lower value DCL ratio, which means lower incremental EPS on incremental sales and lower sensitivity to the slippage in sales.

## Formulas and Calculation

In general terms, the degree of combined leverage can be calculated as the percentage change in sales over the percentage change in EPS.

 DCL = % Change in EPS % Change in Sales

It can be alternatively defined as the combined effect of degree of operating leverage (DOL) and degree of financial leverage (DFL).

DCL = DOL × DFL

In terms of DOL and DFL formulas, the formula above can be modified in the following way:

 DCL = Contribution Margin × EBIT = Contribution Margin = S - TVC EBIT EBIT - I EBIT - I S - TVC - FC - I

Here EBIT represents earnings before interest and taxes, S is sales, TVC is total variable costs, FC is fixed cost, and I represents the interest payment.

The formula above must be modified if there are preferred stocks outstanding.

 DCL = S - TVC = Contribution Margin S - TVC - FC - I - D EBIT - I - D 1 - T 1 - T

Here D is preferred dividends, and T is the tax rate.

## Example

Let’s assume that two companies have the following financial results:

Company Y:

• Sales: \$1,000,000
• Total variable operating costs: \$400,000
• Fixed operating costs: \$200,000
• Interest: \$50,000

Company Z:

• Contribution margin: \$400,000
• Earnings before interest and taxes: \$300,000
• Interest: \$75,000
• Preferred dividends: \$35,000
• Tax rate is 30%.

The degree of combined leverage of Company Y is 1.71 and 2.29 for Company Z.

 DFL of Company Y = S - TVC = \$1,000,000 - \$400,000 = 1.71 S - TVC - FC - I \$1,000,000 - \$400,000 - \$200,000 - \$50,000

 DFL of Company Z = Contribution Margin = \$400,000 = 2.29 EBIT - I - D \$300,000 - \$75,000 - \$35,000 1 - T 1 - 0.30

If both companies face a 5% decrease in sales, Company Y loses 8.55% (5 × 1.71) of EPS and Company Z loses 11.45% (5 × 2.29).