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