What Is Combined Leverage (CL)?
Combined leverage (OL + FL) represents a company’s total risk related to operating leverage, financial leverage, and the net effect on the EPS.
Operating leverage affects the operating risk (i.e., the percentage change in EBIT due to the percentage change in sales), and financial leverage impacts the financial risk (i.e., the percentage change in EPS due to the percentage change in EBIT).
Finance managers may calculate combined leverage to make more precise decisions.
Formula to Calculate Combined Leverage (CL)
Calculate combined leverage using the following formula:
Altenratively, calculate the degree of CL using the following:
- EREHWON Company Ltd. sold 2,000 units at $10 per unit.
- The company’s variable cost is per unit, and the fixed cost equals $2,000.
- The debt burden is 10% on 400 bonds of $10 each, and the equity capital comprises 300 shares of $10 each.
- The company should come under the tax bracket of 50%.
- EBIT and EPS
- Combined leverage
Assuming that the company has increased sales by 10%, comment on the performance.
- EPS = earnings available to equity shareholders / number of equity shares.
- = 1,800 / 300 = 6.
- = 2,100 / 300 = 7.
- CL = % change in EPS (increased from $6 to $7) / % change in sales (increased from 2,000 to 2,200 units).
- % change in EPS = 1 ÷ 6 = 16.67%.
- % change in Sales = 200 ÷ 2,000 = 10%.
- = 01667 / 0.10 = 0.167 (appx.).
Therefore, DCL = 1.67.
The percentage change in sales amounts to 10% (from 2,000 units to 2,200 units), whereas the percentage change in EPS amounts to approximately 16.67% (1/6 x 100). Thus, every 1% change in the sales level results in a 1.67% change in EPS.
Positive leverage occurs as the sales and EPS positively change in the same direction, i.e., higher than the break-even level.
Therefore, one can infer:
- The operating fixed cost over a range of volume of sales prompts the variation in operating leverage.
- The fixed financial charges incurred in the company’s capital structure result in financial leverage variation.
- The net effect on EPS occurs due to the operating leverage and financial leverage being positive or negative, one being positive and the other negative or both being in an indefinable state (break-even level).
Leverage helps the financial manager measure the effect of change in the volume of sales (OL) and the changes resulting from the fixed financial charge in the capital structure (FL).
- Sigma Limited has total capital of $500,000, comprising $300,000 of 6% debentures and $200,000 of equity shares of $100 each.
- The company sells 50,000 units @ $8 per unit.
- The variable cost is $3 per unit.
- The fixed cost is $80,000.
- The company comes under the 50% corporate tax bracket.
- In the coming financial year, the company expects an increase of 20% in the sales volume.
Calculation of EPS and leverage.
Inference: The change in EPS is more substantial (32.9%) than that of EBIT (29%) and the sales volume (20%). Therefore, the future plan shows its viability.
Calculation of Leverage
Inference: Though EPS is favorable in the future plan, the combined leverage is not. Financial leverage’s influence on the combined leverage indicates the company’s failure to utilize its borrowing capacity.
Therefore, the manager should show caution in implementing the future plan.
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About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.