Combined Leverage

What is Combined Leverage (CL)?

Combined leverage (OL + FL) is expected to take care of the total risk of the company, i.e., the risk arising out of operating leverage and the risk arising out of financial leverage and their net effect on the EPS. As we know already, operating leverage has its effects on operating risk (i.e., percentage change in EBIT due to percentage change in sales), and financial leverage has its effects on financial risk (i.e., percentage change in EPS due to percentage change in EBIT). Since both these leverages are related and have an effect on EPS, if combined leverage is obtained, it will indicate the total risk of the company. Hence, finance managers may resort to calculating combined leverage to make their decisions more precise and advantageous.

Formula to Calculate Combined Leverage (CL)

Combined leverage is calculated by using the following formula:

Formula-to-calculate-combined-leverage

Alternatively, We can calculate the Degree of CL:

Formula-to-calculate-degree-of-CL

Example

The following example explains the combined leverage.

EREHWON Company Ltd. has sold 2,000 units at $10 per unit. The variable cost of the company is per unit and the fixed cost is equal to $2,000. The debt burden is 10% on 400 bonds of $10 each and the equity capital consists of 300 shares of $10 each. The company is expected to come under the tax bracket of 50%. Calculate:

  1. EBIT and EPS
  2. Combined leverage.

Assuming that the company has increased sales by 10%, comment on the performance.

Calculation

Example-CL

EPS = Earnings available to equity shareholders / Number of equity shares

= 1,800 / 300 = 6

= 2,100 / 300 = 7

CL = % Change in EPS (increase is from $6 to $7) / % Change in sales (increase is 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

Comment

The percentage change in sales is 10% (from 2,000 units to 2,200 units), whereas the percentage change in EPS is 16.67% (1/6 x 100) approximately. This indicates that every 1% change in sales level results in 1.67% change in EPS. This is positive leverage as the changes in the sales and in EPS are changing in the same direction positively, i.e., higher than break-even level.

In conclusion, it can be inferred that the following:

  1. The variation in operating leverage is due to the operating fixed cost over a range of volume of sales.
  2. The variation in financial leverage is due to the fixed financial charges to be incurred in the company’s capital structure.
  3. The combined leverage indicates the net effect on EPS due to operating leverage and financial leverage — may be both of them being positive or one is positive and another is negative or both are negative or both are at an indefinable state (break-even level).

However, the concept of leverage helps the financial manager in measuring the effect of change in the volume of sales (OL), in measuring the effect of change due to fixed financial charge in the capital structure (FL) and in establishing the relationship between operating leverage and financial leverage and their net effect on EPS (CL).

Example

Capital structure of Sigma Limited has total capital of $500,000 consisting of $300,000 of 6% debentures and $200,000 of equity shares of $100 each. The company currently sells 50,000 units @ $8 per unit. Variable cost is $3 per unit. Fixed cost is $80,000. The company comes under 50% corporate tax bracket. In the coming financial year the company expects an increase of 20% in the sales volume.

Calculate EPS and the leverages.

Solution

Calculation of EPS and Leverage

Combined-Leverage-Example

Calculation-of-EPS-CL

Inference: The percent change in EPS is much higher (32.9%) than the percent change in EBIT (29%) and the percent change in sales volume (20%). Therefore, the future plan is considered to be viable.

Calculation of Leverage

Calculation-of-Leverages

Inference: Though EPs is favorable in the future plan, the combined leverage is not favorable. Since there is an influence of the financial leverage on the combined leverage, it shows that the company os not utilizing its borrowing capacity properly and fully. Therefore, the manager should be cautious in implementing the future plan.

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