The degree of overall leverage is a ratio that compares the rate of change in profits per share (EPS) to the rate of change in revenue from sales for a corporation.
Because it considers the consequences of both operating and financial leverage, the degree of total leverage is also known as the “degree of combined leverage.”
Components of the Total Leverage Degree
The following are the two leverages that that degree of total leverage accounts for:
Operating leverage – This component of a company’s fixed costs indicates how well sales revenue is turned into operating income. Because it has effectively leveraged its operational costs to maximise profits, a company with a high level of operating leverage can dramatically raise its bottom line with only a little rise in revenues.
Financial leverage – Financial leverage is a term that measures how much a company uses debt to grow its assets and profits. Examining a company’s financial leverage reveals the impact of changes in EBIT as a result of taking on more debt on earnings per share.
Calculating the Degree Of Total Leverage
The degree of total leverage can be easily stated or estimated using the following formula:
Degree of total leverage = Degree of operating leverage x Degree of financial leverage =
The following is an example of operating leverage:
Contribution margin (Total sales – Variable costs) / Earnings before interest and taxes (EBIT)
The following is an example of financial leverage:
Earnings before interest and taxes (EBIT) / EBIT – interest expenses
Interpretation and Importance
Even if other things remain constant, a corporation with a high degree of operating leverage will have volatility in earnings before interest and taxes. It also signifies that the fixed cost share is higher than the variable operating cost proportion. In other words, the company’s day-to-day activities are more capital demanding, with a higher utilisation of fixed assets.
The larger a company’s operating leverage, the higher its business risk.
The effects of debt financing are amplified with financial leverage. It indicates that as operational income rises, net income climbs at a higher rate. In the case of declining operational income, the situation will be the polar opposite.
The degree of total leverage provides a vital perspective of the company’s business, prospects, and operations to third parties and analysts. The quality of management and the company’s prospects can be further guided by management’s decisions about the usage of operating and financial leverage.
Leverage makes it easier to estimate future cash flows and analyse risk. It also aids in determining an appropriate discount rate for calculating the present value of cash flows.
The concept of total leverage degree aids in determining the breakeven sales quantity. It is also possible to calculate the company’s net income at various sales levels.
What You Can Learn From the Degree of Operating Leverage
If all other variables remain constant, the higher the degree of operational leverage (DOL), the more sensitive a company’s profits before interest and taxes (EBIT) are to fluctuations in sales. The DOL ratio assists analysts in determining how a change in sales would affect the company’s earnings.
The ratio of a company’s fixed costs to its total costs is known as operating leverage. It is used to determine a company’s breakeven point, which is the point at which sales are sufficient to cover all costs and profit is zero.
Because a company with strong operating leverage has a high proportion of fixed costs, a significant increase in sales might result in outsized changes in profits. A company with low operating leverage has a high proportion of variable costs, which implies it gets a lesser profit per sale but doesn’t need to expand sales as much to pay its lower fixed costs.