Leverage refers to the number of fixed costs that a company has. These fixed costs could be fixed operating expenses like equipment leases or fixed financing costs, such as interest payment on the debt. Higher leverage leads to more significant variability of the firms after-tax operating earnings and Net Income. A given change in sales could lead to a greater change in operating earnings when the company employs operating leverage; a given change in operating earnings would lead to a more considerable change in net income when the company employs financial leverage. Risk is associated with leverage. Business Risk as the name implies the risk associated with the firm’s operating income and is the result of uncertainty about the firm’s revenues and the expenditure which are necessary to produce those revenues. Financial risk refers to the risk that the common shareholder bears when the firm uses fixed-cost financing like debt. Leverage helps both the firm and the investor to invest or operate with elevated risk. If an investor uses leverage to invest, and the investment moves against the investor, the loss is much higher than as compared to the investment had not been leveraged. In the corporate world, a company can use this technique of leverage to try to produce shareholder wealth, but in case it fails to do so, the interest expense and credit risk of default will eventually destroy shareholder value.
Degree of Total Leverage (DTL)
The Degree of Total Leverage combines the degree of operating leverage and financial leverage. DTL measure the sensitivity of EPS to change in sales. DTL is computed as
DTL= DOL X DFL
= % change in EPS/ % change in Sales
This ratio is used to determine the most optimal level of financial and operating leverage to use in any firm. Since the degree of combined leverage is determined by merging both the financial leverage and the operational leverage, it helps us in determining the total risk of the business. The Operating Leverage measures the business risk or operating risk of the company while Financial Leverage determines the financial risk of the company. Together when coupled, both the financial leverage ratio and the operating leverage ratio can provide an idea of how much risk per share is involved. The Operating leverage is determined by the percentage change in earnings before tax or interest is due, also similarly, financial leverage is determined by the percentage change in the gross before the tax and interest per share are due.
It is on the company to determine the level to maintain the degree of combined leverage to reduce the risks involved in the business. Maintaining the risk and not increasing it, the business should try to lower or minimize the financial leverage to balance the operating leverage and by minimizing the operating leverage when the financial leverage is to be balanced. The balanced degree of combined leverage (DCL) presents with an accession in the earnings per share (EPS) of the equity holders which is why it is necessary to calculate Degree of Combined Leverage (DCL) for better knowledge of the position of the company and minimizing the risks of the company.
Degree of Operating Leverage (DOL)
The Degree of Operating Leverage (DOL) is understood as the percentage change in operating income (EBIT) that results from the percentage change in sales. In other words, Operating leverage involves using a high proportion of fixed costs to variable costs in the day-to-day operations of the company. The more the degree of operating leverage, the more volatile will be the EBIT as compared to a given change in sales when all other things remaining the same.
The formula for DOL = Percentage change in EBIT/ Percentage change in sales
To calculate a firm’s DOL for a particular level of unit sales, Q, DOL is:
DOL= Q(P-V)/Q(P-V)-F
where Q= quantity of units sold
P= Price per unit
V = variable cost per unit
F= Fixed Cost
This ratio is very useful as it helps in determining the effects that a given level of operating leverage has on the earnings potential of the firm. It also helps the firm to determine the most appropriate level of operating leverage to maximize the company’s EBIT. It is to be noted that DOL is equal to one if there is no fixed cost.
Degree of Financial Leverage (DFL)
The Degree of Financial Leverage (DFL) is understood as the percentage change in net income (EPS) to the percentage change in EBIT. In other words, it measures the percentage change in EPS for a unit change in earnings before interest and taxes (EBIT)
The formula for DFL= Percentage change in EPS/ Percentage change in EBIT
To calculate For a particular level of operating earnings, DFL is calculated as:
DFL =EBIT / EBIT-Interest
It is to be noted that DFL is equal to one if there is no interest cost. In other words, there is no leverage.
Example:
EBIT= $60,000/-
Interest= $18000/-
Therefore, DFL = EBIT / EBIT-Interest = $60,000/ ($60,000-$18,000) = 1.42
The ratio signifies that the higher the degree of financial leverage, the more volatile is EPS. Since interest is a fixed expense, so the amount of leverage multiples returns and EPS, which is good when operating income is in the upward trend, but it can be problematic during tough economic times when operating income is under pressure. DFL is helpful for the company to assess the amount of debt or financial leverage it should opt for in its capital structure. If operating income is relatively stable, then earnings and EPS would be stable as well, and the company can afford to take on a significant amount of debt. However, if the company operates in a field where operating income is significantly volatile, then it may go for a debt to a bearable level.