What is the Degree of Combined Leverage (DCL)?
A degree of combined leverage (DCL) is a leverage ratio that encapsulates the combined impact that the degree of operating leverage (DOL) and the degree of financial leverage (DFL) have on Earnings Per Share (EPS), given a particular change in sales. This powerful ratio assists firms in identifying the optimal levels of financial and operating leverage to maximize earnings and minimize risk.
The Formula for the Degree of Combined Leverage
DCL = \frac{\% Change in EPS}{\% Change in Sales} = DOL \times DFL
Where:
- DOL = Degree of Operating Leverage
- DFL = Degree of Financial Leverage
Key Insights
- Unified Impact Measurement: The DCL formula encapsulates the combined effects of operating and financial leverage on a company’s EPS, based on specific shifts in sales.
- Guiding Financial Strategy: This ratio aids organizations in determining the most advantageous levels of operational and financial leverage.
- Holistic Understanding of Leverage: The DCL helps companies grasp the total impact on earnings, promoting informed financial planning.
Analyzing the Degree of Combined Leverage
This ratio is crucial for summarizing the combined effects of financial and operating leverage. Understanding this combination helps corporations gauge how leverage variations affect earnings. High combined leverage signifies more fixed costs and inherently more risk.
Degree of Operating Leverage (DOL)
The degree of operating leverage measures the effect of operating leverage on a company’s earnings potential, reflecting the sensitivity of earnings to sales levels. Calculate DOL by dividing the percentage change in EBIT (Earnings Before Interest and Taxes) by the percentage change in sales over the same period.
Degree of Financial Leverage (DFL)
Degree of financial leverage assesses how a company’s EPS is influenced by changes in EBIT. DFL is calculated by dividing the percentage change in EPS by the percentage change in EBIT. A higher DFL indicates a company has more volatile EPS.
A Real-World Example: SpaceRocket Inc.
Imagine a hypothetical company, SpaceRocket Inc. It reported an EBIT of $50 million for the current fiscal year versus $40 million for the previous fiscal year, demonstrating a 25% increase year over year (YOY). Furthermore, SpaceRocket’s sales surged to $80 million from $65 million, representing a 23.08% increase.
In addition to these metrics, SpaceRocket’s EPS rose to $2.50 from $2, showing a 25% increase. Thus, SpaceRocket had:
- DOL: 1.08
- DFL: 1
Calculating the Degree of Combined Leverage:
DCL = DOL \times DFL = 1.08 \times 1 = 1.08
Therefore, for every 1% change in SpaceRocket’s sales, its EPS alters by 1.08%, showcasing the insightful power of DCL in financial assessment and strategic planning.
Related Terms: operating leverage, financial leverage, earnings per share, EPS, sales growth.
