Meaning of degree of total leverage
Leverage is a financial ratio of a Company’s debt or borrowed capital to its equity capital. Leveraging is a strategy of borrowing money for a company’s operations, assuming that the returns from the operations will be higher than the cost of the borrowed capital. The degree of total leverage is a ratio that compares the rate of change in a company’s earnings per share (EPS) to a change in its revenues from sales. Another way to calculate this ratio is to multiply the degree of operating leverage with the degree of financial leverage. Therefore, it is also known as the degree of combined leverage.
Degree of Operating Leverage
The calculation of the degree of operating leverage is dependent upon two factors. These factors are Earnings before interest and taxes (EBIT) and sales revenue for two periods or two years. Once these two factors in percentage terms are available, then we derive this ratio or leverage by dividing the change in EBIT by the change in sales. It shows how a change in sales revenue impacts the EBIT or operating income. Also, an assumption is that the fixed costs do not change over the period.
Degree of financial leverage
A company’s EPS or earnings per share and EBIT or earnings before interest and taxes are the two indicators needed for calculation of the degree of financial leverage. These are first converted into percentage terms over two periods or two years. Once these two factors are known in percentage terms., then we derive this ratio or leverage, by dividing the change in EPS with the change in EBIT over the same period. It measures the extent to which a company uses borrowings to earn a higher income and increase its assets. It shows how a change in EBIT by taking additional debt or by changing the capital structure impacts the earnings per share (EPS).
Calculation of degree of total leverage
The following formula can calculate the degree of total leverage (DTL) or Degree of Combined Leverage (DCL):
DTL= Percentage change in EPS / Percentage change in revenues from sales
In other words, DTL= DOL x DFL
Let us suppose that a company XYZ Pvt.Ltd. Had an EBIT of US$ 15 million in the current financial year whereas it was US$ 12 million in the previous fiscal year. Thus, the calculation for the year-on-year increase of EBIT is US$ 15– 12/ 12 x 100= 25%.
The sales revenue during the same period increased from US$150 million to US$180 million. Hence, the percentage change in year-on-year sales is US$ 180- 150/150 x 100= 20%
Also, the company had an EPS of US$7.50 in the current financial year. The previous year EPS of the company was US$ 6. Thus, its year-on-year increase will be US$ 7.50-6/6 x 100= 25%.
Here, the degree of operating leverage or DOL is:
DOL= 25% / 20% = 1.25
Similarly, calculation of the degree of financial leverage or DFL will be:
DFL= 25% / 25%= 1
Therefore, the degree of total leverage or DTL will be:
DTL= 1.25 x 1= 1.25
It means that a 1% change in sales will result in a difference of 1.25% in its earnings per share (EPS).
Importance and interpretation
- A high degree of operating leverage means unpredictability of earnings before interest and taxes for a company, even if other factors remain constant. Also, it means that the proportion of fixed costs is higher in comparison to the variable operating cost. In other words, the company is more capital intensive with higher use of fixed assets in the day-to-day operations of the company.
- The higher the operating leverage, the higher is the business risk for a company.
- Financial leverage helps to magnify the results of debt financing. It means that when the operating income rises, the net income will increase faster. The case will be opposite in case of a falling operating income.
- The degree of total leverage gives third parties and analysts a critical overview of the company’s business, prospects, and operations. The management’s decisions with regards to the use of operating and financial leverage can further guide the analysts regarding the quality of management as well as the company’s prospects.
- Leverage helps to forecast future cash flows and do a risk assessment. Also, it helps to arrive at a suitable discount rate to calculate the present value of the cash flows.
- The concept of degree of total leverage helps to arrive at the breakeven sales quantity. Also, the calculation of the company’s net income at various sales levels becomes possible.