The degree of overall leverage is a ratio that compares a corporation’s rate of change in profits per share (EPS) to its rate of change in revenue from sales.
The degree of overall leverage is also known as the “degree of combined leverage” since it takes into account the repercussions of both operating and financial leverage.
Total Leverage Degree Components
The two leverages that that degree of total leverage accounts for are as follows:
Operating leverage is a component of a company’s fixed costs that determines how well sales money is converted into operating profitability. A corporation with a high level of operating leverage can drastically increase its bottom line with only a little increase in revenues because it has efficiently leveraged its operational costs to maximise profits.
Financial leverage is a word that describes how much a corporation uses debt to develop its assets and revenues. Examining a company’s financial leverage exposes the impact on earnings per share of changes in EBIT as a result of taking on more debt.
Calculating the Total Leverage Degree
The following formula can be used to easily state or estimate the degree of total leverage:
Total leverage Equals degree of operating leverage multiplied by Financial leverage level =
Here’s an example of operational leverage:
Contribution margin (Total revenue – Variable costs) / EBIT (EBIT)
Here is an example of financial leverage:
EBIT (earnings before interest and taxes) / EBIT (interest expenses)
Importance and Interpretation
Even if all other factors remain constant, profits before interest and taxes will be volatile in a company with a high degree of operating leverage. It also means that the fixed cost proportion is greater than the variable operating cost proportion. In other words, the company’s day-to-day operations require more money and make greater use of fixed assets.
The more a firm’s operating leverage, the greater its business risk.
Financial leverage magnifies the effects of debt financing. It shows that as operational income increases, net income increases at a faster rate. The situation will be the polar opposite in the case of falling operating income.
The degree of total leverage provides third parties and analysts with critical information about the company’s business, prospects, and operations. Management’s actions regarding the use of operating and financial leverage can further steer management’s quality and the company’s prospects.
Leverage simplifies the estimation of future cash flows and risk analysis. It also helps in establishing an appropriate discount rate to use when estimating the present value of cash flows.
The overall leverage degree idea aids in estimating the breakeven sales amount. The net income of the organisation can also be calculated at various sales levels.
What the Degree of Operating Leverage Can Teach You?
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 helps analysts determine how a change in sales affects the company’s profitability.
Operating leverage is defined as the ratio of a company’s fixed costs to overall costs. 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 high fixed expenses has a high share of sales, a significant increase in sales may result in outsized increases in profitability. A company with low operating leverage has a high proportion of variable costs, implying that it earns a smaller profit per sale but does not need to increase sales as much to cover its lower fixed costs.