Degree of Combined Leverage (DCL)

What Is the Degree of Combined Leverage (DCL)?

A degree of combined leverage (DCL) is a leverage ratio that summarizes the combined effect that the degree of operating leverage (DOL) and the degree of financial leverage has on earnings per share (EPS), given a particular change in sales. This ratio can be used to help determine the most optimal level of financial and operating leverage to use in any firm.

The Formula for the Degree of Combined Leverage Is

D C L = %   C h a n g e   i n   E P S %   C h a n g e   i n   s a l e s = D O L    x  D F L where: D O L = Degree of operating leverage D F L = Degree of financial leverage \begin{aligned} &DCL=\frac{\%\ Change\ in\ EPS}{\%\ Change\ in\ sales}=DOL\ \text{ x } DFL \\ &\textbf{where:}\\ &DOL = \text{Degree of operating leverage}\\ &DFL = \text{Degree of financial leverage}\\ \end{aligned} DCL=% Change in sales% Change in EPS=DOL  x DFLwhere:DOL=Degree of operating leverageDFL=Degree of financial leverage

What Does the DCL Tell You?

This ratio summarizes the effects of combining financial and operating leverage, and what effect this combination, or variations of this combination, has on the corporation's earnings. While not all corporations use both operating and financial leverage, this formula can be used if they do.

A firm with a relatively high level of combined leverage is seen as riskier than a firm with less combined leverage because high leverage means more fixed costs to the firm.

Degree of Operating Leverage

The degree of operating leverage measures the effects that operating leverage has on a company's earnings potential and indicates how earnings are affected by sales activity. The degree of operating leverage is calculated by dividing the percentage change of a company's earnings before interest and taxes (EBIT) by the percentage change of its sales over the same period.

Degree of Financial Leverage

The degree of financial leverage is calculated by dividing the percentage change in a company's EPS by its percentage change in EBIT. The ratio indicates how a company's EPS is affected by percentage changes in its EBIT. A higher degree of financial leverage indicates that the company has more volatile EPS.

Degree of Combined Leverage Example

As stated previously, the degree of combined leverage may be calculated by multiplying the degree of operating leverage by the degree of financial leverage. Assume hypothetical company SpaceRocket had an EBIT of $50 million for the current fiscal year and an EBIT of $40 million for the previous fiscal year, or a 25% increase year over year (YOY). SpaceRocket reported sales of $80 million for the current fiscal year and sales of $65 million for the previous fiscal year, a 23.08% increase.

Additionally, SpaceRocket reported an EPS of $2.50 for the current fiscal year, and an EPS of $2 for the previous fiscal year, a 25% increase. SpaceRocket thus had a degree of operating leverage of 1.08 and a degree of financial leverage of 1. Consequently, SpaceRocket had a degree of combined leverage of 1.08. For every 1% change in SpaceRocket's sales, its EPS would change by 1.08%.