Degree of Total Leverage
Degree of total leverage is the ratio of percentage change in earnings per share to percentage change in sales revenue. It is also called degree of combined leverage, a measure which incorporates the effect of both operating leverage and financial leverage.
Degree of operating leverage is function of a company’s fixed costs, it tells how a change in sales revenue translates to a change in operating income. On the other hand, the degree of financial leverage is dependent on a company’s interest expense and it measures how a change in operating income converts to a change in net income. Degree of total leverage is the combined effect of both fixed operating costs and fixed financial costs.
Let’s say your company wants to install a new plant using debt. It will increase your fixed costs thereby making EBIT more sensitive to changes in sales. Additional debt will also result in interest expense which will make any drop in EBIT more pronounced. The degree of total leverage is useful in that it tells management by what percentage net income will drop given a 1% drop in sales revenue.
Formula
Degree of total leverage is the product of degree of operating leverage and degree of financial leverage as shown below:
$$ \text{Degree of Total Leverage}=\text{DOL}\times \text{DFL} $$
Where DOL is the degree of operating leverage and DFL is the degree of financial leverage.
It can be established that DOL equals contribution margin (i.e. sales minus variable costs) divided by earnings before interest and taxes (EBIT) and DFL equals EBIT divided by (EBIT minus interest expense I).
$$ \text{Degree of Total Leverage}\\=\frac{\text{Contribution Margin}}{\text{EBIT}}\times\frac{\text{EBIT}}{\text{EBIT}-\text{I}}\\=\frac{\text{Contribution Margin}}{\text{EBIT}-\text{I}} $$
Example
Your company’s EPS is currently $2.1. Estimate your EPS in case of a 5% increase in sales revenue. Your current contribution margin is $20 million, fixed costs are $5 million and interest expense is $3 million.
To find out new EPS level, you first need to work out by what percentage your EPS will change in response to 1% change in sales revenue which equals the degree of operating leverage:
$$ \text{Degree of Total Leverage}\\=\frac{\text{\$20m}}{\text{\$20m}-\text{\$5m}}\times\frac{\text{\$20m}-\text{\$5m}}{\text{\$20m}-\text{\$5m}-\text{\$3m}}\\=\text{1.33}\times\text{1.25}=\text{1.66} $$
$$ \text{EPS after 5%\ increase in revenue}\\=\text{\$2.1}\times(\text{1}+\text{1.66}\times\text{5%})=\text{\$2.27} $$
by Obaidullah Jan, ACA, CFA and last modified on