Combined/composite/total leverage measures the relationship between quantity produced and sold and EPS.
Thus, the degree of combined leverage (DCL) is computed as under:
Illustration:
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Calculate the degree of operating leverage, degree of financial leverage and the degree of combined leverage for the following firms and interpret the result:
Solution:
Interpretation and Comments:
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From the above statements, the DOL reveals that if there is a variation in sales by 1%, there is a corresponding variation in EBIT by 2.4%, 2.14% and 1 6% in the case of firm B, Q and R respectively On the other hand, the DFL shows that if EBIT varies by 1% there will be a corresponding variation in EPS by 1.11%, 1.07% and 1% in the case of the firms B. O and R.
Similarly, DCL prove that if sales vary by 1%, there will be a corresponding variation in EBT by 2.67, 2.29 and 1.60 in the case of firm B, O and R respectively.
It is also found from the above table that firm B posses all the three highest leverage followed by Q and R. Moreover the DFL is lower than DOL in all the cases. Combined leverage measures the total risk of the firm. Thus, if the two leverages are high, no doubt, it is a very risky one.
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Thus, if a firm enjoys low financial leverage and high operating leverage the same partly adjust the high operating leverage which has been found in the present problem. Because, we know that a low operating leverage presents lower fixed cost and higher variable cost.
A high financial leverage indicates that the firm increase its ROE after applying debt-financing in its capital structure. So it can be concluded that a firm should always have a high financial leverage corresponding to a low operating leverage. If this is taken into consideration none of the said three firms have faithfully followed the norms.