Combined Leverage

What is Combined Leverage?

Combined leverage refers to the use of both operating and financial leverage by a company to magnify the potential return (or loss) on its equity due to changes in sales. It’s a key financial concept that helps businesses understand the overall risk of their operations and financing decisions. While leverage can amplify profits, it also comes with increased risk, especially when sales fluctuate.

To fully understand combined leverage, we need to break it down into its two core components: operating leverage and financial leverage. Let’s explore each of these before putting them together into combined leverage.

Operating Leverage

Operating leverage refers to the degree to which a company uses fixed costs in its operations. A company with high operating leverage has a larger proportion of fixed costs relative to variable costs. This can be advantageous when sales are increasing because the fixed costs stay the same while revenues rise, leading to a sharp increase in profits. However, when sales decline, fixed costs remain constant, and profits can fall just as sharply.

For example, consider a manufacturing company that has invested heavily in automated machinery (a fixed cost). Once these machines are running, the cost of producing each additional unit (the variable cost) may be low, meaning that an increase in sales volume results in a larger percentage increase in profit. However, if sales decrease, the company still has to pay for the machinery, which can result in substantial losses.

The key metric to evaluate operating leverage is the degree of operating leverage (DOL), which can be calculated as:

\text{DOL} = \frac{\%\text{ Change in EBIT}}{\%\text{ Change in Sales}}

This formula shows how much a change in sales impacts the company’s earnings before interest and taxes (EBIT). A high DOL means that a small change in sales will result in a large change in EBIT.

Financial Leverage

Financial leverage relates to how a company finances its operations, particularly the extent to which it uses debt. When a company borrows money, it incurs fixed interest payments (debt servicing costs), which can amplify profits (or losses). A company that uses more debt has higher financial leverage. The idea is that if the company’s return on its investments is higher than the cost of debt, shareholders benefit from the increased earnings.

For example, if a company borrows at an interest rate of 5% and can invest that money to generate a return of 10%, the difference benefits the shareholders. However, if the company's return on investment falls below the cost of debt, the opposite happens: interest payments can erode profits or even lead to losses.

The key metric for financial leverage is the degree of financial leverage (DFL), calculated as:

\text{DFL} = \frac{\%\text{ Change in EPS}}{\%\text{ Change in EBIT}}

This formula shows how sensitive the company’s earnings per share (EPS) are to changes in its operating income (EBIT). A higher DFL indicates that a small change in EBIT will lead to a larger change in EPS, reflecting the effect of financial leverage.

Combined Leverage

When operating leverage and financial leverage are used together, they create combined leverage, which measures the overall risk faced by the company. It reflects how sensitive a company's earnings per share (EPS) are to changes in sales. Essentially, combined leverage multiplies the effects of operating and financial leverage, leading to amplified changes in profits or losses.

Combined leverage can be calculated using the following formula:

Degree of Combined Leverage (DCL) = DOL × DFL

This can also be expressed as:

\text{DCL} = \frac{\%\text{ Change in EPS}}{\%\text{ Change in Sales}}

By combining the effects of operating and financial leverage, this formula shows how much a change in sales will impact the company’s earnings per share. A high DCL means that a small change in sales will result in a significant change in EPS, which can be beneficial when sales are rising but risky when sales are falling.

Understanding the Impact of Combined Leverage

To better understand combined leverage, consider a hypothetical example of a company with the following characteristics:

• Fixed costs: $500,000 per year (high operating leverage)
• Variable costs: $50 per unit
• Sales price: $100 per unit
• Interest expense: $100,000 per year (high financial leverage)

If the company sells 20,000 units in a year, its revenue will be $2,000,000. After deducting variable costs ($1,000,000) and fixed costs ($500,000), the company’s EBIT is $400,000. Subtracting interest expenses ($100,000), the company’s net income before taxes is $300,000.

Now, let’s say sales increase by 10%, to 22,000 units. Revenue increases to $2,200,000, while variable costs increase to $1,100,000. Fixed costs remain constant at $500,000, so the new EBIT is $600,000. After subtracting the same $100,000 in interest expenses, the company’s net income before taxes is $500,000.

This 10% increase in sales resulted in a 66.67% increase in net income before taxes—showing the amplifying effect of combined leverage. If sales had decreased by 10%, the reverse would be true, and the company could experience a significant drop in profits.

Risks of Combined Leverage

While combined leverage can boost profits during periods of rising sales, it can also be dangerous during downturns. Companies with high combined leverage are more vulnerable to fluctuations in sales, as both operating and financial leverage amplify changes in earnings. If sales decline, companies with high combined leverage may struggle to cover their fixed costs, which could lead to financial distress or even bankruptcy.

In the example above, if sales had fallen by 10% instead of increasing, the company’s EBIT would have dropped significantly, leading to a much larger percentage decline in net income.

This risk is particularly pronounced for companies in industries with high fixed costs and cyclical demand, such as manufacturing, airlines, and real estate. When times are good, these companies can see their profits soar, but when demand drops, they can face severe financial difficulties.

Managing Combined Leverage

To manage the risks associated with combined leverage, companies need to carefully balance their use of operating and financial leverage. Here are some strategies that companies may use:

1. Adjust the mix of fixed and variable costs: Companies can try to reduce operating leverage by outsourcing certain functions or using variable-cost structures. For example, instead of investing in expensive fixed assets like machinery, a company might lease equipment or hire contractors. This reduces fixed costs, making the company less vulnerable to sales fluctuations.
2. Manage debt levels: Companies can reduce financial leverage by limiting the amount of debt they take on. This may involve refinancing at lower interest rates or using equity financing instead of debt. Reducing financial leverage lowers interest expenses, which can provide a buffer during periods of declining sales.
3. Maintain strong cash reserves: Companies with high leverage—whether operating, financial, or combined—can protect themselves by maintaining adequate cash reserves. These reserves can be used to cover fixed costs and interest payments during periods of low sales.
4. Monitor economic cycles: Since companies with high combined leverage are more sensitive to changes in demand, they must carefully monitor economic and market conditions. In industries that are highly cyclical, businesses may need to adjust their operations or financing strategies to prepare for downturns.

Practical Applications

Combined leverage is a valuable concept for various stakeholders, including:

• Managers: Helps in making informed decisions about capital structure, cost management, and risk exposure.
• Investors: Provides insight into the potential volatility of a company’s earnings and the risks associated with investing in that company.
• Lenders: Assists in assessing a company’s ability to repay debt, especially during times of fluctuating sales.

Understanding combined leverage helps all these parties evaluate the overall financial risk of a company.

The Bottom Line

Combined leverage measures the overall risk that a company faces due to the combined effects of operating and financial leverage. It amplifies changes in a company’s earnings due to fluctuations in sales, creating both potential rewards and risks. Companies with high combined leverage can experience significant gains when sales are rising, but they also face the risk of steep losses when sales decline.

While combined leverage can be beneficial in favorable economic conditions, it also increases a company’s sensitivity to market fluctuations, which means that managing both operational costs and debt levels is critical. By understanding and managing combined leverage, companies can strike the right balance between growth potential and risk exposure.