Degree of Combined Leverage

Definition

The Degree of Combined Leverage (DCL) is a financial metric that assesses the sensitivity of a company’s earnings per share (EPS) to variations in its operating income due to changes in its quantity sold and operating leverage, which includes both fixed and variable costs. DCL considers both financial and operating leverage to provide a more comprehensive view of a company’s total risk profile. It assists in forecasting and measuring the potential risk or profitability associated with a company’s leverage level.

Phonetic

Degree of Combined Leverage: /dɪˈgriː əv kəmˈbaɪnd ˈlɛvərɪdʒ/

Key Takeaways

1. Measures Risk: Degree of Combined Leverage (DCL) is an important financial ratio that helps understand the overall risk a business is exposed to. It combines the effects of operating and financial leverage. Thus, it provides a comprehensive view of the risk associated with a company’s capital structure.
2. Identifies Flexibility: DCL helps in identifying a company’s flexibility in terms of pending obligations. A high DCL indicates higher fixed costs, implying less financial flexibility. The company would then be highly sensitive to changes in sales volume, implying increased potential risks but also high possible returns.
3. A Tool for Decision-Making: DCL can be used as a valuable tool in decision-making. It helps stakeholders in understanding how sensitive a company’s EPS (Earnings Per Share) is to fluctuations in output or sales. Businesses with a lower DCL will generally have more stable earnings, while those with higher DCL have more volatile, but possibly higher, potential earnings.

Importance

The Degree of Combined Leverage (DCL) is a crucial metric in the world of business and finance because it provides a comprehensive measure of a company’s total risk exposure. By simultaneously factoring both operating and financial leverage, it helps in assessing how changes in sales volume will affect a company’s earnings before interest and taxes (EBIT) and earnings per share (EPS). This enables analysts, investors, and managers to understand the potential volatility and risk in the firm’s profitability due to changes in output, sales, or the cost of capital. Therefore, DCL serves as an essential tool for making strategic decisions and risk management in business planning.

Explanation

The Degree of Combined Leverage (DCL) is a noteworthy financial metric used by companies to understand the complete risk profile related to their cost structure. Essentially, it aids in measuring the sensitivity or volatility of a company’s earnings before interest and taxes (EBIT) due to variations in quantity sold. It combines both operating and financial leverage, hence providing a comprehensive perspective on the aggregated risk a firm bears with respect to alterations in its sales quantity. It is a helpful tool for companies when making major decisions about cost management, capital structure, and budgeting.The purpose of DCL is to evaluate the risk and return trade-off, as both high operating leverage (fixed costs) and high financial leverage (debt) can magnify the potential returns but also increase the firm’s risk profile. Furthermore, DCL allows businesses to model different scenarios and assess the impact of various sales levels on profitability. It helps to understand how a change in the company’s sales would affect its earnings and ability to meet financial obligations. Thus, DCL serves as an integral part of risk assessment and financial management in business.

Examples

Degree of Combined Leverage (DCL) is a gauge of how a company’s operating leverage and financial leverage can amplify the effects of changes in sales on the firm’s earnings before interest and taxes (EBIT). It represents the sensitivity of EBIT for a unit change in sales. Here are three real-world examples:1. **Intel Corporation**: This technology company uses a fair degree of financial leverage in the form of debt to finance its operations, R&D projects, and acquisitions. At the same time, Intel’s high operating leverage, which is the result of high fixed costs associated with manufacturing semiconductors, can multiply the effect of changes in sales on their overall earnings. Therefore, Intel has a high degree of combined leverage.2. **Tesla, Inc.**: As a growing automaker, Tesla has significant fixed costs for its production facilities, translating to a high degree of operating leverage. Besides, Tesla also has a substantial amount of debt, signifying a high degree of financial leverage. This makes Tesla’s earnings extremely sensitive to changes in the level of sales, thus exhibiting a high degree of combined leverage.3. **Amazon.com, Inc.**: Amazon operates with a high degree of operating leverage due to its significant fixed costs related to its e-commerce infrastructure and distribution network. While the company uses less financial leverage compared to Tesla, it still has sizable financial obligations, which increases the company’s combined leverage. This makes Amazon’s earnings extremely sensitive to fluctuations in sales levels. Particularly in high-growth industries or for firms investing heavily in capital assets or R&D, the degree of combined leverage may be high. This can amplify the effects of sales changes on EPS, leading to a higher risk but also higher potential returns.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Operating Leverage
• Financial Leverage
• Break-Even Analysis
• Earnings Before Interest and Taxes (EBIT)
• Cost-Volume-Profit Analysis (CVP)

Sources for More Information

• Investopedia
• Corporate Finance Institute
• Accounting Tools
• Financial Express