Operating and Financial Leverage^87B results in higher levels of EPS; while at levels of EBIT above Rs,9,COO, plan- A
results in higher levels of EPS. The usefulness of this type of analysis is discussed in
Chapter on Capital Structure while discussing methods of evaluating financing plans.Combined Leverage
The operating leverage has its effects on operating risk and is measure by the percentage
change in EBIT due to percentage change in sales. The financial leverage has its
effects on financial risk and is measured by rthe percentage change in EPS due t
percentage change in EBIT. Since both these leverages are closely concerned with
ascertaining the ability to cover fixed charges (fixed-operating costs in the case of
operating leverage and fixed-financial costs in the case of financial leverage), if they
are combined, the result is total leverage and the risk associated with combined leverage
is known as total risk. Symbolically,
DCL = DOL X DFL (14.11)
Where DCL = Degree of combined leverage
DOL = Degree of operating leverage
DFL = Degree of financial leverage
Substituting the values of DOL and DFL, we have:% changeDCL in =EBIT%^ change^ in EPS
% change in sales% change in EBIT¥
DCL = % change in sales% change in EBITDCL = EBIT- 1
Contribution
EBIT- 1EBIT
EBITContribution¥Thus, the DCL measures the percentage change in EPS due to percentage change in
sales. If the degree of operating leverage of a firm is 6 and its financial leverage is 2.5,
the combined leverage of this a firm would be 15(6 X 2.5). That is, 1 per cent change
in sales would bring about 15 per cent change in EPS in the direction of the change in
sales. The combined leverage can work in either direction. It will be favourable if
sales increase and unfavourable when sales decrease because changes in sales will
result in more than proportionate returns in the form of EPS.
The usefulness of DCL lies in the fact that it indicates the effect that sales changes will
have on EPS. Its potential is also great in the area of choosing financial plans for new
investments. If, for example, a firm begins to invest heavily in more risky assets than
usual, the operating leverage will obviously increase. If it does not change its financing