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What is Combined Leverage?

Combined Leverage: It is a combination of financial and operating leverage. With the help of it we can find out the effects of fixed operating cost and fixed financial charges on operating profit and earnings per shares respectively. It measures the total risk of a firm. If operating leverage is greater than financial leverage than firm should try to reduce it to maintain the level of risk vice versa.

Formula:
If one income statement:
Combined Leverage = contribution margin / earnings before tax (EBT)
                                               OR
If two income statements:
Degree of Combined Leverage =% change in earnings before tax (EPS) / % change in sales
                                                   
                                                OR
Degree of Combined Leverage (DCL) = DOL*DFL
Where,
DCL = Degree of Combined Leverage
DOL = Degree of Operating Leverage
DFL = Degree of Financial Leverage

Example: Find out the combined leverage from the following information:

Particulars
Percentage %
DOL
3
DFL
1.45

Solution:
Degree of Combined Leverage (DCL) = DOL*DFL
=3*1.45
=4.35
Interpretation: If 1% increases in sales then there is 4.35% increase in EPS.

Example: Two firms X and Y are in a similar business. Find out the total risk.

Particulars
Firm X
Firm Y
Sales @ Rs.20 each
3,50,000
2,80,000
Fixed Cost
40,000
40,000
Variable cost
1,70,000
1,10,000
Tax
40%
40%

Particulars
Firm  X
Firm Y
Debt @ 10%
3,00,000
2,00,000
Equity Rs.100 each
5,00,000
6,00,000
Preference share@7%
1,00,000
1,00,000

Solution:

Particulars
Amount (Rs.) X
Amount (Rs.) Y
Sales
3,50,000
2,80,000
Less: Variable Cost
1,70,000
1,10,000
Contribution margin
1,80,000
1,70,000
Less: Fixed Cost
40,000
40,000
EBIT
1,40,000
1,30,000
Less: Interest
30,000
20,000
EBT
1,10,000
1,10,000
Less: Tax
44,000
44,000
Profit
66,000
66,000
Less: Dividend on preference shareholders
7,000
7000
Shareholders Profit
59,000
59,000
Number of shares
5000
6000
Earnings per share
11.8
9.83
Degree of operating leverage = Contribution Margin / EBIT
1,80,000/1,40,000 = 1.28
1,70,000/1,30,000
=1.30
Degree of Financial leverage = Contribution/ EBT
1,40,000/1,10,000
=1.27
1,30,000/1,10,000
= 1.18

Combined Leverage = DOL*DFL

Firm X:
=1.28*1.27
= 1.62
Interpretation: If 1% increase in sales then 1.62% increase in EPS.

Firm Y:
= 1.30*1.18
= 1.53
Interpretation: If 1% increases in sales then there is 1.53% increase in EPS. So, the firm X has opportunity to give higher EPS in comparison to firm Y.

Example: Find out the combined leverage with the help of given information of following Companies :

Particulars
Company A
Company B
Company C
Company D
Sales
2, 00,000
1, 50, 200
4, 50, 000
4, 10,000
Variable cost
20, 000
----
50, 000
25, 600
Fixed cost
10, 200
30, 000
10, 000
15, 000
Degree of financial leverage
1.32
1.13
1.10
1.20

Solution:

Particulars
Company A
Company B
Company C
Company D
Sales
2, 00,000
1, 50, 200
4, 50, 000
4, 10,000
Less: Variable cost
20, 000
----
50, 000
25, 600
Contribution margin (A)
1, 80,000
1, 50,200
4, 00,000
3, 84,400
Less: Fixed cost
10, 200
30, 000
10, 000
15, 000
Earnings before tax (B)
1, 69, 800
1, 20,200
3, 90,000
3, 69,400
Degree of Operating leverage(C = A/B)
1.06
1.25
1.03
1.04
Degree of financial leverage (given)(D)
1.32
1.13
1.10
1.20
Degree of combined leverage (C*D)
1.40
1.41
1.13
1.25




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