Combined Leverage: Assessing Overall Risk with Operating and Financial Leverage

Combined leverage integrates operating and financial leverage to evaluate a firm's total risk exposure. It measures the degree to which a company can magnify its earnings before interest and taxes (EBIT) and net income based on its sales levels.

Combined leverage, also known as total leverage, is the integration of operating leverage and financial leverage. It provides a comprehensive view of a firm’s overall risk exposure by measuring how changes in sales can affect both its operating income (Earnings Before Interest and Taxes or EBIT) and its net income. This concept is crucial for financial analysts and managers in decision-making processes related to capital structure and risk management.

Definition and Formula

Combined leverage is quantified as the combined leverage ratio (CLR), calculated by multiplying the Degree of Operating Leverage (DOL) by the Degree of Financial Leverage (DFL):

$$ \text{CLR} = \text{DOL} \times \text{DFL} $$

Where:

• \(\text{DOL} = \frac{%\ \text{Change in EBIT}}{%\ \text{Change in Sales}}\)
• \(\text{DFL} = \frac{%\ \text{Change in EPS}}{%\ \text{Change in EBIT}}\)

Operating leverage reflects the proportion of fixed costs in a firm’s cost structure, indicating how a change in sales affects EBIT. Financial leverage, on the other hand, measures the impact of fixed financial costs (like interest expenses) on the firm’s net income.

Example Calculation

Suppose a company has:

• Sales of $1,000,000
• Variable costs of $600,000
• Fixed costs of $200,000
• Interest expenses of $50,000

Step 1: Calculate EBIT

$$ \text{EBIT} = \text{Sales} - \text{Variable Costs} - \text{Fixed Costs} = \$1,000,000 - \$600,000 - \$200,000 = \$200,000 $$

Step 2: Determine the DOL

$$ \text{DOL} = \frac{(\text{Sales} - \text{Variable Costs})}{\text{EBIT}} = \frac{(\$1,000,000 - \$600,000)}{\$200,000} = 2 $$

Step 3: Calculate Net Income

$$ \text{Net Income} = \text{EBIT} - \text{Interest Expenses} = \$200,000 - \$50,000 = \$150,000 $$

Step 4: Determine the DFL

$$ \text{DFL} = \frac{\text{EBIT}}{\text{EBIT} - \text{Interest Expenses}} = \frac{\$200,000}{\$200,000 - \$50,000} = 1.33 $$

Step 5: Calculate CLR

$$ \text{CLR} = \text{DOL} \times \text{DFL} = 2 \times 1.33 = 2.66 $$

This means for every 1% change in sales, the company’s EPS will change by approximately 2.66%.

Types of Leverage

Operating Leverage

Operating leverage focuses on the extent to which fixed costs are used in a firm’s operational structure. High operating leverage means a high ratio of fixed costs to variable costs, indicating that small changes in sales can lead to significant changes in EBIT.

Financial Leverage

Financial leverage deals with the company’s use of debt to finance its operations. High financial leverage indicates significant debt use, which can amplify both gains and losses in net income relative to changes in EBIT.

Special Considerations

• Business Risk: High operating leverage increases business risk, depending on sales stability.
• Financial Risk: High financial leverage increases financial risk due to obligations to meet fixed financing costs.
• Optimal Leverage: Firms need to balance operating and financial leverage optimally to maximize returns while managing risks.

Historical Context

The concept of leverage became particularly significant during the early 20th century with the advent of large corporations and sophisticated financial markets. The systematic analysis and integration of operating and financial leverage into combined leverage metrics gained traction in the latter half of the century, contributing to modern financial risk management practices.

Applicability

Combined leverage is essential in:

• Decision Making: Assisting management in choosing an optimal capital structure.
• Risk Assessment: Helping investors evaluate the risk profile of potential investments.
• Performance Analysis: Enabling financial analysts to understand the sensitivity of EBIT and net income to sales fluctuations.

Comparisons

• Lower vs. Higher Leverage: Firms with lower combined leverage ratios are less sensitive to changes in sales compared to those with higher ratios.
• Fixed vs. Variable Costs: Firms with higher fixed costs have higher operating leverage, affecting their combined leverage.

Related Terms

• Operating Leverage: The degree to which fixed costs affect a firm’s operating income.
• Financial Leverage: The extent to which debt financing is used in a firm’s capital structure.
• Degree of Total Leverage (DTL): Another term often used interchangeably with combined leverage.

Frequently Asked Questions

Q: What is a good combined leverage ratio? A: There isn’t a one-size-fits-all answer; it depends on the industry, stability of sales, and overall financial strategy of the firm.

Q: How can a firm manage high combined leverage? A: By restructuring debt, reducing fixed costs, or improving sales stability.

Q: Can combined leverage affect investor perception? A: Yes, high combined leverage may signal higher risk, impacting investors’ decisions.

References

1. Brealey, R.A., Myers, S.C., & Allen, F. (2016). Principles of Corporate Finance. New York, NY: McGraw-Hill Education.
2. Ross, S.A., Westerfield, R.W., & Jaffe, J. (2013). Corporate Finance. New York, NY: McGraw-Hill Education.

Summary

Combined leverage is a critical metric that combines operating and financial leverage to provide a holistic risk assessment. Firms with high combined leverage are more sensitive to changes in sales, which can significantly affect their EBIT and net income. Understanding and managing combined leverage allows companies to make informed financial decisions, optimize their capital structure, and mitigate potential risks, ensuring long-term financial stability and performance.