What it means
Every business has costs that do not move with sales, such as rent, salaries and insurance. These fixed operating costs create operating leverage: once sales cover them, each extra dollar of sales drops through to profit quickly, but a sales fall hurts just as quickly.
Borrowing adds a second layer. Interest on debt is a fixed financing cost that must be paid whatever sales do, and that creates financial leverage, which magnifies the effect of changes in operating profit on the profit available to shareholders.
Combined leverage multiplies the two effects together. If operating leverage is 2.5 and financial leverage is 1.5, a 1% change in sales produces roughly a 3.75% change in earnings per share (profit per ordinary share).
This is why a business with high fixed costs and a lot of debt is a risky proposition. When sales are growing it can produce spectacular profit growth, but a modest downturn can wipe out profit entirely and put loan covenants at risk.
Managers use the measure to test their cost structure. Options such as converting fixed costs to variable ones, paying down debt, or choosing leasing over buying all change the balance, and the combined figure shows the net effect on risk.
The measure assumes that costs behave in a straight-line way within the normal range of activity, and that the fixed costs stay fixed. Beyond that range, for example when a new factory has to be opened, the assumptions break down and the calculation should be repeated.
In practice
Real-world examples
Example 1
A budget airline has heavy fixed costs for aircraft leases and crew, and large debts. A 5% fall in passenger numbers cuts its profit by more than 20%, so management watches seat sales daily and adjusts schedules quickly to protect the load factor. The finance team also models the effect of a fuel price rise on the same cost base.
Example 2
A software company with almost no debt but high fixed development costs has a high operating leverage and low financial leverage. When it signs an extra $2,000,000 of contracts, most of the revenue becomes profit, but the lack of interest keeps the combined figure moderate. The founders accept that their risk sits mostly in the product, not the balance sheet.
Example 3
A family-owned bakery borrows $300,000 for a new oven line, adding $24,000 of annual interest. The owner calculates that combined leverage will rise from 2.0 to 3.2, which means a quiet winter would hit profit much harder than before. She decides to pay down the loan faster in the first two years.
Think of it
Combined leverage is like a double-edged sword. Both amplifications work together-great on the way up, devastating on the way down.
Formula
Calculation
Degree of combined leverage = Degree of operating leverage x Degree of financial leverage = Contribution margin / (Contribution margin - Fixed operating costs - Interest)
A company has sales of $1,000,000 and variable costs of $600,000, so the contribution margin is $400,000. Fixed operating costs are $250,000, so operating profit is $150,000, and interest is $50,000, leaving profit before tax of $100,000. Operating leverage = $400,000 / $150,000 = 2.67, financial leverage = $150,000 / $100,000 = 1.5, and combined leverage = 2.67 x 1.5 = 4.0, which equals $400,000 / $100,000. If sales rise 10% to $1,100,000, the contribution margin becomes $440,000, profit before tax becomes $140,000, and profit grows by 40%.Case study
Seen in the real world
Stonebridge Fitness is an illustrative, fictional gym operator with four sites. It leases premises on long contracts, employs fixed-salary trainers and borrowed heavily to open its fourth gym, so its combined leverage was about 5.0.
In a growth year, membership rose 8% and profit jumped by roughly 40%, which pleased the owners. The following year a competitor opened nearby, membership fell by 6%, and profit dropped by about 30%, leaving the group struggling to cover its loan payments.
The finance director used the combined leverage figure to explain the swings to the board. In this illustrative story, the group renegotiated two leases to include a turnover-linked rent, repaid part of the loan and brought combined leverage down to about 3.2, accepting slower upside in return for a steadier business. The finance director now presents the combined leverage figure in each quarterly board pack, alongside the break-even sales level.
Watch out
Common mistakes
- Treating leverage as purely a debt concept, when operating costs create just as much sensitivity to sales.
- Using the calculated figure for large changes in sales, when the cost structure may change beyond the normal range.
- Assuming high combined leverage is always bad, when it is a feature that rewards growth and punishes decline.
Questions
People also ask
How is combined leverage different from financial leverage?
Financial leverage only looks at the effect of debt on the profit after interest, whereas combined leverage adds the effect of fixed operating costs.
What is a safe level?
There is no universal number, but lenders watch it closely and prefer lower figures in industries with volatile sales.
Can combined leverage be negative?
Yes, if the business is making a loss the formula can give a negative or meaningless figure, and the calculation is then not helpful. In that case, a break-even analysis is usually more informative.
Watch