What it means
Leverage in finance means amplification. Operating leverage arises from fixed operating costs: rent, salaried staff, depreciation.
Because those costs do not fall when sales fall, a drop in sales flows almost entirely through to operating profit, and a rise in sales does the same in reverse. A business with mostly variable costs has low operating leverage and gentle swings; a business with mostly fixed costs has high operating leverage and violent ones.
Financial leverage arises from fixed financing costs, principally interest on debt. Because interest must be paid whatever operating profit turns out to be, a change in operating profit produces a larger percentage change in the profit left for shareholders.
A company with no debt has a financial leverage of 1; every dollar of interest raises it. Combined leverage multiplies the two.
Sales move, fixed operating costs amplify the move into operating profit, and fixed interest amplifies it again into net profit and earnings per share. The measure explains why some companies' share prices are so much more volatile than their revenues, and why the same business can be safe or reckless depending on how it is financed.
A capital-intensive manufacturer that also borrows heavily is combining two amplifiers; a services firm with low fixed costs and no debt has almost none. Managers use the concept in two directions.
When choosing between a factory (high fixed cost, low variable cost) and outsourcing (low fixed cost, high variable cost), they are choosing a level of operating leverage. When choosing between debt and equity financing, they are choosing financial leverage.
A prudent combination keeps total leverage at a level the business's sales volatility can bear: a company in a cyclical industry with high operating leverage should carry little debt; a utility with stable revenue can afford more.
In practice
Real-world examples.
Example
An airline with high fixed costs (aircraft, crew, airport slots) and heavy debt has a combined leverage above 6, which is why its profits swing from record highs to losses on modest changes in passenger numbers.
Example
A consulting firm with variable staffing and no debt has a combined leverage close to 1.2, so its profit moves roughly in line with fees.
Example
A retailer deciding whether to buy its stores or lease them recognises that buying (with a mortgage) raises both operating and financial leverage at once.
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 Operating Leverage (DOL) = Contribution Margin / Operating Profit (EBIT)
Degree of Financial Leverage (DFL) = EBIT / (EBIT minus Interest)
Degree of Combined Leverage (DCL) = DOL x DFL = Contribution Margin / (EBIT minus Interest)
Worked example. A furniture manufacturer's results at current sales:
- Sales: $10,000,000
- Variable costs: $6,000,000
- Contribution margin: $4,000,000
- Fixed operating costs: $2,500,000
- EBIT: $1,500,000
- Interest: $500,000
- Profit before tax: $1,000,000
DOL = $4,000,000 / $1,500,000 = 2.67
DFL = $1,500,000 / $1,000,000 = 1.50
DCL = 2.67 x 1.50 = 4.0 (check: $4,000,000 / $1,000,000 = 4.0)
Test with a 10% rise in sales to $11,000,000:
- Contribution margin rises 10% to $4,400,000 (variable costs rise with sales)
- EBIT = $4,400,000 minus $2,500,000 = $1,900,000, up 26.7% (the DOL of 2.67 at work)
- Profit before tax = $1,900,000 minus $500,000 = $1,400,000, up 40% (the DCL of 4.0 at work)
Test with a 10% fall in sales to $9,000,000:
- Contribution margin $3,600,000; EBIT $1,100,000 (down 26.7%); profit before tax $600,000 (down 40%)
A further 15% fall in sales from the original level would take profit before tax to $400,000; a 25% fall would take it to zero. The company's cushion against a downturn is exactly 25% of sales.Case study
Seen in the real world.
A specialist chemicals company built a new plant to bring production in-house, replacing variable-cost outsourcing with a fixed-cost facility, and financed it with a $40 million loan. Management modelled the decision on expected sales and showed a healthy return. What it did not model was the change in leverage.
Before the plant, the company's combined leverage was about 1.8; afterwards it was 5.5. When a major customer moved to a competitor and sales fell 12%, EBIT fell 35% and profit after interest fell 66%, triggering a covenant breach. The plant itself was efficient; the company simply had no room for a bad year.
It survived by raising equity to repay half the loan, cutting financial leverage back to a level its new operating leverage could bear. The finance director now presents the degree of combined leverage alongside the return on every capital project, with a stress case showing profit at sales 20% below plan.
Watch out
Common mistakes.
- Adding operating and financial leverage instead of multiplying them. The effects compound.
- Evaluating a fixed-cost investment on its return alone without considering how much it raises the company's sensitivity to sales.
- Assuming leverage only cuts one way. It amplifies gains as much as losses, which is why it is tempting in a rising market.
Questions
People also ask.
What is a good degree of combined leverage?
Low enough that a plausible fall in sales does not threaten solvency. Stable businesses can carry 3 to 5; cyclical ones should stay closer to 2.
How is combined leverage reduced?
By converting fixed costs to variable (outsourcing, flexible staffing, leasing with usage-based terms) or by replacing debt with equity.
Does combined leverage change with sales volume?
Yes. It is highest near the break-even point, where a small change in sales is a large percentage of profit, and falls as sales rise well above break-even.
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