What it means
Between a company's sales and its earnings per share sit two layers of fixed cost. The first is operating: rent, salaries, depreciation and other costs that do not change with volume.
Because these costs are fixed, a change in sales flows through to operating profit at the contribution margin rather than the net margin, and operating profit changes by a larger percentage than sales. The second layer is financial: interest on debt, and preference dividends, which must be paid whatever operating profit is.
Because interest is fixed, a change in operating profit flows through to profit after interest at more than its own percentage. Each layer is a lever, and the two multiply.
The degree of operating leverage measures the first layer, as the percentage change in operating profit for a given percentage change in sales, and equals contribution divided by operating profit. The degree of financial leverage measures the second, as the percentage change in earnings for a given percentage change in operating profit, and equals operating profit divided by profit after interest.
The degree of combined leverage multiplies them, and the operating profit terms cancel: combined leverage equals contribution divided by profit after interest. It measures the whole chain in one step, from a change in sales to a change in earnings per share.
The number has a direct interpretation. Its reciprocal is the percentage fall in sales that would reduce profit after interest to zero.
A company with combined leverage of 4.0 loses all its earnings if sales fall by 25%; one with combined leverage of 2.0 can absorb a 50% fall. That is the sense in which combined leverage is a measure of risk: it converts the company's cost structure and its capital structure, together, into a statement of how much bad news the earnings can absorb.
It is also a measure of opportunity, since the same multiplier works upwards, and a company with high combined leverage in a rising market sees its earnings grow far faster than its sales. The two components can offset each other, and the combined figure is what a board should manage.
A business with high operating leverage, such as an airline, a steel mill or a software company with large fixed development costs, should carry little financial leverage, because its operating profit is already volatile and adding fixed interest would make its earnings unbearably so. A business with low operating leverage, such as a distributor or a staffing agency whose costs move with volume, can afford more debt, because its operating profit is stable enough to service it.
Many corporate failures involve companies that had high leverage of both kinds at the same time, so that a moderate fall in sales eliminated their earnings and then their ability to pay interest. Combined leverage is measured at a point, for a given level of sales, and it changes as sales move: as sales rise above breakeven and profit grows, the leverage figure falls, and as sales fall towards breakeven it rises towards infinity.
Comparing it across companies or over time therefore requires care, and the figure is best used with the underlying cost and interest data it summarises. It is also based on the linear assumptions of cost-volume-profit analysis, fixed costs that stay fixed and variable costs that stay proportional, which hold over a range of activity rather than at every level.
In practice
Real-world examples.
Example
An airline with combined leverage of 6.0 sees a 5% fall in passenger revenue translate into a 30% fall in earnings, and its board treats the figure as the reason to hold a large cash reserve.
Example
A staffing agency with combined leverage of 1.4 borrows to fund an acquisition, raising its DFL, and its combined leverage moves to 2.1, which the board judges acceptable given the stability of its contribution.
Example
A manufacturer calculates that its combined leverage of 3.5 implies a 29% fall in sales would eliminate its profit, and compares that with the 20% fall it suffered in the last recession.
Think of it
“Combined leverage is double amplification-operating leverage magnifies operating income, then financial leverage magnifies EPS.
Formula
Calculation
Degree of operating leverage (DOL) = Contribution / Operating profit
Degree of financial leverage (DFL) = Operating profit / (Operating profit minus Interest)
Degree of combined leverage (DCL) = DOL x DFL = Contribution / (Operating profit minus Interest)
Also: DCL = Percentage change in earnings per share / Percentage change in sales
Fall in sales that eliminates profit = 1 / DCL
Worked example. A company has sales of $10,000,000, variable costs of 60% of sales, fixed operating costs of $2,500,000 and interest of $500,000.
- Contribution = $10,000,000 minus $6,000,000 = $4,000,000
- Operating profit = $4,000,000 minus $2,500,000 = $1,500,000
- Profit after interest = $1,500,000 minus $500,000 = $1,000,000
- DOL = $4,000,000 / $1,500,000 = 2.67
- DFL = $1,500,000 / $1,000,000 = 1.5
- DCL = 2.67 x 1.5 = 4.0, or directly $4,000,000 / $1,000,000 = 4.0
Check with a 10% rise in sales. Sales $11,000,000; contribution $4,400,000; operating profit $1,900,000; profit after interest $1,400,000, a rise of 40% on the original $1,000,000, as the DCL of 4.0 predicts. A 10% fall gives profit after interest of $600,000, a fall of 40%.
Sales fall that eliminates profit = 1 / 4.0 = 25%. Check: sales $7,500,000; contribution $3,000,000; operating profit $500,000; profit after interest nil.
Alternative structure. If the company had no debt and fixed costs of $2,000,000: DOL = $4,000,000 / $2,000,000 = 2.0; DFL = 1.0; DCL = 2.0; sales would have to fall 50% before profit disappeared. The company's combined leverage of 4.0 is the price of its cost structure and its borrowing together.Case study
Seen in the real world.
A fitness equipment manufacturer had invested in an automated plant that cut its variable costs to 50% of sales but raised fixed operating costs to $14,000,000, and had financed the plant with debt costing $2,000,000 a year in interest. On sales of $40,000,000 its contribution was $20,000,000, its operating profit $6,000,000 and its profit after interest $4,000,000.
Its degree of operating leverage was 3.33, its degree of financial leverage 1.5 and its combined leverage 5.0. The board had approved the plant on the strength of the margin improvement and had not calculated the combined figure.
A 15% fall in sales the following year, to $34,000,000, showed what the number meant. Contribution fell to $17,000,000, operating profit to $3,000,000 and profit after interest to $1,000,000: a 75% fall in earnings from a 15% fall in sales, exactly as a combined leverage of 5.0 implies.
The dividend was cut, the share price fell by more than half, and the bank's interest cover covenant of 2.0 times was breached (operating profit $3,000,000 against interest $2,000,000, cover 1.5 times). A further 5% fall in sales would have eliminated the profit entirely.
The board's response addressed both levers. It moved part of its assembly work to a contract manufacturer, converting fixed cost into variable: fixed operating costs fell to $10,000,000 and variable costs rose to 60% of sales. And it raised $10,000,000 of equity to repay debt, cutting interest to $1,200,000.
On sales of $40,000,000 the new structure gave contribution of $16,000,000, operating profit of $6,000,000 and profit after interest of $4,800,000: the same operating profit as before, higher earnings, and a combined leverage of 16,000,000 / 4,800,000 = 3.33 instead of 5.0. The earnings would now survive a 30% fall in sales rather than a 20% one. The finance director's note to the board observed that the company had given up some of the upside of the automated plant in exchange for a business that could survive an ordinary downturn, and that the combined leverage figure, had it been calculated at the outset, would have shown the trade-off before the market did.
Watch out
Common mistakes.
- Managing operating leverage and financial leverage separately, when it is their product that determines how much a fall in sales hurts earnings; high leverage of both kinds together is the classic pattern of corporate failure.
- Treating the figure as a constant; it changes with the level of sales, rising sharply as sales approach breakeven, and should be recalculated at the relevant volume.
- Reading combined leverage as purely a risk measure; it magnifies gains as well as losses, and a company with high leverage in a growing market earns far more than its sales growth implies.
Questions
People also ask.
What is the difference between operating leverage and financial leverage?
Operating leverage comes from fixed operating costs and measures how operating profit responds to sales; financial leverage comes from fixed interest costs and measures how earnings respond to operating profit. Combined leverage multiplies the two to show how earnings respond to sales.
What is a safe degree of combined leverage?
It depends on the volatility of sales. The reciprocal of the figure is the sales fall the company can absorb before profit disappears; if that is well beyond the worst fall the business has experienced or can plausibly foresee, the leverage is manageable. A company whose sales can fall 25% should not run combined leverage above 3.0 or so.
How can a company reduce its combined leverage?
By reducing fixed operating costs (outsourcing, variable pay, flexible capacity) or by reducing debt and therefore interest. Either lever works, and a company with high operating leverage that cannot easily change should keep its financial leverage low.
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