What is the degree of combined leverage – DCL?
A degree of combined leverage (DCL) is a leverage ratio that summarizes the combined effect that the degree of operating leverage (DOL) and the degree of financial leverage have on earnings per share (EPS), taking into account a particular variation in sales. This ratio can be used to determine the most optimal level of financial and operational leverage to use in any business.
The formula for the combined degree of leverage is
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What does DCL tell you?
This ratio summarizes the effects of the combination of leverage and operating leverage, and what effect this combination, or variations of that combination, has on company profits. Not all companies use both operational and financial leverage, but this formula can be used if they do.
A company with a relatively high level of combined leverage is considered more risky than a company with less combined leverage, because high leverage means more fixed costs for the company.
Degree of operating leverage
The degree of operating leverage measures the effects of operating leverage on a company’s profit potential and indicates how profits are affected by sales activity. The degree of operating leverage is calculated by dividing the percentage change in the profit of a business before interest and taxes (EBIT) by the percentage change in its sales during the same period.
Degree of financial leverage
The degree of financial leverage is calculated by dividing the percentage change in a company’s EPS by its percentage change in EBIT. The ratio indicates how a company’s EPS is affected by percentage changes in its EBIT. A higher level of financial leverage means that the company has more volatile EPS.
Key points to remember
- The DCL formula summarizes the effects that the combined degree of operating leverage and the level of financial leverage have on a company’s earnings per share, based on a given change in shares.
- The ratio helps a company to discern its best possible levels of operational and financial leverage.
- The formula helps companies understand how combined leverage affects the company’s bottom line.
Example of degree of combined effect
As indicated above, the degree of combined leverage can be calculated by multiplying the degree of operational leverage by the degree of financial leverage. Suppose the hypothetical company SpaceRocket has an EBIT of $ 50 million for the current year and an EBIT of $ 40 million for the previous year, an increase of 25% from one year to the next (YOY ). SpaceRocket reported sales of $ 80 million for the current year and sales of $ 65 million for the previous year, an increase of 23.08%.
In addition, SpaceRocket reported EPS of $ 2.50 for the current year and EPS of $ 2 for the prior year, an increase of 25%. SpaceRocket therefore had an operating leverage of 1.08 and a financial leverage of 1. Therefore, SpaceRocket had a combined leverage of 1.08. For each 1% change in SpaceRocket sales, its EPS would change 1.08%.