Degree of Combined Leverage

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Degree of Combined Leverage (DCL)

The Degree of Combined Leverage (DCL) measures how a percentage change in sales is expected to affect earnings per share (EPS) by combining the effects of operating leverage and financial leverage. It helps assess how sensitive a firm’s EPS is to changes in sales and aids in evaluating the trade-off between risk and return from fixed operating and financing costs.

Formula

DCL = (% change in EPS) / (% change in sales) = DOL × DFL

where:
* DOL = Degree of Operating Leverage = (% change in EBIT) / (% change in sales)
* DFL = Degree of Financial Leverage = (% change in EPS) / (% change in EBIT)

What the components mean

  • Degree of Operating Leverage (DOL): Shows how operating income (EBIT) responds to changes in sales. High operating leverage means a larger proportion of fixed operating costs, so EBIT is more sensitive to sales fluctuations.
  • Degree of Financial Leverage (DFL): Shows how EPS responds to changes in EBIT. High financial leverage indicates more fixed financing costs (interest), making EPS more volatile relative to EBIT.

Interpretation

  • DCL indicates the combined sensitivity of EPS to sales changes: a DCL of 1.5 means a 1% change in sales leads to a 1.5% change in EPS.
  • Higher DCL implies greater risk because it reflects higher fixed costs (operating and/or financing) that amplify earnings swings.

Example

SpaceRocket:
* Sales: $65M → $80M = +23.08%
EBIT: $40M → $50M = +25.00%
 EPS: $2.00 → $2.50 = +25.00%

Calculate:
* DOL = 25.00% / 23.08% ≈ 1.08
DFL = 25.00% / 25.00% = 1.00
 DCL = DOL × DFL = 1.08 × 1.00 = 1.08

Interpretation: For every 1% change in sales, SpaceRocket’s EPS is expected to change by approximately 1.08%.

Key takeaways

  • DCL = DOL × DFL summarizes the combined impact of operating and financial leverage on EPS sensitivity to sales changes.
  • It helps firms evaluate optimal levels of fixed operating and financing commitments.
  • A higher DCL signals greater potential reward but also greater risk due to amplified earnings volatility.

Caveats

  • DCL is an approximation that assumes proportional percentage changes and may be less accurate for large changes or when nonlinearity, taxes, or one-time items are significant.