The degree of combined leverage is the degree to which a company’s operations are financed by borrowed funds. It is calculated by dividing the sum of a company’s long-term debt and its preferred stock by its total equity. A high degree of combined leverage indicates that a company is more reliant on borrowing to finance its operations, which can increase its risk.

A company’s degree of combined leverage can be a useful tool for assessing its financial health and risk. A high DCL may indicate that a company is more likely to default on its debt obligations if its operations do not generate enough cash flow to cover its interest payments. Conversely, a low degree of combined leverage may indicate that a company has more flexibility to service its debt obligations even if its operations are not generating sufficient cash flow.

## What is a Degree of Combined Leverage?

The degree of combined leverage is the leverage ratio that combines the influence of the Degree of Operating Leverage (DOL) and Degree of Financial Leverage (DFL) on Earnings Per Share or EPS with a specific change in shares. It is used to determine the optimum financial and operational leverage available in a business or organization.

Investors and creditors often use the degree of combined leverage as one metric to assess a company’s financial health and risk. A high degree of combined leverage indicates that a company is more reliant on borrowing to finance its operations, which can increase its risk. As such, the degree of combined leverage is an important factor to consider when assessing a company’s creditworthiness.

## Understanding Combined Leverage

Combined leverage occurs when a company uses multiple forms of leverage, such as financial and operating leverage. The degree of combined leverage is a measure of how much a company’s earnings will change in response to a given change in sales.

- Operating income is a good measure of a company’s profitability. It is equal to a company’s revenue minus its operating expenses. The higher a company’s operating income, the more profitable it is.
- Operating leverage occurs when a company has more fixed costs than variable costs. Fixed cost is the cost that does not change in response to changes in sales. Variable costs are costs that do change in response to changes in sales. The higher a company’s fixed costs, the higher its operating leverage.
- The degree of financial leverage is a measure of how much a company’s earnings will change in response to a given change in its debt. The higher the degree of financial leverage, the greater the earnings response.
- The degree of combined leverage is equal to the degree of operating leverage plus the degree of financial leverage. The degree of combined leverage is the ratio of a company’s fixed costs to its total costs (fixed plus variable).
- The higher the ratio, the greater the leverage and the riskier the company is considered to be. A company with a high degree of combined leverage is more sensitive to changes in revenue than a company with a low degree of combined leverage.
- Combining financial and operating leverage can have a combined effect on a company’s earnings that is greater than the sum of the two effects. The degree of combined leverage will let you gauge a company’s earnings response to changes in sales, given its mix of fixed and variable cost.

## What is Leverage?

The investment strategy of leverage is based on borrowing money in order to enhance the potential return on investment. It’s possible to use it in business, as well as professional trading and even to finance a home. Financial leverage also refers to the amount of debt a firm uses to acquire an asset.

The practice of using borrowed money (debt) to finance an activity or project is known as leverage. As a result, the projected returns on a project are increased. Simultaneously, leverage raises the potential risk if an investment does not work out. When a firm, investment, or property is described as “highly leveraged,” it implies that the same has more debt than equity.

The concept of leverage is used by both investors and enterprises. Investors utilize leverage to boost the returns on their assets. They use instruments such as options, futures, and margin accounts to lever their investments. To invest in assets, businesses can leverage their capital. Hence, you may say that instead of issuing shares to raise money, they may utilize debt financing for investing in company operations in order to enhance shareholder value.

## Calculation of Degree of Combined Leverage

The following formula will help you in calculating the degree of combined leverage

DCL = %Change in EPS / %Change in Sales = DOL * DFL

Where,

- DCL = Degree of Combined Leverage
- EPS = Earnings Per Share
- DOL = Degree of Operating Leverage
- DFL = Degree of Financial Leverage
- Sales = Net Sales

### Example of How to Calculate the Degree of Combined Leverage

Assume that a company’s degree of operating leverage is 1.5 and degree of financial leverage is 2.0. If sales increase by 10%, then what would be the percent change in EPS?

The degree of combined leverage would be-

DCL = 1.5 * 2.0 = 3.0

Therefore, if sales increased by 10%, then EPS would increase by 30%.

## What Does the DCL Tell You?

A high degree of combined leverage indicates that a company is more likely to default on its debt obligations if its operations do not generate enough cash flow to cover its interest payments. A low degree of combined leverage may indicate that a company has more flexibility to service its debt obligations even if its operations are not generating sufficient cash flow.

The degree of combined leverage can be a useful tool for assessing a company’s financial health and risk. However, it is important to remember that the DCL is just one metric among many that should be considered when assessing a company’s creditworthiness. Other factors such as a company’s historical financial performance, industry trends, and macroeconomic conditions also play an important role in determining credit risk.

- When considering the degree of combined leverage, it is also important to remember that a high degree of financial leverage can increase a company’s risk, but it can also lead to higher returns if the company’s operations are successful. As such, the degree of combined leverage is just one factor to consider when assessing a company’s risk and potential return.
- The degree of combined leverage (DCL) indicates the number of a company’s EPS that is attributable to changes in sales. DCL is calculated by multiplying the degree of operating leverage (DOL) by the degree of financial leverage (DFL). A high DCL means that a small change in sales will result in a large change in EPS. This can be either good or bad, depending on whether the sales change is positive or negative.
- A high degree of combined leverage is often considered to be riskier because a small decrease in sales can cause EPS to decline sharply. This can lead to financial distress or even bankruptcy if the company is not able to generate enough cash flow to service its debt obligations. Therefore, investors and creditors often use the degree of combined leverage as one metric to assess a company’s financial health and risk.
- When assessing a company’s degree of combined leverage, it is important to remember that this ratio only measures the sensitivity of EPS to changes in sales. It does not consider other factors that may affect EPS such as changes in costs, prices, or interest rates.

In addition, the degree of combined leverage only provides information about potential risks; it does not predict whether a company will actually experience financial distress. Therefore, the degree of combined leverage should be considered as one metric among many when assessing a company’s creditworthiness.

## The difference amongst Degree of Operating Leverage, Degree of Financial Leverage, and Degree of Combined Leverage

The combined, financial and operating leverage ratio has some notable differences on different grounds, so let us go through them-

### 1. What they measure

The degree of operating leverage measures the sensitivity of a company’s EPS to changes in sales. The degree of financial leverage (DFL) is a financial ratio that measures the sensitivity of a company’s EPS to changes in its capital structure. The degree of combined leverage (DCL) is a financial ratio that measures the sensitivity of a company’s EPS to changes in sales and changes in its capital structure.

While all three ratios measure the same thing (the sensitivity of EPS to changes in sales), they differ in one key respect: the degree of operating leverage only considers the impact of changes in sales, while the degree of financial leverage and degree of combined leverage also consider the impact of changes in a company’s capital structure.

### 2. Calculation

The degree of operating leverage is calculated by dividing the percentage change in EPS by the percentage change in sales. A high degree of operating leverage means that a small change in sales will result in a large change in EPS.

The degree of financial leverage is calculated by dividing the percentage change in EPS by the percentage change in EBITDA. A high degree of financial leverage means that a small change in EBITDA will result in a large change in EPS.

The degree of combined leverage is calculated by multiplying the degree of operating leverage by the degree of financial leverage. A high degree of combined leverage means that a small change in sales will result in a large change in EPS.

### 3. Implications of risk and return

While all three ratios measure the same thing, they each have different implications for a company’s risk and return.

The degree of operating leverage is the most basic measure of a company’s sensitivity to changes in sales. It only considers the impact of changes in sales on EPS and does not take into account the impact of changes in a company’s capital structure.

The degree of financial leverage takes into account the impact of changes in a company’s capital structure on EPS. A high degree of financial leverage can be either good or bad, depending on whether the company is able to generate enough EBITDA to service its debt obligations.

The degree of combined leverage is the most comprehensive measure of a company’s sensitivity to changes in sales and changes in its capital structure. A high degree of combined leverage means that a small change in sales can have a large impact on EPS.

## Pros & Cons of DCL

Some of the notable advantages of DCL are

- Helps to gauge the overall financial risk of a company
- Aids in identifying possible financial distress early on
- Helps assess the degree of financial flexibility a company has

However, DCL also has a few disadvantages, which include-

- It is only one metric among many and should not be used in isolation
- It only measures potential risks and cannot predict actual financial distress
- It does not consider other factors that may affect EPS such as changes in costs or prices.

### Conclusion!

The degree of combined leverage is a financial ratio that measures the sensitivity of a company’s EPS to changes in sales and changes in its capital structure. While it has some advantages, it also has a few disadvantages and should not be used in isolation.

It is quite useful in analyzing the degree of financial risk a company is exposed to and in predicting possible financial distress. However, the degree of combined leverage should not be the only metric used in decision-making as it does not consider other important factors.

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