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Financial Management - CAPITAL STRUCTURE THEORIES

Combined effect of operating and financial leverage - CAPITAL STRUCTURE THEORIES

   Posted On :  20.06.2018 03:12 am

The combined effect of two leverages can be quite significant for the earnings available to ordinary shareholders.

Combined effect of operating and financial leverage
 
The combined effect of two leverages can be quite significant for the earnings available to ordinary shareholders. They cause wide fluctuation in earnings per share for a given change in sales. If a company were to employ a high level of operating and financial leverage, even a very small change in the level of sales will cause significant effect on the earning per share.

Thus the degrees of operating and financial leverages can be combined to ensure the effect of total leverage on earning per share due to a very small change in sales.

The degree of combined leverage is expressed in the following manner

DCL =  (% change in EBIT / % change in sales) x (% change in  EPS / % change in EBIT)

DCL = % change in EPS / % change in sales

Another way of expression of DCL is

DCL = Contribution / (EBIT – INT)

 = Contribution / PBT

 = 1 + (Int + Fixed cost) / PBT 

DCL = (EBIT + Fixed costs) / PBT

Clarity in regard to operating and financial leverage is important because these concepts are important to businesses. Small and medium-sized businesses often have difficulty using the highly sophisticated quantitative methods large companies use.

Fortunately, the simple break-even graph is simple and easy to interpret; yet it can provide a significant amount of information. The algebra necessary to compute operating and financial leverage, too, is not very complex. Unfortunately, it comes in a several guises; not all equally easy to understand or equally useful.
Tags : Financial Management - CAPITAL STRUCTURE THEORIES
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