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Combined effect of operating and financial leverage - CAPITAL STRUCTURE THEORIES
Financial Management - CAPITAL STRUCTURE THEORIES
Combined effect of operating and financial leverage - CAPITAL STRUCTURE THEORIES
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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 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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