What is the difference between operating leverage, financial leverage and combined leverage?
GradeHunt_TeamGradeHunt Team · · CMA Inter
In CMA Inter FMDA I can apply the leverage formulas but I don't understand what they actually mean. If DOL is 2, what does that tell me? And why is DCL equal to DOL multiplied by DFL?
Leverage shows how a change in one figure is magnified in another because of fixed costs.
1. Operating leverage comes from fixed operating costs. It links sales to EBIT.
DOL = Contribution / EBIT
2. Financial leverage comes from fixed financial charges (interest, and preference dividend if any). It links EBIT to EBT and EPS.
DFL = EBIT / EBT (with preference dividend: EBIT / [EBT - preference dividend / (1 - tax rate)])
3. Combined leverage links sales directly to EBT and EPS.
DCL = DOL x DFL = Contribution / EBT
Worked example:
Sales Rs 10,00,000
Variable cost (60%) Rs 6,00,000
Contribution Rs 4,00,000
Fixed operating cost Rs 2,00,000
EBIT Rs 2,00,000
Interest Rs 50,000
EBT Rs 1,50,000
DOL = 4,00,000 / 2,00,000 = 2
DFL = 2,00,000 / 1,50,000 = 1.33
DCL = 4,00,000 / 1,50,000 = 2.67 (and 2 x 1.333 = 2.67)
What it means: if sales rise 10%, EBIT rises 10% x 2 = 20%, and EBT rises 10% x 2.67 = 26.7%.
Check by redoing the statement at sales of Rs 11,00,000:
Contribution = 4,40,000; EBIT = 4,40,000 - 2,00,000 = 2,40,000 (up 20%)
EBT = 2,40,000 - 50,000 = 1,90,000 (up 40,000 / 1,50,000 = 26.7%)
With tax at a flat rate, EPS also rises 26.7%.
Why DCL = DOL x DFL: DOL turns a % change in sales into a % change in EBIT, and DFL turns that into a % change in EBT. Chaining them gives Contribution/EBIT x EBIT/EBT = Contribution/EBT.
The same magnification works in reverse. A 10% fall in sales cuts EBT by 26.7%, so high leverage means higher risk. A firm with high operating leverage usually keeps financial leverage low so that the combined risk stays manageable.
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