Operating, financial and combined leverage
Build a contribution-to-EBT statement and read all three leverage ratios straight off it.
Marks
5 marks
Exam time
8 min
Difficulty
Easy
The question
From the following information, compute the degree of operating leverage, the degree of financial leverage and the degree of combined leverage. Sales ₹10,00,000; variable cost ₹6,00,000; fixed cost ₹2,00,000; interest ₹50,000.
- Given
- Sales = ₹10,00,000Variable cost = ₹6,00,000Fixed cost = ₹2,00,000Interest = ₹50,000
Formulas used
- DOL = Contribution ÷ EBIT
- DFL = EBIT ÷ EBT
- DCL = Contribution ÷ EBT = DOL × DFL
Step-by-step working
01Build the income statement
2Sales ₹10,00,000 Less: Variable cost ₹ 6,00,000 ────────── Contribution ₹ 4,00,000 Less: Fixed cost ₹ 2,00,000 ────────── EBIT ₹ 2,00,000 Less: Interest ₹ 50,000 ────────── EBT ₹ 1,50,000Every leverage figure is a ratio of two lines in this statement. Write the statement first and the three ratios become one line each.
02Degree of operating leverage
1DOL = Contribution ÷ EBIT = ₹4,00,000 ÷ ₹2,00,000 = 2.00 timesA 1% change in sales moves EBIT by 2%.
03Degree of financial leverage
1DFL = EBIT ÷ EBT = ₹2,00,000 ÷ ₹1,50,000 = 1.33 timesA 1% change in EBIT moves EBT — and therefore EPS — by 1.33%.
04Degree of combined leverage
1DCL = Contribution ÷ EBT = ₹4,00,000 ÷ ₹1,50,000 = 2.67 times Check: DOL × DFL = 2.00 × 1.33 = 2.67 ✓Compute DCL directly and verify against the product. If they disagree, one of the earlier two ratios is wrong.
DOL · DFL · DCL
2.00 · 1.33 · 2.67 times
Where marks are lost
- Using EBIT instead of contribution in the numerator of DOL.
- Deducting preference dividend before EBT when the question does not mention one.
- Treating fixed cost and interest as interchangeable — fixed cost drives operating leverage, interest drives financial leverage.
- Reporting leverages as percentages. They are ratios expressed in times.
In the exam
Leverage questions are often paired with a follow-up asking the effect of a stated percentage change in sales on EPS. That is just DCL multiplied by the percentage change — one line, and frequently two marks.
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Talk to usWhat does a high combined leverage mean?
That earnings are very sensitive to sales. Here a 10% fall in sales would cut earnings before tax by roughly 26.7%. High combined leverage magnifies both good and bad years, which is why it is read alongside the stability of the company's revenue.
Does preference dividend affect financial leverage?
It does when the question asks for leverage in terms of EPS, because preference dividend is a fixed charge on earnings available to equity. Adjust it on a pre-tax basis. If the question is silent, use the plain EBIT ÷ EBT form as above.
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