The Power of Combined Leverage

What Is Meant by the Acronym “Combined Leverage” (CL)?

The combined leverage of a corporation, which takes into account both its operating and financial leverage, as well as their combined impact on earnings per share, is referred to as “OL + FL.”

Operating leverage has an effect on operating risk, which is defined as the percentage change in EBIT owing to the percentage change in sales; financial leverage has an effect on financial risk, which is defined as the percentage change in EPS due to the percentage change in EBIT. Both types of leverage are referred to as leverage.

In order to arrive at decisions that are more accurate, financial managers may evaluate combined leverage.

Example of Using the Formula to Calculate Combined Leverage (CL)

At a price of $10 per unit, EREHWON Company Ltd. sold a total of 2,000 units.

The variable cost for the business is calculated per unit, whereas the fixed cost is equivalent to $2,000.

The debt load is equal to 10% of the total value of 400 bonds, which are each worth $10, and the equity capital consists of 300 shares, which are each worth $10.

It is anticipated that the corporation will fall within the 50% tax level.

Do the math.

Both the EBIT and EPS

Leverage in combination

Comment on the performance of the company on the assumption that they have raised revenues by 10%.

The formula for computing EPS is as follows: earnings available to equity shareholders divided by the total number of equity shares.

= 1,800 / 300 = 6.

= 2,100 / 300 = 7.

CL equals the percentage difference in EPS (which went from $6 to $7) divided by the percentage change in sales (which went from 2,000 to 2,200 units).

1 multiplied by 6 results in a 16.67% increase in EPS.

% change in Sales = 200 times 2,000, which is 10% change.

= 01667 / 0.10 = 0.167 (appx.).

As a result, DCL equals 1.67.

A remark on:

The change in sales as a percentage equals to 10% (from 2,000 units to 2,200 units), but the change in earnings per share as a percentage amounts to approximately 16.67% (1/6 x 100). Therefore, there is a 1.67% change in earnings per share for every 1% change in the amount of sales.

When sales and earnings per share (EPS) move in the same positive direction, known as being higher than the level at which the company breaks even, positive leverage has occurred.

As a result, the following can be deduced:

The variation in operational leverage is prompted by the operating fixed cost throughout a variety of volume of sales.

The change in the company’s financial leverage is caused by the fixed financial expenses that are incurred as part of the company’s capital structure.

The operating leverage and financial leverage can both be positive or negative, one can be positive while the other is negative, or both can be in an undefinable condition (at the break-even level), and this will have a positive or negative impact on earnings per share.

The financial management is able to more accurately monitor the effect of changes in the volume of sales (OL) and the changes that occur from the fixed financial charge in the capital structure (FL) thanks to the utilization of leverage.

A Primer On

The total capital of Sigma Limited is $500,000, which is made up of $300,000 in debentures with a 6% interest rate and $200,000 in equity shares with a $100 price tag each.

The company has made 50,000 sales at an average price of $8 per unit.

The cost of the variable is three dollars per unit.

The amount that is always required is $80,000.

This means that the corporation is subject to the corporate tax rate of 50%.

In the upcoming fiscal year, the company anticipates a volume of sales that is 20% higher than it was in the previous year.

Inference drawn from the fact that the change in earnings per share (EPS) is 32.9% higher than that of EBIT (29%) and the amount of sales (20%). As a result, the strategy for the future demonstrates its viability.

The inference drawn from the calculation of leverage is that despite the fact that EPS will increase in the future plan, combined leverage will not. The fact that financial leverage has such an impact on combined leverage suggests that the company is not making effective use of its borrowing capacity.

As a result, the management needs to proceed with extreme caution when putting the future plan into action.

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