Combined leverage refers to the analysis of the combined effect of both operating leverage and financial leverage on a company's earnings before interest and taxes (EBIT) and, ultimately, its net income. It measures the sensitivity of a company's profitability to changes in sales volume. Understanding combined leverage helps stakeholders assess the overall risk and potential returns associated with a company's capital structure and cost structure. Let's explore combined leverage and its implications:
1. Calculation of Combined Leverage: Combined leverage can be calculated by multiplying the operating leverage ratio by the financial leverage ratio. The formula for calculating combined leverage is as follows:
Combined Leverage = Operating Leverage Ratio * Financial Leverage Ratio
2. Impact on Earnings: Combined leverage affects a company's earnings in a similar manner to operating leverage. When a company has both high operating leverage (due to high fixed costs) and high financial leverage (due to high debt), a small change in sales can lead to a significant change in earnings. If sales increase, the combined leverage can magnify the increase in earnings. However, if sales decline, the combined leverage can amplify the decrease in earnings.
3. Profit Sensitivity: Combined leverage makes a company more sensitive to changes in sales or revenue. The presence of both operating leverage and financial leverage means that small changes in sales can have a larger impact on earnings. If sales increase, the higher contribution margin (operating leverage) combined with the interest expense (financial leverage) can result in a higher increase in earnings. Conversely, if sales decrease, the combined leverage can lead to a larger decline in earnings.
4. Risk and Volatility: Higher combined leverage increases a company's risk and volatility. The combination of fixed costs (operating leverage) and debt obligations (financial leverage) makes the company more susceptible to economic downturns or periods of low demand. If sales decline, the company may struggle to cover its fixed costs and interest payments, leading to reduced profitability, financial distress, or even bankruptcy.
5. Breakeven Point: Combined leverage impacts a company's breakeven point, which is the level of sales or production at which total revenues equal total costs. Companies with high combined leverage have a higher breakeven point, as they need to generate a higher level of sales to cover their fixed costs and interest expenses. A higher breakeven point increases the risk of not reaching the necessary sales volume for profitability.
6. Flexibility: Combined leverage affects a company's flexibility in responding to changes in the business environment. Companies with high combined leverage may have less flexibility to adjust their cost structure and debt obligations during economic downturns or periods of low demand. This lack of flexibility can put the company at a disadvantage compared to companies with lower combined leverage.
It's important for companies to carefully manage their combined leverage by balancing their fixed costs, variable costs, and debt obligations. Analyzing the impact of changes in sales on earnings, evaluating the breakeven point, and assessing the company's ability to service its debt are essential when considering the implications of combined leverage. Additionally, understanding the company's risk tolerance and the industry dynamics is crucial for effective management of combined leverage.
To calculate combined leverage, you need to know the operating leverage ratio and the financial leverage ratio. Let's assume we have the following information for a company:
Operating Leverage Ratio: 2.5 Financial Leverage Ratio: 1.8
To calculate the combined leverage, you multiply the operating leverage ratio by the financial leverage ratio. Using the given ratios, the calculation is as follows:
Combined Leverage = Operating Leverage Ratio * Financial Leverage Ratio Combined Leverage = 2.5 * 1.8 Combined Leverage = 4.5
In this example, the combined leverage of the company is 4.5.
The combined leverage value of 4.5 indicates that the company's earnings before interest and taxes (EBIT) are expected to be magnified by a factor of 4.5 due to the combined effect of both operating leverage and financial leverage.
It's important to note that the interpretation of combined leverage depends on the specific context and the company's cost and capital structure. A higher combined leverage value implies a greater sensitivity of earnings to changes in sales or revenue. This means that small changes in sales can have a larger impact on the company's profitability. Consequently, it also signifies a higher level of risk and volatility associated with the company's earnings.
It's recommended to analyze the combined leverage in conjunction with other financial and operational factors to gain a comprehensive understanding of the company's risk profile and potential returns.
