Total leverage refers to the viable use of all fixed, operating and financial costs, to increase the effect on a company’s earnings per share due to changes in sales.
That is, total leverage is an indicator that compares the exchange rate a company sees in its earnings per share with the exchange rate it sees in sales revenue.
Total leverage can also be called combined leverage because it takes into account the effects of operating leverage and financial leverage.
The degree of operating leverage is a function of a company’s fixed costs, indicating how a change in sales revenue translates into a change in operating income.
On the other hand, the degree of financial leverage is a function of a company’s interest expense, calculating how a change in operating income becomes a change in net income.
Finally, the total degree of leverage is the composite result of fixed operating costs and fixed financial costs.
Total leverage features
Total leverage uses the entire financial statement of income to show the impact that sales have on the final item of net income.
The importance of total leverage is that it serves to assess the effect on earnings available to shareholders from a change in total sales, in addition to exposing the interrelationship between financial and operating leverage.
The two types of leverage that represent the degree of total leverage are as follows:
This portion of a company’s fixed costs reveals how efficiently sales revenue is converted into operating income.
A company with a high level of operating leverage can significantly increase its results with only a relatively small increase in revenue, because it has effectively leveraged its operating costs to maximize profit.
Financial leverage is an indicator that serves to assess the extent to which a company uses debt to increase its assets and net income.
Analysis of a company’s financial leverage shows the impact on earnings per share due to changes in earnings before interest and taxes (EBIT) as a result of additional debt.
Calculation of the degree of total leverage
Total leverage can be explained or calculated simply as: Degree of total leverage = Degree of operating leverage x Degree of financial leverage.
We have that the degree of operating leverage is equivalent to: Contribution Margin / EBIT, where Contribution Margin = (Total Sales – Variable Costs) and EBIT is equal to Contribution Margin minus Total Operating Fixed Expenses.
On the other hand, the degree of financial leverage is equivalent to: Earnings before interest and taxes EBIT / (EBIT – Interest expense).
Total leverage opens the door to make different investments and enter various markets that could not be chosen without the support of third-party financing from foreign capital.
Set percentage change
Determining a company’s overall degree of leverage is important as it helps the company establish the percentage change it can expect in its earnings per share in relation to an increase in sales revenue relative to debt.
Understanding the change in earnings per share is important for any company because it helps corporate management assess the company’s performance and because it shows the revenue the company is generating for its shareholders.
Suppose a company takes out debt to locate a new plant. This will increase your fixed costs, making earnings before interest and taxes (EBIT) more sensitive to changes in sales.
This debt will generate interest expenses, making the reduction in EBIT more pronounced. The degree of total leverage is useful because it tells the company the percentage decrease in its net income before a 1% decrease in sales revenue.
The worst enemy of total leverage is that there is a drop in prices. If a debt has been incurred, it ends up being a pretty bad deal because the debt is not devalued and the income and asset accounts are going down.
There is a risk that losses will multiply if the return on an investment is less than the cost of financing. Losses are typically multiplied depending on the degree of leverage.
Higher operating cost
Products associated with financial leverage pay higher interest rates to correct for the increased risk the investor must assume.
While debt is a source of funding that can help a company grow faster, it should not be forgotten that leverage can raise the level of debt to higher than normal levels, thus increasing risk exposure.
The need to resort to more complex financial tools becomes the need to dedicate more management time, also involving several risks.
Total leverage example
Suppose HSC Company has a current earnings per share (EPS) of $3 and is trying to determine what its new EPS will be if it experiences a 10% increase in its sales revenue. Let us also assume the following:
– Contribution margin is $15 million.
– Fixed costs are $3 million.
– Interest expense is $1.5 million.
The first thing to do to determine the new EPS of the HSC company is to calculate the percentage reaction that the current EPS will have when it faces a 1% change in sales revenue, which is equal to the degree of leverage. The calculation would be:
– Operating leverage = $15 million / ($15 million – $3 million) = 1.25% ñ
– Financial leverage = ($15 million – $3 million) / ($15 million – $3 million – $1.5 million) = 1.14%.
– So total leverage = 1.25% x 1.14% = 1.43%.
Thus, the total leverage of the HSC Company is 1.43%. This amount can be used to allow the company to establish what its new EPS will be if there is a 10% increase in sales revenue. The calculation for the new EPS would be: $3 x (1 + 1.43 x 10%) = $3.43.