TOTAL LEVERAGE: CHARACTERISTICS, ADVANTAGES, DISADVANTAGES, EXAMPLE - DUDAS - 2025

The total leverage refers to the feasible use of all fixed costs, both operational and financial, to increase the effect on earnings per share of a company due to changes in sales.

That is, total leverage is an indicator that compares the rate of change that a company sees in its earnings per share with the rate of change that it sees in sales income.

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Total leverage can also be called combined leverage, because it takes into account the effects of both 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 turns into a change in net income.

Finally, the degree of total leverage is the composite result of fixed operating costs and fixed financial costs.

Characteristics of total leverage

Total leverage uses the entire income statement to show the impact that sales have on the bottom line of net profit.

The importance of total leverage is that it serves to evaluate the effect on the earnings available to shareholders due to a change in total sales, as well as to expose the interrelationship between financial and operating leverage.

The two types of leverage that the degree of total leverage represents are:

Operating leverage

This part of a company's fixed costs reveals how effectively sales revenue is converted into operating income.

A company with a high level of operating leverage can significantly increase its bottom line with only a relatively small increase in revenue, because it has effectively leveraged its operating costs to maximize profits.

Financial appeceament

Financial leverage is an indicator used to evaluate the extent to which a company uses debt to increase its assets and net earnings.

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 taking on 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.

The degree of operating leverage is equivalent to: Contribution margin / EBIT, where Contribution margin = (Total sales - Variable costs) and EBIT is equal to the contribution margin minus the total fixed operating expenses.

On the other hand, the Degree of financial leverage is equivalent to: Earnings before interest and taxes EBIT / (EBIT - Interest expense).

Advantage

Total leverage opens the doors to make different investments and enter various markets that could not be chosen if you did not have the backing of third-party financing, from outside capital.

Set percentage of change

Determining the degree of total leverage for a company is important, because it helps the company establish the percentage of change it can expect in its earnings per share relative to an increase in sales revenue over debt.

Understanding the change in earnings per share is important for any company, because it helps corporate management evaluate the company's performance and because it shows the income the company is making for its shareholders.

Suppose that a company takes out a debt in order 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 expense, making any decrease in EBIT more marked. The degree of total leverage is useful because it tells the company the percentage reduction in its net profit in the face of a 1% decline in sales revenue.

Disadvantages

The worst enemy of full leverage is a drop in prices. In the event that a debt has been contracted, it turns out to be a pretty bad business, because the debt is not devalued and the income and asset accounts go down.

There is a risk that losses multiply if the profitability of an investment turns out to be less than the cost of financing. Losses are generally multiplied depending on the degree of leverage.

Increased cost of operation

The products associated with financial leverage pay higher interest rates to offset the increased risk that the investor must assume.

Increased risk

Although debt is a source of financing that can help a company grow more quickly, it should not be forgotten that leverage could increase the level of debt to higher levels than normal, thus increasing exposure to risk.

Greater complexity

The need to resort to more complex financial tools becomes the need to devote additional management time, also involving various risks.

Example of total leverage

Suppose Company HSC 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. Suppose further the following:

- The 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 of reaction that the current EPS will experience in the face of a 1% change in sales revenue, which equals the degree of leverage. The calculation would be:

- Operating leverage = $ 15m / ($ 15m - $ 3m) = 1.25% ñ

- Financial leverage = ($ 15m - $ 3m) / ($ 15m - $ 3m - $ 1.5m) = 1.14%.

- Therefore, total leverage = 1.25% x 1.14% = 1.43%.

Thus, the total leverage for the HSC Company is 1.43%. This value can be used so that the business can establish what its new EPS will be if it has a 10% increase in sales revenue. The calculation for the new EPS would be: $ 3 x (1 + 1.43 x 10%) = $ 3.43.

References

1. Mark Kennan (2020). Degree of Total Leverage Equation. Small Business-Chron. Taken from: smallbusiness.chron.com.
2. CFI (2020). Degree of Total Leverage. Taken from: corporatefinanceinstitute.com.
3. Xplaind (2020). Degree of Total Leverage. Taken from: xplaind.com.
4. OBS Business School (2020). Financial leverage: 2 pros and 3 cons of financial leverage. Taken from: obsbusiness.school.
5. Bryan Salazar López (2016). Total Leverage. ABC Finance. Taken from: abcfinanzas.com.