The degree of total leverage, which is a way to measure the total leverage of the firm, refers to the relationship between sales revenue and EPS. It (financial and operating leverage) is a measure of how potential total fixed costs (fixed operating costs and fixed financial costs) can enlarge the effect that change in sales (P*Q) has on EPS (earnings per share).
When does a firm have total leverage?
If the (DTL) is greater than 1, than total leverage exists (which is the case as long as the company has fixed operating or/and financial costs). Due to total leverage (existence of fixed operating or/and financial costs), any increase in sales will result in an even larger increase in EPS and any decrease in sales will result in an even larger decrease in EPS. The higher the fixed financial and operating costs, the higher the (DTL). There are three approaches to calculate the (DTL):
1st approach to calculate the (DTL)
To calculate the (DTL), we can utilize the following formula:
(DTL) =% change in EPS / % change in sales
Test yourself
ABC has a change in operating profit of 70%, change in EPS of 310% and change in sales of 60%.
Required:
Find the degree of operating leverage, the degree of financial leverage and the degree of total leverage.
Solution:
Degree of operating leverage:
DOL =% change in EBIT / % change in sales DOL =70%/60% DOL =1.17
Degree of financial leverage:
DFL =% change in EPS / % change in EBIT DFL =310%/70% DFL =4.43
(DTL):
DTL =% change in EPS / % change in sales DTL =310%/60% DTL =5.17
2nd approach to calculate the (DTL)
If we have data on the degree of operating leverage and degree of financial leverage, then the (DTL) can be calculated as follows:
(DTL) = DOL * DFL
Test yourself:
ABC has a change in operating profit of 70%, change in EPS of 310% and change in sales of 60%.
Required:
Find the (DTL) using the second approach.
Solution:
Firstly, we need to find the degree of operating leverage and the degree of financial leverage.
Degree of operating leverage:
DOL =% change in EBIT / % change in sales DOL =70%/60% DOL =1.17
Degree of financial leverage:
DFL =% change in EPS / % change in EBIT DFL =310%/70% DFL =4.43
Now, we can calculate the degree of total leverage.
(DTL):
DTL=DOL*DFL
DTL=1.17*4.43
DTL=5.18
Note that this is aligned with the answer that we obtained while using 1st approach above for calculation of the degree of total leverage.
3rd approach to calculate the (DTL)
There is another formula that can be used to calculate the (DTL). A third approach to calculate the (DTL) is a more direct technique. The formula is as follows:
(DTL) at base sales level Q =
Q*(P-VC)/Q*(P-VC)-FC-I-(PD*1/1-T)
WHERE:
Q – sale quantity in units
P – sale price per unit
VC – variable operating cost per unit
FC – fixed operating cost per unit
I – interest
PD – preferred stock dividends
T – tax rate
Test yourself:
ABC Corporation ascertained that Q=1800, P=$8, VC=$3, FC=$1300, I=$1,800, PD=$3,000 and the tax rate is 40%.
Required:
Find the (DTL) using a more direct formula for calculation.
Solution:
The calculation of the (DTL) of ABC Corporation will be as follows:
Degree of total leverage at base sales level Q = 1800*(8-3)/1800*(8-3)-1300-1800-(3000*1/1-.4)
Degree of total leverage at base sales level Q = 9000/900
Degree of total leverage at base sales level Q = 10
Since the result is greater than 1, ABC Corporation has total leverage.
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