Combining Operating and Financial Leverage
Operating and financial leverage can be combined into an overall measure called "total leverage. " Total leverage can be used to measure the total risk of a company and can be defined as the percentage change in stockholder earnings for a given change in sales. In other words, total leverage measures the sensitivity of earnings to changes in the level of a company's sales.
Methods For Finding Total Leverage
Total leverage can be determined by a couple of different methods. If the percentage change in earnings and the percentage change in sales are both known, a company can simply divide the percentage change in earnings by the percentage change in sales. Earnings can be measured in terms of EBIT, earnings before interest and taxes, or EPS, earnings per share. While EBIT can be determined by referencing a company's income statement, we can determine earnings per share by dividing the company's net income by it's average price of common shares.
Another way to determine total leverage is by multiplying the Degree of Operating Leverage and the Degree of Financial Leverage.
Total Leverage Equation 1
Total leverage = DOL x DOF
Total Leverage Equation 2
Total leverage = DOL x DOF
Therefore:
Total Leverage Equation 3
TL = Total Leverage. P = Unit Revenue. V = Unit Variable Cost. X = Units Sold. FC = Fixed Costs. I = Interest Expense.
Fully derived, we see that to multiply Degree of Operating Leverage and Degree of Financial Leverage, we subtract fixed costs and interest expense from the total contribution margin (revenue minus variable cost times the number of units sold), and divide total contribution margin by this result. Companies usually choose one form of leverage over the other when analyzing potential investments. One that utilizes both forms of leverage undertakes a very high level of risk.