Two companies can grow sales by the same 10% and see very different changes in profit. The reason is leverage: fixed costs that do not change with sales. Operating leverage comes from fixed operating costs such as rent, salaries and depreciation. Financial leverage comes from fixed financing costs — interest on debt. Both magnify the effect of changes in sales on profit, in good years and bad.
What you will learn
- Calculate the degree of operating leverage (DOL)
- Calculate the degree of financial leverage (DFL)
- Combine them into the degree of combined leverage (DCL)
- Interpret leverage as a measure of risk and opportunity
Operating leverage
A business with high fixed costs and low variable costs — a cement plant, an airline, a software company — has high operating leverage. Once fixed costs are covered, each extra sale adds a large amount to profit; but if sales fall, profit falls sharply because fixed costs remain.
Degree of operating leverage
DOL = % change in EBIT ÷ % change in sales
At a given level of sales: DOL = Contribution ÷ EBIT, where contribution = sales − variable costs and EBIT = contribution − fixed operating costs.
Financial leverage
When a company borrows, interest must be paid regardless of operating profit. Interest is a fixed financial cost, so it magnifies changes in operating profit (EBIT) into larger changes in profit before tax and earnings per share (EPS).
Degree of financial leverage
DFL = % change in EPS ÷ % change in EBIT
At a given level of EBIT (with no preference dividends): DFL = EBIT ÷ (EBIT − Interest)
Combined leverage
Operating and financial leverage multiply together.
Degree of combined (total) leverage
DCL = DOL × DFL = % change in EPS ÷ % change in sales
At a given level of sales: DCL = Contribution ÷ (EBIT − Interest)
Worked example: one company, three measures
A manufacturer sells 10,000 units at 500 each. Variable cost is 300 per unit, fixed operating costs are 1,000,000 and annual interest is 400,000 (illustrative figures).
- Sales: 10,000 × 500 = 5,000,000. Contribution: 10,000 × (500 − 300) = 2,000,000.
- EBIT: 2,000,000 − 1,000,000 = 1,000,000.
- Profit before tax: 1,000,000 − 400,000 = 600,000.
- DOL = 2,000,000 ÷ 1,000,000 = 2.0.
- DFL = 1,000,000 ÷ 600,000 = 1.67.
- DCL = 2.0 × 1.67 = 3.33 (or 2,000,000 ÷ 600,000).
Check with a 10% rise in sales (11,000 units): contribution 2,200,000; EBIT 1,200,000 (+20% = 2.0 × 10%); profit before tax 800,000 (+33.3% = 3.33 × 10%). Because the number of shares and the tax rate are unchanged, EPS also rises by 33.3%.
A 10% fall in sales would cut EBIT by 20% and EPS by 33.3% — leverage works in both directions.
You can check these measures with the ARBIMETRA DOL, DFL and DCL calculators.
Leverage changes with the level of sales
Degree of leverage is not a fixed number for a company; it depends on how far sales are above break-even. Close to the break-even point, EBIT is small and DOL is very large; far above it, DOL approaches 1. A company with DOL of 2.0 at current sales would have a much higher DOL if sales dropped near break-even. This is why leverage measures are most useful together with the margin of safety. The break-even calculator helps here.
Leverage, risk and return
| Low leverage | High leverage | |
|---|---|---|
| Effect of sales growth | Modest profit growth | Rapid profit growth |
| Effect of sales decline | Modest profit decline | Sharp decline; possible losses |
| Business risk | Lower | Higher |
| Suits | Volatile or uncertain markets | Stable, predictable demand |
A company with high operating leverage (heavy fixed costs) usually cannot afford high financial leverage as well, because the combined effect would make earnings extremely volatile. This interaction is one input into capital structure decisions: lenders look at both.
Using leverage in decisions
- Cost structure choices: automating a process raises fixed costs and reduces variable costs, increasing DOL. It pays off if volumes are reliably high.
- Financing choices: borrowing increases DFL. EBIT-EPS analysis shows at what operating profit the extra interest is justified.
- Risk assessment: analysts and lenders use leverage measures to judge how vulnerable a company is to a downturn, together with solvency ratios such as interest coverage.
Limitations
- The measures assume a constant selling price, constant variable cost per unit and fixed costs that do not change — true only within a relevant range.
- Many costs are semi-variable, so splitting them into fixed and variable requires judgement.
- DOL and DFL describe sensitivity at one point; they are not constant for large changes.
- Taxes, preference dividends and changes in share numbers complicate the EPS link in practice.
Common mistakes
- Treating DOL as a permanent characteristic of a company rather than a point estimate.
- Calculating DFL with profit after tax instead of profit before tax.
- Ignoring the downside: high leverage magnifies losses as much as gains.
- Mixing up operating leverage (cost structure) with financial leverage (debt).
Key terms
- Operating leverage — the effect of fixed operating costs on the sensitivity of EBIT to sales.
- Financial leverage — the effect of fixed financing costs on the sensitivity of EPS to EBIT.
- DOL — contribution ÷ EBIT; % change in EBIT for a 1% change in sales.
- DFL — EBIT ÷ (EBIT − interest); % change in EPS for a 1% change in EBIT.
- DCL — DOL × DFL; % change in EPS for a 1% change in sales.
Frequently asked questions
Is high operating leverage good or bad?
Neither by itself. It rewards growth and punishes decline. It suits businesses with stable, high volumes and is risky for those with uncertain demand.
Why does DOL fall as sales rise?
As sales rise above break-even, EBIT grows relative to contribution, so the ratio contribution ÷ EBIT moves towards 1.
How do lenders use financial leverage measures?
They assess how much operating profit could fall before interest becomes difficult to pay, often through interest coverage and debt service coverage ratios.
Key takeaways
- Fixed operating costs create operating leverage: DOL = contribution ÷ EBIT.
- Fixed interest costs create financial leverage: DFL = EBIT ÷ (EBIT − interest).
- Combined leverage DCL = DOL × DFL links changes in sales to changes in EPS.
- Leverage magnifies both gains and losses and is highest near break-even.