What is the Degree of Combined Leverage (DCL)?
– The Degree of Combined Leverage (DCL) measures how a percent change in sales is amplified into a percent change in earnings per share (EPS) when both operating leverage and financial leverage are present. It summarizes the joint impact of fixed operating costs and fixed financing costs on shareholders’ earnings for a given change in revenue.
Core formulas (definitions first time used)
– DCL = (% change in EPS) / (% change in sales)
– DCL = DOL × DFL
– DOL (degree of operating leverage) = (% change in EBIT) / (% change in sales)
– EBIT = earnings before interest and taxes
– DFL (degree of financial leverage) = (% change in EPS) / (% change in EBIT)
What the DCL tells you
– DCL > 1: EPS moves proportionally more than sales; the firm has leverage that magnifies sales swings into EPS swings.
– Higher DCL implies higher earnings volatility for a given sales fluctuation, which typically signals greater risk because fixed costs (operating and/or financing) must be covered before profits reach shareholders.
– DCL helps managers compare combinations of operating structure (fixed vs. variable costs) and financing mix (debt vs. equity) to assess trade-offs between risk and potential reward.
Step-by-step checklist to compute DCL
1. Choose two comparable periods (e.g., consecutive years or quarters).
2. Collect sales, EBIT, and EPS for both periods.
3. Compute percent changes:
– %ΔSales = (Sales_new − Sales_old) / Sales_old × 100%
– %ΔEBIT = (EBIT_new − EBIT_old) / EBIT_old × 100%
– %ΔEPS = (EPS_new − EPS_old) / EPS_old × 100%
4. Compute DOL = (%ΔEBIT) / (%ΔSales).
5. Compute DFL = (%ΔEPS) / (%ΔEBIT).
6. Compute DCL = DOL × DFL (or directly DCL = (%ΔEPS) / (%ΔSales)).
7. Interpret: for each 1% change in sales, EPS changes by approximately DCL%.
Worked numeric example (recast from the provided case)
– Given:
– Sales: prior = $65 million, current = $80 million.
– EBIT: prior = $40 million, current = $50 million.
– EPS: prior = $2.00, current = $2.50.
1. %ΔSales = (80 − 65) / 65 = 15 / 65 = 0.230769 = 23.08%
2. %ΔEBIT = (50 − 40) / 40 = 10 / 40 = 0.25 = 25.00%
3. %ΔEPS = (2.50 − 2.00) / 2.00 = 0.50 / 2.00 = 0.25 = 25.00%
4. DOL = 25.00% / 23.08% ≈ 1.08
5. DFL = 25.00% / 25.00% = 1.00
6. DCL = DOL × DFL = 1.08 × 1.00 = 1.08
Interpretation: In this example, every 1% change in sales is associated with an approximate 1.08% change in EPS. The combined leverage effect is modestly above 1, indicating some amplification of sales changes into EPS but not extreme volatility.
Important practical notes and assumptions
– These measures use percent changes between two periods, so results depend on the choice of periods and base values. Large percentage changes or very small base figures can distort ratios.
– DCL is a short‑hand sensitivity measure for a particular change in sales; it does not predict future sales or EPS levels by itself.
– The multiplicative identity DCL = DOL × DFL assumes the chain relationship: sales → EBIT → EPS. It applies when the chosen changes are measured consistently.
– A high DCL implies higher potential reward but also greater downside risk. It is one input among many when evaluating capital structure or cost structure decisions.
Quick checklist for interpretation
– DCL close to 1: EPS tracks sales changes roughly one-for-one.
– DCL > 1: EPS is more volatile than sales; check sources of fixed costs (operating or financing).
– DCL < 1: EPS changes less than sales changes; uncommon but possible if financial structure or taxes dampen EPS swings.
Further reading (trusted sources)
– Investopedia — Degree of Combined Leverage (DCL): https://www.investopedia.com/terms/d/dcl.asp
– Corporate Finance Institute — Degree of Combined Leverage (DCL): https://corporatefinanceinstitute.com/resources/knowledge/finance/degree-of-combined-leverage-dcl/
– AccountingTools — What Is the Degree of Combined Leverage?: https://www.accountingtools.com/articles/what-is-the-degree-of-combined-leverage.html
Educational disclaimer
This explainer is for educational purposes only and is not individualized investment advice or a recommendation