Combined Leverage

Operating leverage arises from fixed operating costs: a change in sales leads to a larger percentage change in operating profit. Financial leverage arises from fixed interest costs: a change in operating profit leads to a larger percentage change in earnings for shareholders. Combined leverage brings the two together.

The degree of combined leverage is the degree of operating leverage multiplied by the degree of financial leverage. For example, if a company's degree of operating leverage is 4 and its degree of financial leverage is 2, its degree of combined leverage is 8. A 5% rise in sales would increase earnings per share by about 40%, and a 5% fall would reduce them by about 40%.

High combined leverage means profits swing sharply with sales, increasing both potential rewards and risks. Companies with high operating leverage, such as manufacturers with large fixed costs, often choose lower debt to limit their total risk.

These measures apply around a given level of sales and change as sales change, so they are best used as approximations.