The degree of total leverage is a ratio that compares the rate of change in earnings per share (EPS) to the rate of change in revenue from sales. It is a financial metric used to assess a company’s degree of leverage and its ability to generate growth.
In general, a higher degree of total leverage indicates a higher degree of risk. A company with a high degree of total leverage may be more volatile and less predictable than a company with a lower degree of leverage.
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What is Degree of Total Leverage?
The degree of total leverage is the proportional change in net income resulting from a specific variation in revenues. It’s made up of two elements: operating leverage and financial leverage.
It is used for estimating the sensitivity of the net income of a company to the changes in the number of units sold. The DTL can be determined by dividing the percentage change in earnings per share by the percentage change in sales or the percentage change in the number of units sold.
Understanding Degree of Total Leverage
Fixed financial costs, also known as capital structure, are a company’s long-term debt and equity financing. The mix of these funds makes up a company’s total capitalization. A company’s degree of total leverage (DTL) measures the percentage of financing that comes from debt.
Fixed costs are those costs that do not change with an increase or decrease in the level of production. A company’s sales revenue, interest expense, and company’s net income are all examples of fixed costs. Debt financing is a type of financing that a company can use to finance its fixed financial costs. The capital structure of a company is the mix of debt and equity that the company uses to finance its operations.
The degree of total leverage is a measure of the financial risk of a company. It is calculated by dividing the total debt of a company by the sum of the company’s total debt and equity. The higher the degree of total leverage, the higher the financial risk of the company.
Components of the Degree of Total Leverage – Operating and Financial Leverage
1. Operating leverage
Operating leverage is a metric that shows how revenue expansion translates into growth in operating income. It’s a measure of leverage and the degree to which a company’s operating income is volatile. Operating leverage is a cost accounting method that compares the capacity of a company or project to raise operating income by increasing sales.
2. Financial leverage
It is understood as the use of borrowed money (debt) for financing the purchase of assets with the hope that the capital gain or income from the new asset might surpass the cost of borrowing. Financial leverage is a strategy employed by management in order to increase the potential return on equity (ROE). The degree of financial leverage (DFL) is the percentage change in EPS divided by the percentage change in EBITDA.
Calculation and Formula of Degree of Total Leverage
The following formula may be used to calculate the degree of total leverage (DTL)
Degree of total leverage = Degree of operating leverage x Degree of financial leverage
Another way of calculating DTL is
DTL= Percentage change in EPS / Percentage change in sales revenue
Importance of the Degree of Total Leverage
A company’s degree of total leverage is an important financial metric that should be monitored by management and investors. It is a good indicator of risk and can be used to assess the potential volatility of a company’s earnings.
A high degree of total leverage indicates that a company is more leveraged and therefore, riskier. A low degree of total leverage indicates that a company is less leveraged and therefore, less risky.
The degree of total leverage can also be used to assess a company’s ability to generate growth. A higher degree of total leverage indicates a higher degree of growth potential.
However, it is important to remember that a high degree of total leverage also comes with a higher degree of risk. Therefore, companies with a high degree of total leverage should be carefully monitored by management and investors.
How does DTL work?
DTL works by quantifying the degree to which a company’s earnings are sensitive to changes in revenue. The higher the DTL, the more sensitive a company’s earnings are to changes in revenue.
A company with a high degree of total leverage may be more volatile and less predictable than a company with a lower degree of leverage.
The degree of total leverage is made up of two elements: operating leverage and financial leverage.
Operating leverage is a measure of how revenue expansion translates into growth in operating income. It’s a measure of the degree to which a company’s operating income is volatile.
Financial leverage is a measure of how borrowed money (debt) is used to finance the purchase of assets in the hopes that the capital gain or income from the new asset might surpass the cost of borrowing.
Example
Let’s assume that Company A has operating leverage of 2 and financial leverage of 3. The degree of total leverage would be 6. (2 x 3 = 6)
This means that for every 1% increase in revenues, there would be a 6% increase in EPS. However, it also means that for every 1% decrease in revenues, there would be a 6% decrease in EPS.
Thus, the degree of total leverage is a good indicator of risk. Company A is riskier than a company with a degree of total leverage of 3 (3 x 1 = 3).
When assessing the degree of total leverage, it is important to remember that it is only one metric among many. It should not be used as the sole basis for investment decisions. Rather, it should be used in conjunction with other financial metrics to get a complete picture of a company’s financial health.
Combined leverage and Total leverage
The difference between combined leverage and total leverage is important to understand when trying to analyze a company’s financial statements. Combined leverages are the term used to describe the degree to which a company is using debt to finance its operations. Total leverage, on the other hand, looks at the overall financial picture of the company and includes both debt and equity.
When companies have a high degree of combined leverages, it means that it is using more debt than equity to finance their operations. This can be a risky strategy because if the company is not able to make its debt payments, it could default on its loans and face serious financial repercussions. Total leverage, on the other hand, takes into account both debt and equity when looking at a company’s financial picture. This is a more holistic approach and can give you a better idea of the company’s overall financial health.
What the Degree of Total Leverage can tell you?
The degree of total leverage is an important financial metric that should be monitored by management and investors. It is a good indicator of risk and can be used to assess the potential volatility of a company’s earnings.
A high degree of total leverage indicates that a company is more leveraged and therefore, riskier. A low degree of total leverage indicates that a company is less leveraged and therefore, less risky.
The degree of total leverage can also be used to assess a company’s ability to generate growth. A higher degree of total leverage indicates a higher degree of growth potential.
Calculating DTL is important for management in order to make well-informed strategic decisions about the future of the company. It is also important for investors to know a company’s degree of total leverage to make informed investment decisions.
Factors that affect DTL
There are a few key factors that can affect a company’s degree of total leverage
1. The mix of debt and equity financing
A company that is financed primarily with debt will have a higher degree of total leverage than a company that is financed primarily with equity.
2. The interest rate on debt
A higher interest rate will increase the degree of total leverage.
3. The maturity of the debt
Long-term debt will have a greater effect on the degree of total leverage than short-term debt.
4. The tax rate
A lower tax rate will increase the degree of total leverage.
What is an optimal DTL?
There is no one “optimal” degree of total leverage. The right degree of leverage for a company depends on its business model, growth prospects, and risk tolerance.
Pros of DTL
- Can be used to assess risk
- Can be used to assess growth potential
- Can be used to make informed strategic decisions
Cons of DTL
- The high degree of total leverage can be risky
- Should not be used as the sole basis for investment decisions
Conclusion!
On the final note, it is clear that the degree of leverage is an important metric to consider while making investment decisions or taking on new debt.
Although the degree of leverage can give you some insight into a company’s financial health, it should not be the only metric you use.
Be sure to consider other factors such as the company’s business model, growth prospects, and risk tolerance before making any final decisions.
What are your thoughts about the degree of total leverage? Do you think it’s a good metric to consider? Let us know in the comments below!
