Degree of Total Leverage: Combining DOL and DFL | CFA Level I Corporate Issuers

Welcome back as we combine DOL and DFL we learnt in the past 2 lessons, into the degree of total leverage.

What is the Degree of Total Leverage?

So far, we have learnt that the degree of operating leverage is the sensitivity of a firm’s EBIT to its sales, and the degree of financial leverage is the sensitivity of the firm’s net income to its EBIT. So, what is the sensitivity of a firm’s net income to its sales?

That’s the degree of total leverage! Put it simply, multiply a firm’s DOL with its DFL, and you get its DTL!

Why is DTL Important?

A firm’s management will be more concerned with the factors separately, as its investments decisions affect the fixed operating costs of the firm, which determines the operating leverage, while the financing decisions affect the fixed financing costs of the firm, which determines the financial leverage of the firm.

Shareholders, on the other hand, may be more concerned with the combined effect because they are primarily concerned with the net profit of the firm. The degree of total leverage gives them an idea of the factor that converts the company’s sales to profits.

DTL = (Percentage change in Net Income) / (Percentage change in Sales)

Calculating DTL

Besides the above formala, you can calculate the DOL and DFL separately and multiply them:

DTL = DOL x DFL

Or use formulas derived from DOL, which we went through before.

Like DOL and DFL, DTL is not a constant for the firm. In this case, it is dependent on the number of units produced and sold.

Conclusion

And that concludes this quick lesson on the degree of total leverage. In our next lesson, we shall learn how to calculate the breakeven point. See you again!