Question

Advise the companies on the implications of having a high degree of combined leverage if the industry in which they operate is highly cyclical.

Answer 1

Combined leverage refers to the sum of the effects of degree operating leverage(DOL) and the degree of financial leverage(DFL) has on the Earnings Per Share(EPS) of the firm.It is also referred to as the degree of total leverage.Degree of Combined Leverage is computed using the formula=% change in EPS/%change in Sales or DOL*DFL

Degree of operational leverage gives an idea of the effect that sales has on the company's earning potential.Degree of operating leverage is obtained by dividing the percentage of change in Earnings Before Interest And Tax(EBIT) with the percentage change in sales.

Degree of financial leverage indicates the effect change in EBIT has on the EPS of the company.It is computed by dividing the percentage change of a company's EPS with percentage change in EBIT.

So a high degree of combined leverage would be extremely risky for a firm that is operating in a highly cyclical industry.This is due to the fact that a high degree of combined leverage implies a higher amount of fixed costs.The problem with fixed costs is that thy remain the same regardless of the level of activity.So in a highly cyclical industry during the off season when the sales are low and the level of activity is low the firm would face a lot of difficulty in meeting these fixed costs.