Economic leverage ratio

What Is Economic Leverage Ratio?

The Economic Leverage Ratio, often referred to as the Degree of Combined Leverage (DCL) or Total Leverage, is a financial analysis metric that quantifies the sensitivity of a company's earnings per share (EPS) to changes in its sales revenue. This ratio falls under the broader umbrella of corporate finance and provides a comprehensive view of how both a firm's operating cost structure and its financing decisions impact the ultimate profitability available to shareholders. It combines the effects of operating leverage and financial leverage, showing the magnified impact that fluctuations in sales can have on a company's bottom line. The Economic Leverage Ratio helps assess a company's overall risk profile, as higher leverage generally implies greater volatility in earnings for a given change in sales.

History and Origin

The concept of leverage in finance, from which the Economic Leverage Ratio derives, has roots in the understanding of how fixed costs, both operational and financial, can amplify returns. The foundational ideas of operating and financial leverage gained prominence with the development of modern corporate finance theory in the mid-20th century. Academics and practitioners sought to understand how a company's cost structure and its use of debt could influence its earnings and the risk borne by shareholders.

The aggregation of operating and financial leverage into a single "combined leverage" or "total leverage" metric emerged as a natural extension, offering a holistic view of a company's sensitivity to sales changes. This comprehensive measure became particularly relevant as businesses scaled and capital markets evolved, allowing for more intricate capital structure decisions. The importance of understanding and regulating leverage, especially in financial institutions, became starkly apparent during major economic downturns, such as the 2008 financial crisis, prompting heightened scrutiny and the implementation of stricter capital requirements by regulatory bodies like the Federal Reserve Board.

Key Takeaways

• The Economic Leverage Ratio (Degree of Combined Leverage) measures the sensitivity of earnings per share (EPS) to changes in sales revenue.
• It incorporates both fixed operating costs (operating leverage) and fixed financing costs like interest expense (financial leverage).
• A higher Economic Leverage Ratio indicates that a small percentage change in sales will lead to a proportionally larger percentage change in EPS.
• While high economic leverage can amplify profits during periods of rising sales, it can also magnify losses during sales downturns, increasing a company's overall financial risk.
• Understanding this ratio is crucial for investors, managers, and creditors in evaluating a company's risk exposure and its ability to generate returns for shareholders.

Formula and Calculation

The Economic Leverage Ratio, or Degree of Combined Leverage (DCL), is typically calculated in two primary ways:

1. Using Percentage Changes:

   $$\text{DCL} = \frac{\text{\% Change in Earnings Per Share (EPS)}}{\text{\% Change in Sales Revenue}}$$

2. Multiplying Operating and Financial Leverage:
   The Economic Leverage Ratio is also the product of the Degree of Operating Leverage (DOL) and the Degree of Financial Leverage (DFL).

   $$\text{DCL} = \text{DOL} \times \text{DFL}$$

   Where:

   • Degree of Operating Leverage (DOL) measures the sensitivity of earnings before interest and taxes (EBIT) to changes in sales. It reflects the extent to which a company uses fixed costs in its operations. $$\text{DOL} = \frac{\text{\% Change in EBIT}}{\text{\% Change in Sales Revenue}} \quad \text{or} \quad \frac{\text{Contribution Margin}}{\text{EBIT}}$$ Contribution Margin = Sales Revenue - Variable Costs
   • Degree of Financial Leverage (DFL) measures the sensitivity of EPS to changes in EBIT. It reflects the extent to which a company uses debt financing. $$\text{DFL} = \frac{\text{\% Change in EPS}}{\text{\% Change in EBIT}} \quad \text{or} \quad \frac{\text{EBIT}}{\text{EBIT} - \text{Interest Expense}}$$

By multiplying DOL and DFL, the intermediate effect of EBIT cancels out, directly linking changes in sales to changes in EPS.

Interpreting the Economic Leverage Ratio

Interpreting the Economic Leverage Ratio provides critical insights into a company's risk and reward profile. A DCL greater than 1 indicates that a given percentage change in sales will result in a larger percentage change in earnings per share. For example, an Economic Leverage Ratio of 2.5 means that a 1% increase in sales is expected to lead to a 2.5% increase in EPS. Conversely, a 1% decrease in sales would lead to a 2.5% decrease in EPS.

Companies with high fixed operating costs or significant debt obligations will typically exhibit a higher Economic Leverage Ratio. While this can lead to substantial gains in EPS during periods of sales growth, it also exposes the company to magnified losses when sales decline. Therefore, a high Economic Leverage Ratio signals increased volatility in net income and EPS, which can impact shareholder returns and the company's overall financial stability. Analysts often compare a company's Economic Leverage Ratio to industry averages to understand its relative risk posture within its sector.

Hypothetical Example

Consider "Alpha Manufacturing Inc." which sells a single product.

• Current Annual Sales: 10,000 units
• Selling Price Per Unit: $50
• Variable Cost Per Unit: $20
• Total Annual Fixed Costs: $150,000
• Annual Interest Expense: $30,000
• Number of Shares Outstanding: 50,000

Let's calculate the Economic Leverage Ratio for Alpha Manufacturing:

1. Calculate Initial EBIT and EPS:

   • Total Sales Revenue: $50 \times 10,000 = $500,000
   • Total Variable Costs: $20 \times 10,000 = $200,000
   • Contribution Margin: $500,000 - $200,000 = $300,000
   • EBIT: $300,000 (Contribution Margin) - $150,000 (Fixed Costs) = $150,000
   • Earnings Before Tax (EBT): $150,000 (EBIT) - $30,000 (Interest Expense) = $120,000
   • Assuming a 25% tax rate, Tax = $120,000 \times 0.25 = $30,000
   • Net Income: $120,000 - $30,000 = $90,000
   • EPS: $90,000 / 50,000 shares = $1.80

2. Calculate DOL:

   $$\text{DOL} = \frac{\text{Contribution Margin}}{\text{EBIT}} = \frac{\$300,000}{\$150,000} = 2$$

3. Calculate DFL:

   $$\text{DFL} = \frac{\text{EBIT}}{\text{EBIT} - \text{Interest Expense}} = \frac{\$150,000}{\$150,000 - \$30,000} = \frac{\$150,000}{\$120,000} = 1.25$$

4. Calculate DCL (Economic Leverage Ratio):

   $$\text{DCL} = \text{DOL} \times \text{DFL} = 2 \times 1.25 = 2.5$$

This Economic Leverage Ratio of 2.5 implies that for every 1% change in sales, Alpha Manufacturing Inc.'s EPS will change by 2.5%. If sales increase by 10%, EPS would be expected to increase by 25%. Conversely, a 10% decrease in sales would lead to a 25% decrease in EPS, illustrating the amplifying effect of both fixed operating and financing costs.

Practical Applications

The Economic Leverage Ratio serves several practical applications across finance and business analysis:

• Investment Analysis: Investors utilize the Economic Leverage Ratio to gauge the risk associated with a company's return on equity and potential for earnings volatility. Companies with high DCL may offer higher potential returns during economic expansions but also pose greater risks during downturns.
• Corporate Planning: Management teams use this ratio to understand the impact of strategic decisions, such as increasing production capacity (which often entails higher fixed costs) or taking on more debt. It helps them assess how changes in sales forecasts could affect profitability and make informed decisions about their operational and financial structures.
• Credit Analysis: Lenders and credit rating agencies examine the Economic Leverage Ratio as part of their assessment of a company's creditworthiness. A high ratio, especially when combined with volatile sales, signals a greater risk of default if the company's cash flows become insufficient to cover its fixed obligations, including interest payments. Recent warnings from the International Monetary Fund (IMF) and other financial bodies highlight increasing global public and corporate debt levels, underscoring the importance of such leverage metrics in assessing financial stability. The IMF, for instance, has noted that global public debt is expected to exceed $100 trillion by the end of 2024, emphasizing potential fiscal risks.⁴
• Regulatory Oversight: Financial regulators, particularly in the banking sector, impose leverage ratio requirements to ensure that financial institutions maintain adequate capital buffers against potential losses. For example, the Federal Reserve Board, alongside other agencies, has continued to refine and propose modifications to the Enhanced Supplementary Leverage Ratio (eSLR) for large, systemically important banks to ensure financial stability.³ This regulatory scrutiny aims to prevent excessive risk-taking that could destabilize the broader economy, a lesson reinforced by past financial crises.

Limitations and Criticisms

While the Economic Leverage Ratio offers valuable insights, it also has limitations and faces criticisms:

• Sensitivity to Assumptions: The ratio's calculation relies on various assumptions, particularly regarding the linearity of costs and revenues. In reality, variable costs may not always change proportionally with sales, and fixed costs can vary over different production ranges.
• Ignores Non-Linearity: The DCL provides a point estimate based on current operating and financial structures. It does not fully capture the non-linear relationship between sales and earnings, especially at extreme levels of activity or during significant changes in market conditions.
• Static View: The Economic Leverage Ratio offers a snapshot in time, using historical financial data. It may not accurately reflect future conditions if a company significantly alters its cost structure or capital structure, or if the economic environment shifts dramatically.
• Industry Specificity: What constitutes an acceptable or risky Economic Leverage Ratio can vary significantly across industries. A high ratio might be standard for a capital-intensive industry, while it could be alarming for a service-based business. Therefore, comparisons must be made within the same industry.
• Risk of Financial Distress: Excessive economic leverage can lead to financial distress or even bankruptcy, particularly for companies that cannot consistently generate sufficient sales to cover their high fixed costs and debt obligations. News reports frequently highlight the proliferation of "zombie companies" – businesses so burdened by debt that they struggle to cover even interest payments – underscoring the real-world dangers of high leverage in challenging economic environments. Fur²thermore, concerns about growing U.S. debt and its potential impact on interest rates and market stability indicate that the risks associated with high leverage are ever-present and closely monitored by market participants.

##¹ Economic Leverage Ratio vs. Financial Leverage

The terms Economic Leverage Ratio and Financial Leverage are related but distinct concepts in financial analysis. Financial leverage specifically measures the impact of a company's use of debt financing on its earnings per share. It quantifies how sensitive EPS is to changes in earnings before interest and taxes (EBIT), highlighting the risk and reward associated with fixed interest expense payments.

In contrast, the Economic Leverage Ratio (or Degree of Combined Leverage) provides a broader perspective. It encompasses both operating leverage (the effect of fixed operating costs) and financial leverage (the effect of fixed financing costs). Therefore, the Economic Leverage Ratio measures the total magnifying effect of both types of fixed costs on EPS as a result of changes in sales revenue. While financial leverage focuses solely on the impact of debt on shareholder returns, the Economic Leverage Ratio offers a holistic view of how overall business activity and financing decisions combine to affect the ultimate profitability available to equity holders.

FAQs

What is the primary purpose of calculating the Economic Leverage Ratio?

The primary purpose of calculating the Economic Leverage Ratio is to understand the total sensitivity of a company's earnings per share to changes in its sales revenue. It reveals how effectively a company can translate sales fluctuations into magnified changes in profitability for its shareholders by combining the effects of fixed operating and financing costs.

How does the Economic Leverage Ratio differ from Operating Leverage?

Operating leverage specifically assesses the impact of fixed costs within a company's operations on its earnings before interest and taxes (EBIT) as sales change. The Economic Leverage Ratio, on the other hand, is a more comprehensive measure that considers the effects of both operating leverage and financial leverage (from debt financing) to show the overall impact on net income and EPS.

Can a high Economic Leverage Ratio be good for a company?

A high Economic Leverage Ratio can be beneficial for a company during periods of increasing sales, as it will lead to a proportionally larger increase in earnings per share. This amplification of returns can significantly boost shareholder value. However, it also means that a slight decline in sales can lead to a much larger decrease in EPS, increasing the company's risk exposure.

What are common ways to reduce a high Economic Leverage Ratio?

To reduce a high Economic Leverage Ratio, a company can focus on lowering its fixed cost base, perhaps by converting some fixed costs to variable costs (e.g., outsourcing production). Additionally, reducing reliance on debt financing, such as paying down existing debt or funding operations more through equity rather than debt, would decrease the financial leverage component, thereby lowering the overall Economic Leverage Ratio. Analyzing the company's balance sheet and debt ratios like the debt-to-equity ratio or debt-to-assets ratio can guide these decisions.