Question

Explain how combined leverage brings together operating income and earnings per share.

Short answer

Operating leverage primarily affects the operating income of the company. And, the financial leverage determines the overall impact on earning per shares. Degree of combined leverage use the entire income statement and show the impact of change in sales on bottom line EPS. In other word, we can say that the degree of combined leverage is a combination of both degree of operating leverage and degree of financial leverage.

Step-by-step solution

Step-by-Step Solution:Step 1: Degree of combined leverage

Degree of combined leverage is computed to express the combined effect that the degree of operating leverage and the degree of financial leverage have on earning per share of the company.

Derivation of degree of combined leverage formula from DOL & DFL

$$\begin{gathered} \mathbf{DCL}\mathbf{=}\mathbf{DOL}\mathbf{\times }\mathbf{DFL} \\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\frac{\mathrm{Contribution}}{\mathrm{EBIT}}\mathbf{\times }\frac{\mathrm{EBIT}}{\mathrm{EBT}} \\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\frac{\mathrm{Contribution}}{\mathrm{EBT}} \end{gathered}$$

As per the formula, it can be concluded that the combination of the degree of operating leverage and the degree of financial leverage is called as the degree of combined leverage, which will bring together the operating income and earning per share of the company together.