Combined Leverage

Combined Leverage: The link between a change in sales and the related change in taxable income is shown by this leverage. The management will use this leverage if they believe that a given percentage change in sales will result in a percentage change in taxable income. They do this because they want to know how much of a change will occur. Thus, the degree of leverage is used to project future sales levels and the consequent rise or fall in taxable revenue. The link between contributions and taxable income is established to this extent.

Example of Combined Leverage

It should be noted that a specific sales point is used to determine the leverage. Various composite leverages are attained when different sales levels are used. When sales volume rises and fixed costs stay the same, leverage decreases. This occurs as a result of fixed costs in the cost structure.

Relevance of Financial and Operating Leverage

The effect on earnings per share and the price-earnings ratio is calculated using these two leverages. Operating leverage is less common since financial leverage has a greater impact on EPS. The management is able to maximize profits for equity owners thanks to the various debt-to-equity ratios. This aids management in maximizing wealth over the long term.

The hazards associated with finances rise when debt continues to grow in magnitude. The bulk of income will be used to pay down debt-related interest expenses. The organization’s overall performance is negatively impacted. He should thus assess the various capital mixes that involve financial risk to the company.

Operating leverage is based on the marginal costing concept, where BEP may be determined at various sales levels. Any sales rise over BEP sales will result in better operating profit (fixed cost remain constant). Higher operational profits derive from any change in sales brought on by a change in operating costs. Operating leverage is thus referred to as “First phase leverage,” which increases the profit as a result of a change in sales volume.

Since it begins where operational leverage ends, financial leverage is referred to as the “second phase of leverage.” The two goals of financial management—profit maximization and wealth maximization—are achieved by a good blending of these two levers.