What is Degree of Total Leverage?
The Degree of Total Leverage (DTL) ratio estimates the sensitivity of a company’s net income to changes in the number of units sold.
How to Calculate Degree of Total Leverage (DTL)
- Degree of Operating Leverage: DOL measures the proportion of a company’s cost structure that is comprised of fixed costs as opposed to variable costs.
- Degree of Financial Leverage: DFL quantifies the sensitivity of net income (or EPS) is to changes in its operating profit (EBIT) that is attributable to debt financing (i.e. the fixed financing costs, namely interest expense).
The DTL can be interpreted as stating, “For each 1% change in number of units sold, the company’s net income will increase (or decrease) by ___%”.
Thus, the degree of total leverage (DTL) quantifies a company’s total leverage, which is composed of operating and financial leverage.
The general guidelines for interpreting the two metrics are as follows:
- Degree of Operating Leverage (DOL): The greater the DOL, the more sensitive operating income (EBIT) is to changes in sales.
- Degree of Financing Leverage (DFL): The higher the DFL, the more sensitive that net income is to changes in operating income (EBIT).
Degree of Total Leverage Formula (DTL)
One method to calculate the degree of total leverage (DTL) is to multiply the degree of operating leverage (DOL) by the degree of financial leverage (DFL).
Suppose a company has a degree of operating leverage (DOL) of 1.20x and a degree of financial leverage (DFL) of 1.25x.
The company’s degree of total leverage is equal to the product of DOL and DFL, which comes out to 1.50x
- Degree of Total Leverage (DTL) = 1.20x × 1.25x = 1.50x
Degree of Total Leverage Calculation Example
A different method to calculate the DTL consists of dividing the % change in net income by the % change in number of units sold.
Suppose a company experienced an off-year, where sales declined by 4.0%.
If we assume the company’s DTL is 1.5x, the percentage change in net income can be calculated by re-arranging the formula from above.
DTL is equal to the % change in net income divided by the % change in units sold, so the implied % change in net income comes out to the % change in sales multiplied by the DTL.
- % Change in Net Income = –4.0% × 1.5x = –6.0%
DTL Formula Breakdown
The final formula to calculate the degree of total leverage (DTL) that we’ll discuss is shown below.
The contribution margin equals “Quantity Sold × (Unit Price – Variable Cost Per Unit),” so the formula can be further expanded to:
- Q = Quantity Sold
- P = Unit Price
- V = Variable Cost Per Unit
- FC = Fixed Costs
- I = Interest Expense (Fixed Financial Costs)
DTL Calculation Analysis (% Change in Net Income)
For example, let’s assume that a company has sold 1,000 units at a unit price of $5.00.
If the variable cost per unit is $2.00, fixed costs are $400, and interest expense is $200, then the DTL is 1.25x.
- DTL = 1,000 ($5.00 – $2.00) ÷ [1,000 ($5.00 – $2.00) – $400 – $200)
Therefore, if the company were to sell 1% more units, its net income would be anticipated to rise by approximately 1.25%.