**
3.11 Degree of Financial Leverage and
Degree of Total Leverage**

In this section we explored operating leverage which is sometimes
referred to as first stage leverage and in the early topic on the
DuPont decomposition we introduced the term financial leverage.
The degree of financial leverage results from a second stage
analysis of Earnings Before Taxes (EBT) and Earnings Before Interest
and Taxes (EBIT).

Alternatively, when viewed from the perspective of the Income Statement we can define the degree of Financial Leverage in terms of Net Income as follows:

Degree of Financial Leverage = % Change in Net Income/% Change
in EBIT

**
Degree of Total Leverage**

This number relates a firm’s operating and financial leverage to its
net income. This is a
useful number for financial analysts to assess because it allows
earnings’ forecasts to be made starting from Sales.
However, first we consider the operational details including
how to estimate this number from the financial statements.
In relation to Sales Revenue the Degree of Total Leverage is
defined as follows:

Degree of Total Leverage = Degree of Operating Leverage * Degree of Financial Leverage

Degree of Total Leverage = (% Change in EBIT / % Change in Sales) * (% Change in Net Income / % Change in EBIT)

Degree of Total Leverage = % Change in Net Income / % Change in
Sales

Or rearranged this yields:

% Change in Net Income = Degree of Total Leverage * % Change in
Sales

That is, by starting with the problem of forecasting sales revenue
then the Degree of Total Leverage can relate this forecast to an
earnings’ forecast.

We can further decompose the Degree of Total Leverage into the
product of its two drivers, the Degree of Operating Leverage times
the Degree of Financial Leverage.
In this form it can be related directly to the Contribution
Margin format of a Variable or Direct Income Statement as follows:

Degree of Total Leverage = Degree of Operating Leverage * Degree
of Financial Leverage

Degree of Total Leverage = Contribution Margin/EBIT * EBIT/Net
Income = Contribution Margin/Net Income

Next consider how this is computed from the financial statements.

**
Tutor Reconciliation:
Proctor and Gamble (PG)**

Our objective is to reconcile the following from the 10-K:

**
Step 1:**
Now bring up two Income Statements for Proctor and Gamble as
described in section 3.2 as displayed below.

For Proctor and Gamble you can see that the Cost of products sold =
$37,919 and the “Selling, general and administration” expense
=$24,998. Plus now
Interest Expense is $946.

To recast the income statement from its full or absorption costing
format to a direct or variable costing format we need to break up
these costs into their fixed and variable components.
For reconciliation purposes suppose we assume that 80% of the
COGS are variable and 20% of the SA&G expenses are variable.
These percentages can be subject to more refined analysis
later but for now we are more concerned with mastering the
operational details.

**
Step 2:**
Click on Calculate and we can verify the input and derived
fields for the following:

The above demonstrates the power of recasting the income statement
in this manner. This
lets you estimate the Degree of Financial Leverage as well as the
Break Even points for Sales Revenue and implied Margin of Safety
(i.e., Sales minus B/E Sales.
The Degree of Total Leverage is the product of the Degree of
Operating Leverage and the Degree of Financial leverage.

The reconciliation from the Income Statement is provided below.