Breakeven concerns itself with an entity’s margin of safety. The term is used by accounting firms, investment institutes, and companies. Financial breakeven differs from accounting breakeven.
While accounting breakeven concerns the point at which a company is neither making a profit nor a loss, that is a position where the company’s revenue and expenditure equate.
Financial break-even differs in some ways. Here we would base more on financial breakeven.
The financial breakeven point is the level of earning before Interest and taxes where the company’s earnings per share equate to zero; that is, the company’s net income will equal zero.
It is also considered the minimum EBIT (earnings before interest and tax) a company should earn to attain its fixed target.
Put in another way, it could be seen as the level of EBIT which equates to a fixed financial cost for the company, such cost could be preference dividends, debt interest, and its likes.
It is also seen as the level that equates the company’s interest expenditure in addition to its associated taxes and the dividend paid to preferred shareholders.
Any earning learning from the company beyond this level is usually considered a profit to its shareholders. Financial break-even concerns itself with the ending section of a company’s income statement.
Most companies with a mixed capital structure calculate their financial break-even point.
Companies usually have various choices when raising funds, such as bank loans, debentures, preference, equity, etc.
Instruments like this come with mandatory payment, which makes up for the company’s fixed cost.
A company will need to review its strategy if it earns anything less than the fixed expenditure it has to make.
Based on priority scaling, companies usually pay out their interest on loans first, then preferred dividends to their preferred shareholders, and then finally make use of the remains for its equity shareholders and are retained early.
Here is where financial break-even comes in; companies will need to understand how they are to generate enough profit after having covered their fixed financial expenses. This is very important.
To realize the financial breakeven point, the EBIT is expected to result in a net income of zero. The relationship between the EBIT and the net income is stated as
Net Income = EBIT x (1- Interest Expense) x (1-Tax rate) – Preferred Dividends
Making 0 the net income will therefore be
0 = EBIT x (1- Interest Expense) x (1- Tax Rate) – Preferred Dividends.
To obtain the exact financial break-even point formula, we would arrange the above equation, which will result to
Financial BEP = Preferred Dividend / 1 – tax rate + Interest Expenses.
Zino has a $500 million preferred stock @ 10% per annum. The company incurs a total interest expense of $20 million, earning an interest income of $2 million—the tax rate at 20%.
The financial breakeven point for Zino Company will be what?
To obtain the Financial BEP of the company, you will first calculate the preferred dividend payments, the earnings before taxes, preferred dividend payments, taxes, and interest expenses.
Preferred Dividends = 500 x 10% = $50 million
Net Interest expense = $20 million – $2 million = $18 million
By obtaining the above figures, we can now proceed to calculate the financial break-even point, as follows
Financial breakeven (EBIT) = Preferred Dividends/ 1- tax rate + Net Interest expense
= ($50 million/1-20%) + $18. million = $80.5 million.
Zino company’s financial BEP = $80.5 million
Here is another example to consider
Lee Company has a new project to fund and it came up with three financing plans. Plan A– $10,0000 Equity
Plan B– $150,000 in Equity and $80,000 in 8% Debentures;
Plan C– $60000 in Equity, $20000 in 8% Debenture, and $50000 in 10% Preference Share Capital.
Assuming the tax rate is 30%, what will be the financial break-even for each option?
The break-even point for plan A is 0. This is because there is neither an interest expense nor a preferred dividend.
Plan B has only interest expenses with no preferred dividend. Thus, the financial break-even level will be
Financial BEP = $80000*8%
Using the figures supplied in Plan C, the company’s financial break-even point will be
Financial BEP = (8%*$20000)/(1-30%) + (10%*$50000)
= 1600/0.7 + $5000
From the above examples, particularly that of example two, we can deduce that the financial break-even point tends to increase as the company takes more debt.
Certain factors influence the break-even of a company. Some factors cause a reduction while others an increase in the BEP.
Factors that Increase Company’s breakeven Point
- The company’s BEP also rises when there is repair in equipment.
- An increase in customer sales increases the BEP
- An increase in production cost increases a company’s BEP
Factors That Reduce Company’s Breakeven Point
- When a company opts for outsourcing, its BEP tends to be reduced.
- There will also be a reduction in a company’s BEP when product prices are raised.
Briefing In Accounting Break-Even Point
In the light of accounting, break-even analysis is the level at which production revenue equals production cost.
For that investment, the break-even is the point at which the original cost equates to the market price.
While the breakeven for options trading is attained when the underlying asset gets to the point where buyers would have to incur any loss.
The Break-even point in business is generally calculated as the fixed cost is divided by the gross profit margin. The break-even point equation is expressed as
BEP = Gross Profit Margin/ Fixed Costs
Inputting figures into the equation produces the figure that a company needs to break even. With regards to stocks, if a trader buys a stock at $500, and six months later it reaches $600 and finally falls back to the original $500, The market would be said to have gotten to the point that it can be termed break-even point.
|Financial Break-even Point||Accounting Break-even Point|
|Financial BEP is majorly used in calculating zero net income||Accounting BEP is used in calculating zero operating margin.|
|For calculation, Financial BEP makes use of EBIT as its earnings||In calculating accounting BEP, the cost per unit, variable cost, and fixed cost are required.|
|It helps in the estimation of a company’s earnings, for which the earnings per share is equal to zero||It helps in determining the number of units that should be sold to minimize cost.|
|The formula for Financial BEP is Preferred Dividend / 1 – tax rate + Interest Expenses.||The formula for Accounting BEP is (Total fixed cost/price per unit ) – variable cost.|
Financial break-even is a necessity for most companies. It serves as a warning against their puffing up their capital structure with excess unhealthy debts.
And also helps to maintain the balance between their debt and equity.