A breakeven point is when a company is making no profit, no loss, or it is a threshold beyond which the company starts to make a profit. Financial Breakeven is also a similar concept, but uses a different measure to arrive at that point.
It is a point defining the level before the EBIT (earnings before interest and tax) at which the earnings per share of the company is equal to zero. Or, we can say, it is the level of EBIT that equals the fixed financial costs for the company, such as interest on the debt, preference dividend and more. Or, we can also call it the minimum EBIT that a company should earn to meet its fixed commitments. Anything that a company earns beyond this level or point is the profit to the shareholders.
Financial risk related to investing in a company’s stock grows as the breakeven point increases. For calculating a financial breakeven point, it is mandatory to include Interest expense and dividend on preference shares. On the other hand, one may or may not include common dividends.
Table of Contents
One can express the relationship between EBIT and net income in the following way:
Net Income = EBIT x (1- Interest Expense) x (1-Tax rate) – Preferred Dividends
For the financial break-even point, we need the EBIT that could result in zero net income.
Therefore, 0 = EBIT x (1- Interest Expense) x (1- Tax Rate) – Preferred Dividends
Thereby, arranging the above situation, we get Financial Breakeven = Preferred Dividends / 1- tax rate + Interest Expense
Accounting Breakeven Vs Financial Breakeven
Accounting Breakeven is the simplest form of analysis to know the number of units that a company needs to sell in order to equal the cost. Every unit sold after the break-even unit will result in a profit for the company. Calculating the accounting break-even is easy as it requires fixed cost, cost per unit and variable cost.
The formula for accounting breakeven is = (Total Fixed cost/price per unit) – variable cost. Firms targeting to achieve accounting breakeven strive towards selling the minimum number of units to cover the fixed cost.
Although similar in various aspects, financial breakeven deploys different measurements. As said above, it includes estimating the level of earnings for a firm at which the earnings per share equals to zero. For its calculation, we take EBIT as earnings.
There is one more difference between the financial break-even point and operating or accounting break-even point. The latter calculates the unit sales that a firm needs to achieve for zero operating margins. Financial break-even, on the other hand, deals with the bottom line of the company’s income statement. Or, we can say, financial break-even point attempts to find EBIT that results in zero net income.
Examples of Financial Breakeven
Example 1: Company A has $100 million preferred stock at 5% per annum. The company incurs a total interest expense of $10 million and earns an interest income of $1 million. Tax rate is at 33%. What would be the financial breakeven point for Company A?
First step would be to calculate the earnings before taxes, preferred dividend payments, taxes and interest expenses.
Preferred Dividends = 100 x 5% = $5 million
Net Interest expense = $10 million – $1 million = $9 million
Now, that we have all the metrics to calculate the financial break-even point, let’s see the final calculation;
Financial breakeven (EBIT) = Preferred Dividends/ 1- tax rate+ Net Interest expense
= ($55 million/1-33%) + $9 million = $16.58 million.
Example 2: Let’s consider another example to make things clearer. Company A has come up with three financing plans to fund its new project. Plan 1 – $15,0000 Equity, Plan 2 – $100000 in Equity and $50000 in 8% Debentures; Plan 3 – $75000 in Equity, $25000 in 8% Debenture and $50000 in 10% Preference Share Capital. In this, we have to calculate the financial breakeven for each option assuming a 50% tax rate.
For Plan 1, the break-even point is 0 as there is no interest expense and preference dividend.
In the Plan 2, the financial break-even level will be = $50000*8% = $4000. In this case, there are only interest expenses and no preference dividend.
For the Plan 3, the financial break-even point will be = (10%*$50000)/(1-50%) + (8%*$25000) = $10000 + $2000 = $12000.
It is clear from the second example that the financial break-even point increases as the company takes on more debt.
Usually, organizations with a mix capital structure calculate the financial break-even point. A firm has multiple options to raise funds such as equity, preference, Bank loans, debentures and more. Some of these instruments come with mandatory payment, meaning are a fixed cost for the company.
In terms of priority, a business first pays out the interest on loans, then dividend on preference shares and then uses the remaining for the equity shareholders and retained earnings. Therefore, understanding when the company will generate enough profit after covering fixed financial charges is very crucial. This is where financial breakeven steps in.
Thus, if a company is earning anything less than the fixed charges that it has to pay, then it would need to reassess the strategies. Financial breakeven also warns the companies against not beefing up their capital structure with too much of debt (as shown in the example above). Instead, maintain a balance between debt and equity. 1,2