Chapter 10
FINANCIAL ANALYSIS : Margin analysis: risks

ALL PARTS
  • FINANCIAL ANALYSIS
  • INVESTORS AND MARKETS
  • VALUE
  • CAPITAL STRUCTURE POLICIES
  • FINANCIAL MANAGEMENT

The breakeven point is the level of business activity, measured in terms of sales, production or the quantity of goods sold, at which total revenues cover total costs. At this level of sales, a company makes zero profit.

The breakeven point is not an absolute level – it depends on the length of period being considered because the distinction between fixed and variable costs can be justified only by a set of assumptions and, sooner or later, any fixed cost can be made variable.

Three different breakeven points may be calculated:

  • operating breakeven, which is a function of the company's fixed and variable production costs. It determines the stability of operating activities, but may lead to financing costs being overlooked;
  • financial breakeven, which takes into account the interest expense incurred by the company, but not its cost of equity;
  • total breakeven, which takes into account both interest expense and the net profit required by shareholders. As a result, it takes into account all the returns required by all of the company's providers of funds.

Operating breakeven is calculated by dividing a company's fixed costs by its contribution margin ((sales – variable costs)/sales). Financial breakeven is calculated by adding interest expense to the fixed costs in the previous formula. Total breakeven is computed by adding the net income required to cover the cost of equity to fixed operating costs and interest costs.

The calculation and a static analysis of a company's breakeven point can be used to assess the stability of its earnings, its normal earnings power and the actual importance of the differences between budgeted and actual performance. The further away a company lies from its breakeven point, the more stable its earnings and the more significant its earnings trends are. The higher its fixed costs as a share of total costs, the higher the breakeven point and the greater the operating leverage and the volatility of its earnings are.

An analysis of trends in the operating leverage over time reveals a good deal about the company's industrial strategy. An attempt to harness economies of scale will raise the breakeven point and thus make a company more sensitive to economic trends. Efforts to make its industrial base more flexible will lower its breakeven point, but may also reduce its potential earnings power.