REVIEW OF BASICSBREAK-EVEN & LEVERAGE ANALYSIS
N Murugesan CAFA Module 1 Financial Planning
Earnings RiskRisk in Return in Finance is generally defined as
Variability in Earnings Variability in earnings causes uncertainty
with regard to returns to shareholders and hence it is related to
risk involved in the investment The variability in earnings can
happen through either of the two components of income statement
Sales Expenses
Sales VariabilityEarnings of a firm can vary due to variability
in Sales Sales could vary due to economic environment or industry
causes or due to reasons internal to the firm The reasons that are
economic wide are common for all firms as against the internal
causes The causes that are specific to industry affects the
industry beta For the individual firms, it further modifies the
systematic risk of the firm
Variability in ExpensesThe second category that affects
variability in earnings is expenses The Variability in sales does
not translate directly into variation in EBIT The Variability in
expenses of the firm depends on the cost structure of the firm The
cost structure of the firm depends on various factors like Level of
Automation, Total Fixed Costs, % of variable costs, change in unit
variable costs etc
Variability in ExpensesTwo major categories of expenses that
magnifies the variability of earnings are: Fixed
Costs Interest Expenses
Level of Fixed costs depends on the decisions of the firm in
terms of cost structure and technology Level of interest expenses
depend on the amount of debt in capital structure
LeverageA firm has a leverage in altering the impact on earnings
variability through the choices affecting fixed costs and interest
expenses Fixed Cost Once the firm covers its fixed costs, an
increase in sales gets directly translated into profit increase
(EBIT) Interest Cost Once the firm break evens in terms of interest
cost, any increase in gross profit is directly reflected in profit
(EBT) This magnification is huge when the firm is nearer to the
break even point
Operating LeverageThe magnification (or variability) due to
fixed cost is called Operating Leverage as the firm has the
leverage of changing its cost structure in favor of fixed or
variable costs For example, when sales goes down and if the firm
has high operating leverage, it will adversely affects the
profitability. But the firm can always reduce its variable costs
(say, by decreasing overtime) when sales goes down. But a firm with
high fixed cost, do not have this option A Firm with high level of
automation is likely to have high fixed costs
Variability due to Fixed CostFirm A Sales Variable Cost Gross
Profit Fixed Cost EBIT % Change 1000 800 200 100 100 Firm B 1000
600 400 300 100 Firm A Firm B 10% Incr in Sales 1100 1100 880 660
220 440 100 300 120 140 20% 40%
An increase of 10% in Sales, has resulted in 40% increase in
EBIT for Firm B as against 20% for Firm A
Operating and Financial LeverageThe magnification (or
variability) due to Interest Expenses is called Financial Leverage
as the firm has the leverage of changing its capital structure in
favor of debt or equity Financial Leverage is sometimes equated to
financial risk as the firm can go even bankrupt if it can not cover
the interest costs A firm with a high degree of financial leverage
could face financial difficulty even though it is in a stable
industry.
Variability due to Interest CostFirm A Sales Variable Cost Gross
Profit Fixed Cost EBIT Interest EBT % Change 1000 800 200 100 100
20 80 Firm B 1000 800 200 100 100 0 100 Firm A Firm B 10% Incr in
Sales 1100 1100 880 880 220 220 100 100 120 120 20 0 100 120 25%
20%
An increase of 20% in EBIT, has resulted in 25% increase in EBT
(and hence EPS) for the firm A
Measures of LeverageThe risk due to fixed cost can be measured
using the measure called Degree of Operating LeverageDOL = %Change
in EBIT / % Change in Sales DOL = (Sales Variable Cost) / EBIT
The variability due to financial cost can be measured using the
measure Degree of Financial LeverageDFL = % Change in EPS / %
Change in EBIT DFL = EBT/(EBIT-PD/(1-t))
The Degree of Combined Leverage (DCL)The degree of combined
leverage is a measure of the total leverage (both operating and
financial leverage) that a company is using: DCL = (% Change in
EPS) / (% Change in Sales) DCL = % Change in EBIT / % Change in
Sales ) * (% Change in EPS / % Change in EBIT) Degree of Combined
Leverage is a product of DOL X DFL
%( EBT %( EBIT %( EBT DCL ! ! v ! DOL v D %( Sales %( Sales %(
EBIT
Degree of Combined LeverageUse of financial leverage must
consider risk, not just maximizing profit. Managers who are risk
averse and uncertain about the future would most likely minimize
combined leverage. Management should tailor the use of leverage to
meet its own risk-taking desires. A firm with high operating
leverage may not have the privilege of taking financial leverage
For example, Japanese firms that have high levels of operating and
financial leverage, maintaining sales volume is of critical
importance even at the cost of price.
Break Even AnalysisBreak Even Analysis is normally done for
profit planning as it helps ascertaining minimum units to produce
to cover fixed costs To understand impact of leverage on firms, it
is essential also to understand BEP of the firm and its cost
structure Break Even Point is the point of sales where firm meets
its fixed costs Similarly, from interest expenses it can be defined
as the point of EBIT where it meets the interest cost
Break Even AnalysisOnce the firm reaches BEP, its profits
increases directly with increase in sales As the profit is near
zero at BEP, any small increase is magnified by huge amount
(denominator is small) The degree of leverage is Infinity at BEP.
If a firm is operating near BEP, any change in sales will be
magnified by a number of times Hence while analyzing firms, its
important to know where the firm is currently operating
The Operating Break-even in UnitsWe can find the operating
break-even point in units by simply solving for Q:FC FC Q ! ! p v
CM$ / unit*
Where CM$/unit is the contribution margin per unit sold (i.e.,
CM$/unit = p - v) The contribution margin per unit is the amount
that each unit sold contributes to paying off the fixed costs
Cash Break-even PointsNote that if we subtract the depreciation
expense (a non-cash expense) from fixed cost, we can calculate the
break-even point on a cash flow basis:Q* T arg et
FC Depreciation ! pv
Characteristics of Break Even PointLinear break-even analysis
assumes that costs are linear functions of volume. Linear breakeven
analysis and operating leverage are only valid within a relevant
range of production. If fixed costs rise while other variables stay
constant, the breakeven point rises, degree of operating leverage
increases, and total profit declines. If the price per unit
decreases because of competition but the cost structure remains the
same, the breakeven point rises A firm's break-even point will rise
if variable cost per unit rises. As the contribution margin rises,
the breakeven point goes down.
Behavior of Leverage MeasuresWhen the cost structure remains
same, as the sales increases, the operating leverage decreases
Since DOL = Q(p-v)/(Q(p-v)-F), as Q approaches Q*, DOL approaches
infinity And as Q increases further, DOL approaches unity. Similar
is the case of DFL. Thus the leverage measures are bounded between
Infinity and 1 with an asymptomatic curve with infinity near BEP
and approaches 1 as the sales increases A firm that is farther away
from BEP and already making huge profits, will find its operating
leverage near one does not have much impact
Behavior of Leverage Measures6000
Behavior of Leverage Measures
150
5000 100 4000 50 3000
2000
0
1000 -50 0 0 -1000 50 100 150 200 250 300 -100
-2000
-150
Revenue
Total Cost
ebit
Operating Leverage
Important AssumptionThis analysis of BEP and leverage applies
only for a particular cost structure (or cost range) If the fixed
cost or unit selling price or unit variable cost changes, the
leverage of the firm also changes For example, as the sales
increases, if the firms fixed cost also increases, the leverage
again increases from one
Queries?
