Financial Management

Break-Even Analysis and Leverages

BITS Pilani
Pilani Campus
 BITS Pilani
Pilani|Dubai|Goa|Hyderabad

Risk Management
- Break-Even Analysis and Leverages
Agenda

• Business Risk

• Operating Leverage

• Break even analysis

• Financial Risk

• Financial Leverage

• Total Leverage

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Drivers of business risk

• Uncertainty about demand (sales).

• Uncertainty about output prices.
• Uncertainty about costs.
• Product, other types of liability.
• Competition.
• Operating leverage.

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Operating leverage

Operating Leverage refers to the use

of fixed operating costs by the firm.

– One potential “effect” caused by the

presence of operating leverage is that
a change in the volume of sales
results in a “more than proportional”
change in operating profit (or loss).

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Operating leverage

• OL is defined as (%change in
EBIT)/(%change in sales)

• Operating leverage is high if the

production requires higher fixed costs and
low variable costs.

• Key point: High fixed costs translate small

increases in sales into large increases in
EBIT

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Effect of operating leverage
• Large operating leverage leads to higher
business risk because a small sales decline
causes a huge decline in profits

$ Rev. $ Rev.
TC } Profit
TC
FC
FC
QBE Sales QBE Sales

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Operating leverage

Low operating leverage

Probability
High operating leverage

EBITL EBITH

• Higher operating leverage leads to higher

E(EBIT), but risk also increases.
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Break-Even Analysis

Break-Even Analysis – A technique for studying

the relationship among fixed costs, variable costs,
sales volume, and profits. Also called
cost/volume/profit analysis (C/V/P) analysis.

– When studying operating leverage,

“profits” refers to operating profits before
taxes (i.e., EBIT) and excludes debt
interest and dividend payments.
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Break-Even Chart

Total Revenues

Profits
REVENUES AND COSTS

250
($ thousands)

Total Costs
175

100 Fixed Costs

Losses
Variable Costs
50

0 1,000 2,000 3,000 4,000 5,000 6,000 7,000

QUANTITY PRODUCED AND SOLD

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Break-Even Point
(Quantity)

Break-Even Point – The sales volume required so

that total revenues and total costs are equal; may
be in units or in sales dollars.
How to find the quantity break-even point:
EBIT = P(Q) – V(Q) – FC
EBIT = Q(P – V) – FC
P = Price per unit V = Variable costs per unit
FC = Fixed costs Q = Quantity (units)
produced and sold

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Break-Even Point
(Quantity at operating cost level)

Breakeven occurs when EBIT = 0

Q (P – V) – FC = EBIT
QBE (P – V) – FC = 0
QBE (P – V) = FC

QBE = FC / (P – V)
a.k.a. Unit Contribution Margin

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Break-Even Point
(Sales)
How to find the sales break-even point:

EBIT = P(Q) – V(Q) – FC

= Sales – V(Q) – FC

For break-even, EBIT =0

 Sales – V(Q) – FC = 0

 SBE = FC + (QBE )(V)

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Break-Even Point- Example

India Handicrafts wants to determine both

the quantity and sales break-even points
when:
• Fixed costs are $100,000
• Baskets are sold for $43.75 each
• Variable costs are $18.75 per basket

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Break-Even Point- Example
Breakeven occurs when:
QBE = FC / (P – V)
QBE = $100,000 / ($43.75 – $18.75)

QBE = 4,000 Units

SBE = (QBE )(V) + FC

SBE = (4,000 )($18.75) + $100,000

SBE = $175,000

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Break-Even Chart

Total Revenues

Profits
REVENUES AND COSTS

250
($ thousands)

Total Costs
175

Fixed Costs
100
Losses
Variable Costs
50

0 1,000 2,000 3,000 4,000 5,000 6,000 7,000

QUANTITY PRODUCED AND SOLD
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Financial leverage and
Financial risk

• Financial leverage is defined as

(%change in PBT) / (% change in
EBIT)
• High usage of debt can cause
small increases in EBIT to lead to
large increases in net income.
• Financial leverage increases with
increasing levels of debt

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Financial risk?

• Financial risk is the additional risk

concentrated on common stockholders as a
result of financial leverage.
– More debt, more financial leverage, more financial
risk.
– More debt will concentrate business risk on
stockholders because debt holders do not bear
business risk (in case of no bankruptcy).

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Summary

Operating Financial Business Financial

Leverage Leverage Risk Risk
%change in %change in Variability in Additional
EBIT/%change in PBT/%change in the firm’s variability in net
sales EBIT expected EBIT. income to
common
shareholders.
Increases with Increases with Increases with Increases with
higher fixed cost higher debt high OL. high FL.

If a firm already has high business risk, then it may be advisable to use less debt
to lower the financial risk. If a firm has less business risk, then it may be able to
afford higher financial risk.

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

Total leverage

Degree of Total Leverage – The percentage

change in a firm’s PBT resulting from a 1
percent change in output (sales).

DTL at Q units Percentage change in

(or S dollars) of PBT
output (or = Percentage change in
sales) output (or sales)
DTL Q units (or S dollars) = ( DOL Q units (or S dollars) ) x ( DFL EBIT of X dollars )

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

 Thank You

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