What is a Financial Break Even Point? How is it calculated | ApnaCourse

by | Nov 10, 2016 | Financial Management

 Manu

Conversation Between

Vinu

 1

 Manu and Vinu about
Financial Break Even Point

 2
Vinu Manu! I know little bit about Break Even Point in Costing.

But in Capital Structuring also, I understand there is a Break Even Point.

Do you have any idea about that?

Manu Yes Vinu! It is called Financial Break Even Point.
Vinu Why we have to find that?
Manu Vinu! It is calculated when we have mix of funds in capital structure.
Vinu Can you explain that in simple terms?
Manu Ok!

You know, that business entities can raise funds for its business in different forms.

Vinu Yes.
Manu It can be in the forms like…………….
Vinu Equity Share Capital,

Preference Share Capital,

Debentures,

Bank Loans, etc.

Manu Good! Some of these funds will have fixed cost whereas some will not have.
Vinu Yes.

Bank Loans / Debentures / Preference Share Capital have to be paid fixed interest / dividend whereas Equity share holders are paid dividends only when the business makes profits.

Manu Correct. So when your business generates profits, firstly it should be sufficient enough to cover the fixed financial charges like interest and preference dividend.
Vinu Yes.
Manu So finding whether your business generates sufficient profits to cover the fixed financial charges are called as finding Financial Break Even Point.
Vinu Fine! So it is the level of profit which will match our Fixed Financial Charges.
Manu Yes! So which profit is that?

Is it PBIT / PBT / PAT?

Vinu Hmmmm???

We are talking about charges like Interest / Preference Dividend.

Then profits should be before those items.

So Profit Before Interest and Tax (PBIT) should be the ideal one. Is that right?

Manu Yes! Because from PBIT you pay Interest and after providing for taxes, you will pay your Preference Dividend. So PBIT is the right profit.
Vinu But, how to find the PBIT level which covers Fixed Financial Charges?
Manu Let’s take an example:

Let’s say you have

-10% Debentures of Rs.100 Crs;

-14% Preference Shares of Rs.50 Crs;

-30% Income Tax Rate.

Vinu Ok.
Manu In this example, both the debentures and preference shares carry fixed cost.
Vinu Yes!
Manu Please calculate those costs.
Vinu
Funds Value Interest % Interest Amount
Debentures 100.00 10% 10.00
Preference Shares 50.00 14% 7.00
                                                                             TOTAL 17.00
Manu Good! These are your …………..?
Vinu Fixed Financial Charges.
Manu Excellent! So how much should be your minimum profit to cover / pay these Fixed Financial Charges?
Vinu Obviously Rs.17 Crs!
Manu No, you are getting it wrong?
Vinu Why is that?

Fixed Financial Charges are Rs.17 Crs and Profit should be at least Rs.17 Crs.

Manu No. It is wrong?
Vinu Please prove that then!
Manu I am not going to prove. You will find by yourself.

Since you say, minimum profit should be Rs.17 Crs., work out in a table form and check whether this profit is sufficient to pay both the charges.

Vinu Ok! Let me do that!

EBIT 17.00
Less:Interest on Debenture (10.00)
Earnings Before Tax 7.00
Less: Tax @ 30% (2.10)
Earnings After Tax 4.90
Less: Preference Dividend (7.00)
????????????????????????????? ??????

 

Oops!!! My profits are not covering Preference Dividend!!!

Manu Why did that happened?
Vinu Ya! Now I understood.

 

Preference Dividends are paid out of Profits available after Tax.

 

In this case our Profit after Tax was Rs.4.90 Cr whereas Preference Dividend is Rs.7.00 Crs

Manu So, what should be your ideal Profit After Tax at your Financial Break Even Point?
Vinu At Financial Break Even Point, Profit after Tax should be equal to Preference Dividend.
Manu In this case, what should have been your PAT?
Vinu It should have been Rs.7.00 Cr, so that it can be used for paying Preference Dividend.
Manu Good! If PAT is Rs.7 Cr what should have been your PBT?
Vinu I can tell you that.

PAT can be equated to 70% because it is after 30% Tax.

So PBT should be 100%.

 

In this case, if PAT is 7 Cr (70%), then PBT should be Rs.10 Cr (100%)

Manu Good! Then what should be your PBIT?
Vinu If PBT is Rs.10 Cr, which is after subtracting Interest of Rs.10 Cr, then PBIT should be Rs.20 Cr
Manu Very Good! Now construct what you have said in the form of table.
Vinu Ok!

PBIT 20 Cr
Less: Interest on Debentures @ 10% 10 Cr
PBT 10 Cr
Less: Tax @ 30% 3 Cr
PAT 7 Cr
Less: Preference Dividend 7 Cr
Earnings available for Share holders Nil
Manu So, what do you understand from this?
Vinu Financial Break Even Point is a level of profit which covers all the fixed financial charges.
Manu So?
Vinu At this level of EBIT, only Fixed Financial charges are covered and there will be no returns for Equity Share holders.
Manu Exactly! It is a level of EBIT at which earnings for the shareholders in NIL. To put it simply, EPS will be ZERO.

 

Now tell me why this level of profit is calculated?

Vinu To know when they reach BEP!
Manu That’s right. But why they should know it?
Vinu Hmmm…..By finding Financial Break Even Point, we can compare our Expected EBIT? Does it make sense?
Manu Yes! It makes sense. Let us go back to our example.

 

We have calculated Financial Break Even Point as Rs.20 Crs when we had 10% Debentures of Rs.100 Crs and 14% Preference Shares of Rs.50 Crs under 30% Tax Rate.

Vinu Yes!
Manu The message from Financial Break Even Point of Rs.20 Crs is

-the company should earn at least Rs.20 Crs. of EBIT if it is planning the above funding structure.

Vinu Correct! If the company doesn’t earn Rs.20 Crs, it will not be able to pay interest / dividend and it will affect the credibility and even solvency of company.
Manu Very True. On the other hand, let’s say the business entity has capacity to make EBIT of Rs.30 Crs. Then what message you would get from Financial BEP?
Vinu Then it would mean, they can take some more fixed cost funds in their capital structure, because EBIT is greater than Financial BEP and the difference can be used for paying further fixed charges.
Manu Very correct. So when ever, entities makes profit more than Financial BEP, it would mean, they can take more debt funds because, their profit would support payment of interest / preference dividend to the extent of difference.
Vinu Yes!
Manu At the same time, when the entities earn less than Financial Break Even Point, then it is a serious warning message to the entities that they would be defaulting in their future payments.
Vinu So it’s an action call right?
Manu Yes! It’s an action call for the entity to not to add too much of debt to their capital structure because their earning capacity (EBIT) is limited.
Vinu Wow! A simple computation carrying very serious message for business entities. I am happy I have understood an important concept.
Manu Yes Vinu! Business entities who manage their Financial Management professionally will test for Financial Break Even Point before finalising their capital structure so they can avoid damages on account of fixed cost funds.
Vinu Yes Manu! I’ll try to practice the same in our business. Thanks for the explanation!
Manu Welcome Vinu!
N Raja CA, A Practicing Chartered Accountant with tonnes of passion for teaching. He also holds a PGDBA – Finance from Symbiosis SCDL and a B.Com., from Loyola College, Chennai. Read More.

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