What is a Financial Break Even Point? How is it calculated | ApnaCourse
Manu and Vinu about
|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?|
You know, that business entities can raise funds for its business in different forms.
|Manu||It can be in the forms like…………….|
|Vinu||Equity Share Capital,
Preference Share Capital,
Bank Loans, etc.
|Manu||Good! Some of these funds will have fixed cost whereas some will not have.|
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.|
|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?
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.
|Manu||In this example, both the debentures and preference shares carry fixed cost.|
|Manu||Please calculate those costs.|
|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!
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.|
|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.|
|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.
|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.|
|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!|