Financial Break-even Point
Financial break-even point is the level of earnings before interest and taxes that will result in zero net income or zero earnings per share. It equals the company’s interest expense plus dividends paid to preferred stock-holders and associated taxes.
Interest expense and preferred dividends are obligatory payments hence they are included in financial break-even calculation while common dividends, being optional, are excluded.
While the operating break-even point analysis finds out the sales dollar level or sales units needed to result in zero operating margin, i.e. earning before interest and taxes (EBIT), the financial break-even deals with the bottom line of the company’s income statement.
Formula
Financial break-even point attempts to find EBIT that results in zero net income. The relationship between EBIT and net income can be expressed as follows:
Net Income
= EBIT × (1 − Interest Expense) × (1 − Tax Rate) − Preferred Dividends
Financial break-even point attempts to find EBIT that results in zero net income.
0 = EBIT × (1 − Interest Expense) × (1 − Tax Rate) − Preferred Dividends
Rearranging the above equation, we get the following formula to find the financial break-even (i.e. EBIT level that results in zero net income):
$$ \text{Financial Breakeven}\ (\text{EBIT}) \\= \frac{\text{Preferred Dividends}}{\text{1} - \text{Tax Rate}}+\text{Interest Expense} $$
Example
You company has $100 million preferred stock issue paying 5% per annum, total interest expense of $10 million, interest income of $1 million and tax rate of 33%. Calculate your company’s financial break-even point.
We need to find the earnings before taxes needed to cover the preferred dividend payments, taxes and interest expense.
Preferred dividends will amount to $5 million (=$100 million × 5%). Net interest expense is $9 million ($10 million - $1 million).
Plugging the above values in the equation for financial break-even point, we get the following:
$$ \text{Financial Breakeven}\ (\text{EBIT})\\=\frac{\text{\$5m}}{\text{1} - \text{33%}}+\text{\$9m}\\=\text{\$16.58m} $$
by Obaidullah Jan, ACA, CFA and last modified on