What Does the Break-even Point mean?

For the owner of small business, it is necessary to understand the Break-even point of the business. Most of the owner of the business wants to know how much business needs to achieve in sales to realize the profit. Fixed cost, the variable cost, contribution margin, and sales revenue are the main component of the Break-even point analysis.

For the achievement of the desired income of the company, the break-even point is helpful for the management to make an important decision.

The Basics of Break-even Analysis

For the determination of the level of production break-even point is useful. break-even point calculation is just used by the management of the business only and it is not used by the external resources like investors, regulators, or financial institutions. If the company has a low level of fixed cost then the break-even point of sale of such company is also low.

There are different ways to use this concept. The production manager of the company and executives fully aware of the sales level of the company and how close the company to cover the fixed and variable cost at all times. that is the reason they change the element in the formula reduce the number of units need to produce and increase profitability.

In the calculation of Break-even, all the noncash expenses like depreciation are reflected. In the advance calculator of break-even analysis, all the noncash expenses reflect from the fixed cost to compute break-even analysis.

Fixed and Variable Cost:  Fixed costs represent the cost of the company which not change by the change of the production level or sales of the company. In a company, common fixed cost includes salaries paid to a full-time worker, interest on the debt, and insurance expenses. With the increment of the sales variable cost also increase. Cost of Good Sold, Shipping expenses, sales commission are examples of the variable cost.

Contribution Margin Calculation

Before the deduction of fixed cost the amount of earned money is called contribution margin. Contribution margin is the excess between the selling price of the product and the variable cost. Contribution margin shows the company’s financial resources to cover its fixed cost. Contribution margin can be calculated by subtracting the variable expenses from revenue.

Break-even point determining

break-even point determines the sales amount needed in order to achieve the net income of zero. Break-even is the point when the company’s revenues equal total fixed cost and variable cost, and its fixed cost equals the contribution margin. the break-even point can be calculated by dividing the total fixed cost by contribution margin ratio.

Advertisement

Why are Solvency Ratios Important?

Owner and the management of the company consider the solvency ratios very important because by using these ratios they know the ability of the company to meet its financial obligation in present and in future.

The solvency ratio of the company determines whether the company has sufficient cash flow to manage its debt when it becomes due. Those companies which have high solvency ratios have good financial health and easily pay its obligations. Whereas with low solvency ratio company will be risky for the banks and the creditors. Some time the solvency ratio considers as the leverage ratio.

Solvency ratios do not consider the same as the liquidity ratios. A liquidity ratio measures the ability of the company to pay its short term liabilities whereas the solvency ratios used to measure the ability of the company to pay its long term liabilities. If a businessman keeps an eye on the solvency ratio then he determines whether the business handle or not handle the additional debt.

Importance of Calculating Solvency

Ensure the fiscal health of the company it is necessary to check periodically the solvency ratio of the business. For the evaluation of the capital structure, this ratio also used and management decides whether the internal and external equities must be redistributed.

After calculating the solvency ratio Owner may change the decision of taking more debt because with excessive debt company may struggle to manage the cash flow.

The lender wants to know that the company has the ability or not to pay back the principal amount as well as interest. If the result of the solvency ratio is low for the company then the company is not able to meet its obligations in the long term.

By the industries, a good solvency ratio varies so it is necessary to compare the result of the solvency ratio of the company with its competitors. As compare to debt-heavy industries like utilities the solvency ratio result of the technology industries is higher.

In the long term, most of the companies take the step to improve the solvency ratio results in order to increase profitability. Companies also strive to improve sales in order to improve solvency and profitability.

Types of Solvency Ratios

For tracking the different elements of your financing, you can use different types of solvency ratios. Most popular solvency ratios discuss below which mostly track by the companies on a regular basis.

Debt-to-Equity: Debt to equity ratio can be calculated by dividing the total liabilities of the business by the shareholder’s equity. As compare to shareholder’s equity this ratio is used to calculate the total debt.

If the result of this ratio is high for a company then the company has ever utilized debt to bankroll its growth. Interest level also increases and the company may suffer from the volatile earning. Such type of company needs to reduce the debt and increase the profitability to reducing the solvency ratio result.

Total Debt to Total Asset: It can be calculated by diving the long term and short term liabilities by the total asset of the company. If the company has a high result of the total debt to total asset ratio for a company then the company is risky for the creditors and banks.

Interest Coverage Ratio: this ratio is used to measure the ability of the company to keep up with interest payment, which increases along with the debt. This ratio can be calculated by dividing the earnings before interest and tax (EBIT) by interest expenses.

If the interest coverage ratio of the company is 1.5 or less then it then the company is financially unstable and may struggle to secure loans from banks and other lenders. For boost, the interest coverage ratio company need to reduce the debt and increase the overall profit.

From this ratio, you can forecast the financial health of your company for the upcoming years. Also, this ratio affects your ability t get loans from the banks and creditors.

How to do Liquidity Ratios Analysis

Below is the list of Liquidity Ratios

Current Ratio

Acid Test Ratio

Current Ratio

Quick Ratio

Networking capital

Working Capital

Working Capital Ratio

What is Liquidity Ratios

Liquidity Ratios used to measure the ability of the company to meet its short term current obligations. TO measure the ability of the company to pay off its short term current liabilities most of the companies as well as investors use the liquidity ratios.

If the result of the liquidity ratio is 1 then short term obligation fully covered by the company. With high liquidity ratio company have a high margin of safety because of which company can easily cover its current obligations.

Generally, a company has a high margin of safety if the calculation result of a liquidity ratio of the company is greater then 1 and such type of company has good financial health. If the liquidity ratio of the company is less then 1 then the margin of safety of such company is low and the financial health of such a company is not good. If the liquidity ratio result is equal to 1 then the margin of safety is very low and such type of company is not considered good for the investors.

Current Ratio, Acid Test Ratio, Cash Ratio, Quick Ratio, and working capital ratio are the most common examples of the liquidity ratio. The analyst considers different types of assets relevant to the liquidity ratio. Cash and cash equivalent mostly used to meet short term liabilities in an emergency because of which analyst consider only cash and cash equivalent as relevant assets. In addition to cash and cash equivalent, some analysts consider the debtors and trade receivable as receivable.

For the understanding of the liquidity ratio in a better way, the concept of the cash cycle is very important. Through the operations of the company the cash continuously cycle.

Below are the definitions of the most popular liquidity ratios

Current Ratio: Current ratio calculated by dividing the current assets by current liabilities. Current assets represent the cash, debtor, inventory, bill receivable. Current liabilities represent the sundry creditors, bills payable, outstanding expenses, and so on. If the company want to maintain the current ratio of 3:1 then for every 1 dollar of current liability, the company has 2 dollars of current assets.

Liquid Ratio: Liquid Ratio can be calculated by dividing the quick assets by current liabilities. Quick assets represent all current assets except inventory and prepaid expenses. Current liabilities represent all the liabilities mentioned in the above definition of the current ratio. 1:1 is the ideal liquid ratio because by having this ratio company covert all of its assets quickly into cash. With this ratio for every 1 dollar of current liabilty, there is 1 dollar of quick asset.

Cash Ratio: Cash Ratio can be calculated by dividing the sum of cash, Bank balance, stock, mutual funds by the current liabilities. The company wants to stable the cash ratio is equal to 1 or greater than 1 so that the company can easily pay the current liabilities without delay.

Net Working Capital Ratio: Net Working Capital Ratio can be calculated by dividing the Working capital by the Total Assets and multiply it by the 100. By the difference of current assets and current liabilities working capital calculated and total assets are all types of assets of the company. If the ratio result is high then the company has enough cash flow to pay the liabilities. If the ratio result is low then it is the problem for the company to pay the liabilities.

Why Financial Ratios are important?

Financial ratios are very important for investors because by using these ratios investors find the operational efficiency, liquidity, profitability and stability of any company. Information gain through the financial ratios is much more than the information gain by the raw financial data of the company. Through ratio analysis investors analyze that which is the best company in which investors can invest and get more profit and avoid from loss.

A Standardized Method of Comparison

Financial ratios is the platform which provides the standardized method by using which you can compare the companies or industries. Analysts place all the companies on the same playing field and judge all the companies on the base of their performance rather than the size, sales volume, and market share. By the comparison of raw financial data of 2 companies or industries, the analyst can get limited data. So analysts use the financial ratios for the wider analysis of the companies. Financial ratios use for the actual performance indicators of the companies.

Now we take the example of 2 companies in which 1 is the older company and the 2 is the new company. The older company might boast 40 times much revenue as compare to the new company and in the first glance older company seems stronger. When both the companies compare by using different financial ratios such as Return on Asset (ROA), Return on Equity (ROE), and net profit margin then it is realized that the smaller company is more efficiently generate more profit per dollar of asset employed. There are many other Financial Ratios available on www.lowpersonalloan.com which are also very helpful and informative about the business terms.

Stock Valuation For Strength and Weakness

Understanding of financial ratios and common language is helpful for analysts and investors to evaluate and communicate the weakness and strength of the individual companies or industries. Fundamental Analysis Term, given to use of the financial ratios to find the relative strength of the company or industry for the purpose of investing. By the careful analysis of the ratios of the company, it can analyze which companies have the fundamental strength to enhance their stock value over time and are a potentially profitable opportunity. Also in the market pointing out the weaker point as well.

Planning and Performance

Through ratios, entrepreneurs get guidance at the time of creating the business plan or preparing of the presentation for investors and lenders. By revealing the financial opportunities and weakness of the business these ratios keep the managers on their toes.

Users of Financial Ratios

Financial ratios used to determine the financial position of the company through its liquidity, profitability and other indicators. Below are some users who use the financial ratios to find the financial performance of the company.

Bankers and Lenders: Bankers and Lenders use the profitability and liquidity ratio to find the ability of the borrowing business in regular schedule interest payment and the repayment of the principal amount.

Investors: Investors use the profitability ratio and investment to find the profitability of the company because investors concern about its profit on its investment.

Customers: Customers use the liquidity ratio because they make sure that the company to continue the supply.

Suppliers: Suppliers use the liquidity ratio to find the liquidity of the company that the company has the ability to settle its short term obligations as and when they are due.

Government: Government use the profitability ratio to find the profit of the company for the purpose of taxation.

Management: Management use all the financial ratios because management is interested in all aspects.

There are many people across the globe who really focus on the use of Financial Ratios and there are many forums sharing ideas about such ratios. on of the famous forum where you can learn different financial ratios is https://www.investopedia.com/ or you can also check https://corporatefinanceinstitute.com for the better understnding of such concepts.