# Break-Even Analysis

Break-Even Analysis Definition:

A technique for analyzing how revenue, expenses and profit vary with changes in sales volume

One useful tool in tracking your business's cash flow is a break-even analysis. It's a fairly simple calculation and can prove very helpful in deciding whether to make an equipment purchase or in knowing how close you are to your break-even level. Here are the variables needed to compute a break-even sales analysis:

• Gross profit margin
• Operating expenses (less depreciation)
• Annual debt service (total monthly debt payments for the year)

Since we're dealing with cash flow, and depreciation is a noncash expense, it's subtracted from the operating expenses. The break-even calculation for sales is:

(Operating Expenses + Annual Debt Service)/Gross Profit Margin = Break-Even Sales

Let's use ABC Clothing as an example and compute this company's break-even sales for years one and two. In Year 1, the company's sales were \$1 million and their gross profit was \$250,000, resulting in a gross profit margin of 25 percent (\$250,000/\$1 million). In Year 2, sales were \$1.5 million and gross profits were \$450,000, resulting in a gross profit margin of 30 percent ((\$450,000/\$1.5 million). Now let's use calculate their break-even sales figure:

Break-Even Sales for Year 1:
(Operating Expenses of \$170,000 + Annual Debt Service of \$30,000)/
Gross Profit Margin of 25 percent (.25) = \$800,000 break-even sales figure

Break-Even Sales for Year 2:
(Operating Expenses of \$245,000 + Annual Debt Service of \$30,000)/
Gross Profit Margin of 30 percent (.30) = \$916,667 break-even sales figure

It's apparent from these calculations that ABC Clothing was well ahead of break-even sales both in Year 1 (\$1 million sales) and Year 2 (\$1.5 million sales).

Break-even analysis also can be used to calculate break-even sales needed for the other variables in the equation. Let's say the owner of ABC Clothing was confident he or she could generate sales of \$750,000, and the company's operating expenses are \$170,000 with \$30,000 in annual current maturities of long-term debt. The break-even gross margin needed would be calculated as follows:

(\$170,000 + \$30,000)/\$750,000 = 26.7%

Now let's use ABC Clothing to determine the break-even operating expenses. If we know the gross margin is 25 percent, the sales are \$750,000 and the current maturities of long-term debt are \$30,000, we can calculate the break-even operating expenses as follows:

(.25 x \$750,000) - \$30,000 = \$157,500

## Cash Float Accounts

A bank account specifically set up by a business owner to float money through from Business A to enhance the perceived value of Business B

## Cost-Benefit Analysis

A process by which you weigh expected costs against expected benefits to determine the best (or most profitable) course of action

## Assets

The value of any tangible property and property rights owned by a company less any reserves set aside for depreciation. Assets don't reflect any appreciation in value unless they're sold for the greater value.

## Debt-to-Equity Ratio

A measure of the extent to which a firm's capital is provided by owners or lenders, calculated by dividing debt by equity. Also, a measure of a company's ability to repay its obligations. If ratios are increasing--more debt in relation to equity--the company is being financed by creditors rather than by internal positive cash flow which may be a dangerous trend.

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