Breakeven: zeroing in on a much-neglected concept in finance

April 2024 | SPOTLIGHT | FINANCE & ACCOUNTING

Financier Worldwide Magazine

April 2024 Issue

In his 2009 book ‘Predictably Irrational’, published at the height of a global financial crisis that proved many of his key points, Dan Ariely summarises the twists and turns that the number zero has experienced over time, from being mistrusted by the Ancient Greeks (who pondered how nothing could be something), to the landmark use of zero in early decimal theory a millennium later, to the rediscovery of zero’s power (along with the power of one) in modern computer science. We believe that the concept of the financial breakeven similarly deserves a rediscovery. This article will explain why the concept matters, provide an overview of accounting issues, and then propose six financial breakeven points to consider.

Many financial professionals – whether managers or investors – put all their planning into maximising returns and minimising losses, but they rarely stop to ask: compared to what? What is the breakeven we are measuring, above which we make a profit and below which we have suffered a loss? Yet without this point, we cannot know if we have succeeded. In fact, there is not a single breakeven point but several, depending on the goals we set. Breakeven points can be calculated differently for identical projects, depending on the financier’s goal. Those ‘breakeven points’ can be used as strategic key performance indicators for business unit managers.

Breakeven is both a financial concept and an accounting matter because financial performance (the province of financial managers) and financial reporting (the province of accounting) are intertwined. Because the concept of breakeven relies heavily on revenue recognition and cost analysis, we need to acknowledge the standards of the accountants who are measuring profits, losses and (however rarely) breakeven results. But even here there are no hard and fast rules; standards differ.

Consider the standards of the International Financial Reporting Standards (IFRS). They are recognised in 140 jurisdictions, including the UK and France, but not in the US, despite efforts to unify. In May 2014, the IFRS and the US standard setter, the Financial Accounting Standards Board, which sets forth generally accepted accounting principles (GAAP), agreed on a convergence of standards for recognising revenue from contracts, but the two organisations are hardly in lockstep on the issue. For the past 10 years, the US has been issuing formal amendments to Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606). Nor do the two organisations see eye to eye on costs. To understand breakeven, the manager must be able to decompose the total cost of a business into fixed costs (independent of the level of sales) and variable costs (assumed here to be proportional to the level of sales), but standards for measuring costs vary, too. As noted by PwC in its comparative study ‘Expense Recognition: Gains/Losses’, under the IFRS remeasurement effects are recognised immediately in ‘other comprehensive income’ and are not subsequently recorded within profit or loss, while US GAAP permits delayed recognition of gains and losses, with ultimate recognition in profit or loss.

Furthermore, these standard setters are not the only ones out there. For example, there is an official standard known as the ‘plan comptable general’ for privately held French firms, validated by the Authority of Accounting Rules and the French Minister of the Budget.

These various accounting standards, as important as they are, only scratch the surface of what matters about breakeven. They do not fully answer the question of breakeven from the financial manager’s point of view. In the remainder of this article, we will explore the concept of the breakeven point. We see three breakeven points from the firm’s view, and three from a shareholder’s perspective.

The simplest calculation of breakeven is the operating breakeven. This assumes a level of sales high enough to have a positive earnings before interest and taxes (EBIT). Assuming a business with €10m of operating fixed costs, including wages, rents or leasing, energy and infrastructure, insurance, software licences, and so on, and a 40 percent variable cost margin (operating margin without fixed costs) then the operating breakeven is €25m. Clearly here one can easily understand that the lower the breakeven point, the better. So, managers can focus on reducing fixed costs, improving the pricing, and optimising the production process (the two latter with an aim of enhancing the variable cost margin). Depending of the depth of a company’s management accounting system it can even calculate an operating breakeven by business unit, the main challenge being the allocation of indirect costs to each business unit. Top financial planning and analysis teams can even forecast the evolution of the breakeven point. Indeed, one can model the ‘staircase’ shape of fixed cost evolution, the economy of scale in the supply chain, the pricing premium with the growing market share, and the learning effect in the production process. We recommend starting with the operating breakeven point in order to diffuse a breakeven consciousness and culture into the firm.

The second breakeven point, and the first from the perspective of the shareholder, is the total breakeven for the shareholder. The question is: what positive net income do you need to break even from this perspective? Here you just add financial expenses to fixed costs. For example, if you have a net debt of €40m with a 6.5 percent interest then you have €2.6m in financial expenses and so the total breakeven is €31.5m. Clearly, there may be huge differences between the operating breakeven point and the total breakeven for the shareholder if the firm is highly leveraged with variable interest rates in a rising interest rate environment. Obviously, since the financial expenses are fixed costs, the total breakeven for the shareholder is harder to reach than the operating one.

The next two breakeven points are interesting because they introduce to managers the fact that assets have a cost.

With the economic value added (EVA) breakeven, you assume that your assets have a cost, and that this cost is the cost of capital. Fixed asset is of course a fixed cost, but working capital is a variable cost. For example, with a weighted average cost of capital (WACC) of 9 percent, €70m of fixed assets, and the working capital equal to 15 percent of sales, then the EVA breakeven is €48.2m. Clearly, here we are focused on value creation and so the EVA breakeven is to have a return on capital employed (ROCE) bigger than the WACC. This is a very important concept because this cost of capital is not on the income statement and so a lot of managers of small and mid-sized businesses simply ignore it. We strongly recommend companies utilise this EVA breakeven because it aligns the employees with the notion of asset frugality. Here again, EVA breakeven can be deployed at the business unit level, with special care given to the allocation of fixed assets and working capital.

The shareholder value added (SVA) breakeven point is similar to the EVA breakeven, but from the shareholder perspective, so you assume a cost for equity (cost of equity multiplied by book equity). This ‘cost of equity’ represents the expectation of return by the shareholder and hence is a ‘fictive cost’ which reduces the net income. The higher the book value of equity and the higher the return expected by the shareholder, the higher the ‘cost of equity’ that one should subtract to net income to have the SVA. With €60m of book equity and a cost of equity of 12 percent, the SVA breakeven is €55.5m. Here the goal is to allow the shareholder to have a return on equity (ROE) that is bigger than the cost of equity: the expected rate of return for the shareholder given the risk of the investment.

The final two breakeven measures are critical for any businesses that are highly leveraged. Here we invoke the maxim ‘cash is king’. Coined by former Volvo chief executive Pehr G. Gyllenhammar at the height of the leveraged buyout (LBO) craze in the 1980s, this aphorism remains true to this day, so putting a ‘cash culture’ in a business is of utmost importance.

With the free cash flow (FCF) breakeven, we assume that net capex (measured here as capital expenditures minus depreciation and amortisation) is a fixed cost, but that working capital change is a variable cost linked to the growth rate. For example, with a net capex of €3m and a growth rate of 5 percent, the FCF breakeven is €35.9m. Again, here the goal is to think strategically about what can be done to enhance free cash flow in a regular manner. As with the other breakeven points, the FCF breakeven should be managed on a ‘going concern’ basis, which means any drastic actions, such as deep cost cutting with only a short-term focus while harming long term value creation, should be strictly avoided. Just keep in mind that those metrics are here to allow ‘continuous improvement’ in a regular and smooth way.

The last breakeven measure is one for private equity fund managers during an LBO. The internal rate of return (IRR) breakeven is the level of sales we have to reach if we resell a business one year later with the same EBIT multiple and assuming the same cost structure to have the target IRR. So, imagine that our past EBIT is €12m and we buy the business for 11 times EBIT. In order to have 15 percent IRR if we resell it next year with the same multiple, we need to reach €57.2m in sales.

In conclusion, breakeven matters. Some may say that what we have discussed here are only financial numbers; that the reality of transactions and cash flow are what really matter, however formulated. We disagree. By understanding and embracing a variety of valid approaches to calculating breakeven points, financiers will become more committed to the revenue goals they are seeking, and more aware of what costs may prevent the attainment of those goals.

Benjamin Forestier is a professor at the Ecole Polytechnique/ESSEC/HEC and Alexandra R. Lajoux is chief knowledge officer emeritus at the National Association of Corporate Directors. Mr Forestier can be contacted by email: benjamin.forestier@polytechnique.edu. Ms Lajoux can be contacted by email: arlajoux@capitalexpertservices.com.

Benjamin Forestier

Ecole Polytechnique/ESSEC/HEC

Alexandra R. Lajoux

National Association of Corporate Directors