$$ Entrepreneurial Finance, 5th Edition Adelman and Marks Pearson Higher Education ©2010 by Pearson...

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Entrepreneurial Finance, 5th EditionAdelman and Marks

Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458

4-1

Chapter 5

Profit, Profitability, and Break-Even Analysis

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4-2

Efficiency and Effectiveness

Efficiency is obtaining the highest possible return with the minimum use of resources.

Effectiveness, on the other hand, is accomplishing a specific task or reaching a goal.

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4-3

Profit Versus Profitability

Profit is an absolute number that is earned on an investment. › Accounting profit, for a business, is typically shown at the

bottom of an income statement as net income. › Entrepreneurial profit is the amount that is earned above and

beyond what the entrepreneur would have earned if he or she had chosen to invest time and money in some other enterprise.

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4-4

Earning Power Profitability can be measured in a business by using a

ratio that is obtained by dividing net profit by total assets. Profitability, therefore, is our Return on Investment (assets).

The earning power of a company can be defined as the product of two factors: › The company’s ability to generate income on the amount of

revenue it receives, which is also known as net profit margin; and › Its ability to maximize sales revenue from proper asset

employment, also known as total asset turnover.

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4-5

Earning Power Formulas

Earning power is equal to net profit margin multiplied by total asset turnover which is equal to return on investment (total assets).

Earning power Net profit margin x Total asset turnover

Net profit (income) Net sales x

Net sales Average total assets

ROA AssetsTotal Avg

(Income Profit NetPower Earning

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4-6

Break-Even Analysis Break-even analysis is a process of determining how

many units of production must be sold, or how much revenue must be obtained, before we begin to earn a profit.

For break-even quantity:

VC- P

FC BEQ

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4-7

Cost Category Payment Basis Cost ($)

Rent Monthly 2000.00Salaries Monthly 5000.00Employee benefits Annually 7000.00Insurance Quarterly 1500.00Property taxes Annually 3000.00Wood Per truck 1.25Paint and finishing Per truck 0.25Labor Per truck 2.50Packing and shipping Per truck 2.00

Table 5-1 Cost Data for Carl’s Toy Trucks

What is the annual fixed cost?What is the VC per unit?

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4-8

Break Even in Units

FX = $100,000 VC = $6.00 If the price is $10 per truck, what is the BE?

What if the price is $20?

units 000,25$6- $10

$100,000 BEQ

units 142,7$6- $20

$100,000 BEQ

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4-9

Break-Even Analysis (continued)

Contribution margin is the amount of profit that will be made by a company on each unit that is sold above and beyond the break-even quantity.

Contribution margin (CM) is also the amount the company will lose for each unit of production by which it falls short of the break-even point.

Contribution Margin = Price – Variable cost If CM = FC, then the firm is at break-even.

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4-10

Break-Even Analysis (continued)

Break-even dollars:

Where VC is variable cost expressed as a percentage of sales (revenue).› For retail firm: VC percentage =(Cost of Goods Sold)/(Net Sales)› For manufacturing firm: VC percentage = (Variable cost of a

unit)/(Selling price)

P

VCFC

BE

1

$ 000,250$

10$6$

1

000,100$$BE

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4-11

Profit and Break-Even

Desired profit with break-even analysis in quantity to produce.

› VC is variable cost per unit Desired profit with break-even analysis in dollars.

› VC is a percentage of sales dollar (e.g., cost of goods sold as a percent).

VC - P

profit Desired FC quantity Total

dollar) sales theof percentage a (as VC-1

profit Desired $

FCBE

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4-12

Break-Even Charts

Figure 5-1 Break-Even Chart for Carl's Toy Trucks

0

100

200

300

400

500

600

700

0 10 20 30 40 50 60 70

Units Sold in Thousand (000)

Do

llars

in T

ho

usan

ds (

000)

Total Revenue

Total Cost = FC + VC

Break-Even Point

Fixed Costs (FC)

LossArea

Profit Area

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4-13

Leverage

Leverage uses those items that have a fixed cost to magnify the return to a company. Fixed costs can be related to company operations or related to the cost of financing.› Interest expenses paid on the amount of debt incurred is the fixed

cost of financing.› A firm is heavily financially leveraged if the fixed costs of

financing are high.

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4-14

Leverage (continued)

Degree of operating leverage (DOL) is the percentage change in operating income divided by the percentage change in sales.

salesin change Percentage

income operatingin change Percentage DOL

Degree of financial leverage (DFL) is the percentage change in earnings per share divided by the percentage change in operating income.

income operatingin change Percentage

shareper earningsin change Percentage DFL

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4-15

Leverage (continued) Degree of combined leverage (DCL) is the percentage

change in earnings per share divided by the percentage change in sales.

sales change Percentage

shareper earningsin change Percentage DCL

income operatingin change Percentage

shareper earningsin change Percentage

salesin change Percentage

income operatingin change Percentage DCL x

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4-16

Bankruptcy

Bankruptcy for a business occurs when the liabilities of the firm exceed the assets and the business does not have sufficient cash flow to make payments to creditors. There are essentially three types of bankruptcy, Chapter 11, Chapter 13, and Chapter 7.

› Chapter 11 bankruptcy occurs when a business seeks court protection while it develops a reorganization plan.

› Chapter 13 bankruptcy is reserved for individuals and sole proprietorships and is similar to, but much simpler than, Chapter 11.

› Chapter 7 bankruptcy requires liquidation of all assets of the business, and payment to the creditors.

http://www.youtube.com/watch?feature=player_detailpage&v=-oW4M3vpuRM

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4-17

Bankruptcy (continued) Bankruptcy Abuse, Prevention, and Consumer Protection

Act.› Signed into law by President Bush on April 20, 2005.› Took effect October 17, 2005.› Makes it much more difficult for individuals and business to

declare Chapter 7 bankruptcy. › Establishes a means test to determine if an individual filing

Chapter 7 is abusing the system.› Imposes federal guidelines for using the homestead exemption.

http://www.youtube.com/watch?feature=player_detailpage&v=mxVWyzzMOXM

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4-18

Personal Bankruptcy

http://www.youtube.com/watch?feature=player_detailpage&v=9jGufOGo88A

$$ Entrepreneurial Finance, 5th Edition Adelman and Marks Pearson Higher Education ©2010 by Pearson...

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