OPERATING LEVERAGE AND BREAK-EVEN ANALYSIS: HOW LOW CAN YOU GO?

Introduction: Breaking Even is Hard to Do

           Economic cycles are a fact of life in business, and those who are successful pay a hefty tuition in this economy’s school of hard knocks. After all, as Confucius said, he who will not economize will have to agonize. The purpose of this article is to explain why profits can be so volatile and what must be managed in order to break even.

Formula for Distress: No Pain, No Gain

           The great American unionist Samuel Gompers warned that the worst crime against working people is a company which fails to operate at a profit. We working bankers learn early in our accounting and finance classes that profit is the difference between revenue and expense, and the surefire way to improve profit is to increase revenue and/or decrease expense:

·      Revenue – Expense = Profit

·      Increased Revenue – Decreased Expense = Higher Profit

Boosting revenue and cutting expense is easier for some than others, and then consider the two variables that drive revenue, price per unit and quantity of units:

·      Total Revenue = Price per unit x Quantity of units

Ambrose Bierce’s The Devil’s Dictionary defined price as value plus a reasonable sum for the wear and tear of conscience in demanding it.  In good conscience, a firm could raise prices, but competitors are likely to match or undercut the firm’s prices. Worse, some industries, such as construction, are further restricted in price flexibility by the use of fixed price contracts, and the typical contractor wins a construction contract only by bidding the lowest possible price. Adjusting prices on a current contract is further constricted by the change order process, basically, modifying the original contract’s price, so boosting prices is not a feasible strategy for a contractor competing for work in a fixed price bidding environment. 

           Ben Franklin warned to “Beware of little expenses; a small leak will sink a great ship.” Operating a business can run up to a boatload of costs, and bailing out of them is not easy. Let’s try, anyway, by stating the obvious, that total costs are the product of cost per unit and quantity of units:

·      Total costs = Cost per unit x Quantity of units

Some borrowers operate in fixed price bidding environments which substantially reduce both the price and cost flexibility that other businesses enjoy under more open marketplaces. If neither price nor cost is easily changed, the fixed price firm’s choices are limited to ensuring that the contracted price is maintained and that costs are contained. In effect, with a tacit ceiling on revenue and a floor on costs, the firm’s odds of increasing its profits are far less than an individual transaction’s profit being reduced because of unexpected costs.

           On top of possible price and cost limits, firms must survive economic and industry cyclicality. If these cycles are volatile from year to year, generating enough revenue to break even is even harder when sales are unpredictable from year to year. Let’s look at some measures that quantify revenue volatility and break-even sales points. How much will changes in sales impact profits, and how much revenue is needed to break even?

Operating Leverage: A Little goes a long way

Operating leverage measures the impact of changes in sales on profits. All things being equal, if sales rise by 10%, how much will profits increase? If a 10% increase in sales results in a 25% rise in profits, that is an operating leverage of 2.5x. However, financial gravity can be painful because a 2.5x operating leverage means that a 10% decline in sales would reduce profits by 25%. Worse, companies doing business in industries characterized by both high operating leverage and volatile sales will be vulnerable to erratic profits. Construction suffers from both maladies, so recession and expansion can give the construction industry a bad case of the shakes. Let’s now learn how to calculate operating leverage.

Suppose a firm generated $1 million of revenues, enjoyed a 20% gross profit margin, and incurred $164,000 of fixed costs to earn a $36,000 pretax profit. What would happen if his sales rose or fell by l0%?

   Sales                                 Change

Income Statement ($) Actual                   + 10%                                          -10%

Revenues                  $1,000                     $1,100                                        $900

 -COGS                           800                          880                                             720

GP @ 20%                  $200                         $220                                          $180

 -Fixed Costs                164                            164                                            164

PBT                              $36                            $56                                             $16

GP/PBT (x)                    5.5                           +55%                                           -55%

If sales were to rise by 10%, and all things being equal, GPM remains at 20% of revenues and fixed costs stay at $164,000, the result is that pretax profits rise $20,000, or 55%, to $56,000. On the other hand, if sales were to slip 10% to $900,000, all things being equal, pretax profits amount to $20,000 and 55% less than the actual figure, just $16,000. What is the significance of 55%?

Operating leverage (OL) is the ratio of gross profit to profit before taxes (GP/PBT). In this example, OL is 5.5. How do we use it? Just multiply the change in sales by the operating leverage to yield the change in pretax profits, so a 10% change in sales times 5.5 means PBT will change by 55%, all things being equal. Of course, if all things do not stay equal, OL will change. The significance of OL is its reliance on GPM’s sufficiency to cover fixed costs. The lower the gross profit margin, and the higher the fixed costs, the higher the operating leverage. Naturally, GPM’s tend to narrow in recession as firms drop prices to drum up business, and given overhead’s natural resistance to immediate reduction, the result is a rising OL in a declining sales environment. Financial gravity comes down hard in these circumstances with even minor drops in revenues resulting in substantial declines in profits.

BREAK-EVEN ANALYSIS

              Another way to illustrate operating leverage is to examine its link to break-even analysis, the level of revenues necessary to cover all expenses. A simple way to cal-culate break-even sales is to figure out how much gross profit is needed to cover fixed expenses. In the preceding example of the $1 million firm, about $820,000 is the break-even point, or about 82% of sales ($820,000/$1,000,000):

Break-Even Sales (BES) =   fixed expenses        =  $164,000      =  $820,000

                                              gross profit margin          20%

With a little algebraic substitution, BES can be expressed in terms of operating leverage (OL):

BES = (OL - 1) (Actual Sales) = (5.5-1) (1,000,000) = $820,000

                        OL                                    5.5

Does this break-even work? It does, indeed:

                                                      Break-Even Sales                                     $820,000

                                                      - Cost of Sales @ 80%                               656,000

                                                      Gross Profit                                                164,000

                                                      - Fixed Cost                                                 164,000

                                                      Profit before Taxes                                             $ 0

           We can also express BES as a percentage of sales:

BES % = (OL – 1)/OL = (5.5 – 1)/5.5 = 4.5/5.5 = 82%

 Imagine if gross margins tightened from 20% to just 18% and drove the OL to 11.25 [($180 gross profit/ ($180 GP-$164 overhead=$16 PBT) = $180/$16 = 11.25] then the BES sales would be (11.25-1)/11.25 = 91.1%. Despite gross margins in the 40 to 50% range, retailers carry large overheads as a result of their brick-and-mortar investments, and they often carry OL ratios in the 10-15 range. What a surprise that many of them do not break even until the Christmas season!

The point of all this math is simply to say, the lower the gross margin, the high-er the break-even point, and the higher the operating leverage, the higher the break-even point. Too high a break-even point could break both the borrower and the banker. A key element in lowering the break-even point are the expenses below the gross profit line:

General & Administrative Expenses. General and administrative (G&A) expenses are a key group of expenses because of their fixed nature. They represent the “nut” that must be covered by the gross profit. Their intractability is best explained by example. Whether there are ten workers in the factory or a hundred hands on deck, some office contingent is necessary to process payroll, pay bills, prepare invoices, and collect the receivables. This headquarters staff needs housing, and that requires heat, light, water, phones, rent, equipment leases, and so forth.

One pragmatic way to determine the reasonableness of this and all other expenses between the gross profit margin line and the pretax profit margin line is to compare them with industry averages. If the firm’s expenses exceed the industry benchmark but the gross profit margins are in line, it is appropriate for the lender to review the G&A expenses with the borrowing firm.

Officers’ Salaries and Bonuses. Fair compensation is a reasonable expense, but unusually large salaries and bonuses without any clear connection to production or sales can look like a hidden dividend being passed through to the principals before the debt repayment to the lenders. RMA industry statistics tracks owners’ compensation as a percentage of sales, so this data provides bankers with a measure of reasonableness. Meanwhile, the IRS has its own internal guidelines on compensation, and amounts that grossly exceed the IRS standards can be declared constructive dividends taxable to the individuals.

Bankers may employ covenants to restrict officers’ compensation and to limit dividends, but covenants that require a minimum net worth or capital funds—to give credit for amounts subordinated to the bank—can achieve the same end, especially if “step-up provisions” boost the minimum each year. If the step-up approximates the firm’s profits based on more modest salaries and excludes any provision for dividends, the contractor is free to compensate and reward as he sees fit so long as he meets the minimum equity covenant. A capital funds definition of minimum net worth solves the problem created by an S corporation’s dividend payments to comply with tax law. The lack of cash to pay the dividends often results in an S corporation’s booking notes payable to stockholders, so counting the subordinated notes as net worth gives the borrower a reward for standing behind the bank. Thus, the banker is not caught up in the day-to-day operations and possible lender liability litigation, and the borrower is not entangled in wasteful negotiations to circumvent compensation or dividend restrictions.

Rent & Lease Expense. Rent and lease expense is typically the consequence of furniture, equipment, and premises. The lessors are creditors just as much as bankers are, and the firm may need the equipment to perform the work. If renting equipment is cheaper than buying machinery outright, the borrower should be encouraged to pursue this alternative. However, fixed charges coverage is a sound way to monitor the ability of the borrower to generate sufficient operating earnings to cover rent and lease expense. Another approach is to capitalize rent and lease obligations to estimate their total obligation, add them to total debt, and calculate the debt-to-worth ratio. If the result is well above the industry’s leverage norms, the borrower is probably renting or leasing too much.

Travel & Entertainment Expense. Travel and entertainment (T&E) expense warrants the same close attention that any well-run business gives to this category if for no other reason than the IRS scrutinizes it so intently. Ideally, Sophisticated firms exert vigorous control over this expense by employing T&E reports that require classification of daily expenses into travel, hotel, meals, etc., in order to be reimbursed. The report form with attached receipts stands up to IRS inspection better than a check voucher stapled to a vague invoice. T&E expense reports offer a candid view of a borrower’s propensity to incur legitimate expenses. If a borrower is pushing across the boundaries of allowable expenses into potentially disallowable expenditures, the borrower is courting a possible IRS audit. Remember, tax liens tend to enjoy priority over bank loans.

Other expenses warrant cursory review if only because anything that does not fit the previous categories falls into this “other” or “miscellaneous” classification. Keep in mind that most expenses decrease profits and most consume cash otherwise available for debt repayment. The lender is entitled to be sure that cash-absorbing expenses are legitimate and necessary.

SUMMARY AND CLOSING: COZY UP TO THE BAR

           During an earlier difficult era, Winston Churchill argued the importance of the profit motive to the political economy, “It is a socialist idea that that making profits is a vice; I consider the real vice is making losses.” Recession reminds us all how vital a role business profits play in recovery, so it is appropriate to review how prices and costs impact profits and how important break-even analysis is to a firm’s survival. Remember Chubby Checker’s sage question from his 1962 Limbo Rock: Limbo lower now, Limbo lower now, how low can you go?” Don’t let borrowers dance around the question, set the expectations bar as low as your borrowers can go. The lower the fixed costs, the lower their break-even points, the happier both borrowers and bankers will be.