Chapter 5

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Entrepreneurial Finance, 4th EditionBy Adelman and Marks

PRENTICE HALL©2007 by Pearson Education, Inc.Upper Saddle River, NJ 07458

5-1

Chapter 5

Profit, Profitability, and Break-Even Analysis

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5-2

Learning Objectives Understand the difference between efficiency and

effectiveness. Distinguish between profit and profitability. Compare accounting and entrepreneurial profit. Understand the relationship of profit margin and asset

turnover on the earning power of a company.

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5-3

Learning Objectives (continued)

Given the variable costs, revenue, and fixed costs of a business, determine the break-even point and contribution margin.

Construct and analyze a break-even chart when given variable costs, revenue, and fixed costs of a business.

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5-4

Learning Objectives (continued)

Understand the use of leverage and its relationship to profitability and loss.

Distinguish between Chapters 11, 13, and 7 bankruptcy. Compare and contrast the degree of operating, financial,

and combined leverage and their effect on the profitability of a corporation.

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5-5

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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5-6

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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5-7

Profit Versus Profitability (continued)

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).

assets Total

(income)profit Net ROI =

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5-8

Earning Power

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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5-9

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).

assets Total

sales Net x

sales Net

(income) profit Net

turnover asset Total x margin profit Net power Earning

=

=

assets Total

(income) profit Net power Earning =

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5-10

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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5-11

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

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5-12

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

$

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5-13

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

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5-14

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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5-15

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)

Dollars in Thousands (000)

Total Revenue

Total Cost = FC + VC

Break-Even Point

Fixed Costs (FC)

LossArea

Profit Area

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5-16

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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5-17

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 =

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5-18


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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5-19


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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5-20

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.

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5-21

Bankruptcy (continued)

› 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.

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5-22

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.

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5-23

AssetsCurrent assets Checking account 2,000$ Accounts receivable 10,000 Inventory 35,000 Total current assets 47,000$ Fixed assets Land 50,000$ Buildings 250,000$ Less: Accumulated depreciation 100,000 150,000$ Equipment 50,000 Less: Accumulated depreciation 30,000 20,000$

Total fixed assets 220,000$

Total assets 267,000$

Liabilities and owner’s equity

Current liabilities Accounts payable trade 20,000$ Notes payable bank 20,000 Taxes payable 3,000

Total current liabilities 43,000$

Long-term liabilities Building mortgage 200,000$ Equipment loan 30,000

Total long-term debt 230,000$

Total liabilities 273,000$

Owner’s equity (6,000)

Total liabilities and owner’s equity 267,000$

Table 5-3 Balance Sheet, The Tom Jones Company

The Tom Jones CompanyBalance Sheet

As of December 31, 2006

Chapter 5

Documents

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