Most people have probably heard the term “breakeven” but maybe are not so sure what it actually means and why it’s important to lenders.
But what if we said that the breakeven figure doesn’t really tell lenders very much? And, if that’s true, how can we use the figure as the basis for something useful?
Using a breakeven calculation, a business owner can know what level of revenue will cover all expenses and result in zero profit and zero loss and, with an understanding of that figure, can then consider what impact changes in total expenses or in the selling price of his or her product will have on the business.
So, from a business owner’s perspective, calculating the breakeven sales figure helps to avoid setting up a business venture, starting a project, launching a new product or making changes in an existing business that is going to cause the business to make a loss. Fine.
As lenders though, we want to know a bit more. One of the things we want to know is what level of revenue has to be generated to not only cover all the expenses but to generate a profit since, ultimately, we want to be lending to businesses that are profitable and, therefore, sustainable in the long-term.
To make that calculation, what do we need to do? Simply add a targeted level of desired profit to the total expenses when calculating the breakeven figure. The resulting revenue figure will obviously be higher than in the original calculation and this gives us the opportunity to consider whether that level of revenue is achievable by the business and whether the business really is sufficiently profitable.
The second thing we need to know is what level of revenue has to be generated to cover all the expenses, provide a level of profit …and repay the bank’s debt. It’s always a good idea of think about whether the business has the ability to repay before providing the loan and this is a tool for doing just that.
To figure out this new breakeven figure what do we have to do? You’ve probbaly guessed that we need to add one year’s interest and capital repayments to the total expenses and the targeted profit figure that we would have used in the previous calculation.
A potential drawback here is that we’ve used future debt in the calculation but only the previous year’s revenue. Hopefully, the new debt will be applied productively in the business and should help to grow the revenue so it might be fairer to use a projected revenue figure in this last calculation – as long as that figure is reasonable and achievable. Or you could be conservative and ignore any revenue growth.
So, the breakeven figure on its own is only partially useful. With a couple of simple tweaks it can help us gain much better insight into the credit risk.