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Breakeven and Cash Flow Analysis Is Critical To The Success Of Your Business - Jul 2, 2010

Posted by: Charles G. Yacoobian in Articles

In this tough economy, it is important for the business owner to review two critical analytical tools to ensure the success of his/her firm.

Breakeven Analysis

Let’s take a look at how increases and decreases in sales and expenses affect your bottom line.

It is very helpful to breakdown expenses into “fixed” and “variable” categories to better understand how each expense category is affected by an increase/decrease in sales. Fixed expenses are those that remain level/constant regardless of the sales level. Variable expenses are those that will go up or down in relation to a change in sales. Some expenses have both fixed and variable aspects to them.

Examples of “fixed” expenses are rent (not tied to a percentage of sales), telephone, depreciation, most utilities and administrative salaries. Examples of “variable” expenses are sales commissions (tied solely to a percentage of sales), cost of goods sold, shipping expenses and supplies. Examples of expenses that have both fixed and variable aspects to them include rent (which may have a fixed portion and a portion based on a percentage of sales, license/franchise fees, sales commissions (commissions paid once sales reach a certain level) and insurance (premium based on sales).

Sales $1,000,000

Variable Expenses $ 750,000 75% of sales

Profit left over to offset fixed expense $ 250,000

Fixed Expenses $ 200,000

Profit $ 50,000

Break-even point of company is $800,000 in sales:

Sales $ 800,000

Less: Variable Exp ($800,000 x .75) $ 600,000

Profit left over to offset fixed expense $ 200,000

Fixed Expenses $ 200,000

Profit $ 0

Current sales of $1,000,000 are $200,000 above the break-even point. This is commonly known as the margin of safety. You have the comfort of knowing that sales could decline 20% ($200,000) and your company would still be above break-even. Reducing fixed expense, brings down the break-even level. In the example, if fixed expense is reduced by just $25,000, it drops the break-even point to $700,000, thus raising the margin of safety by $100,000.

What happens if sales increase to $1,200,000

Variable Expenses ($1,200,000 x .75) $ 900,000

Profit left over to offset fixed expense $ 300,000

Fixed Expenses $ 200,000

Profit $ 100,000

So, in this example, an extra $50,000 in profit is generated from a $200,000 (20% increase) increase in sales. Sounds good, but you must also consider whether you can afford the increase in sales….what is the effect on A/R, Inventory, A/P, machinery & equipment, etc. Do you have the capital/cash or access to the capital/cash to finance the sales growth?

Cash Flow Analysis

Comparative balance sheet data show the change that has taken place in a company’s working capital position. Analysis of comparative balance sheet data together with a review of activities of the period will reveal the sources and the uses of working capital.

Examples of sources of cash:

Owners make additional cash deposit/investment
Bank or other financing
Decrease accounts receivable
Decrease inventory
Increase accounts payable
Net profits

Examples of uses of cash:

Pay down debt
Decrease accounts payable
Increase inventory
Increase accounts receivable
Purchase machinery & equipment
Net Loss

Effect on Cash

12/31/10 12/31/09 Increase Decrease

Cash $ 75,000 $ 70,000 $

Notes Receivable 5,000 5,000 0 0

Accounts Receivable 80,000 83,000 3,000

Inventory 60,000 71,000 11,000

Machinery & Equipment 83,000 44,000 $ 39,000

Total $ 303,000 $ 273,000

Notes Payable $ 58,000 $ 39,000 19,000

Accounts Payable 15,000 25,000 10,000

Owner’s Equity 80,000 30,000 50,000

Retained Earnings 150,000 179,000 29,000

Total $ 303,000 $273,000 $ 83,000 $ 78,000