Analyzing Your Company's Capital Structure Using EBIT Breakeven
It is important to have an understanding of your capital structure. Your capital structure consists of the combination of debt and equity as reflected on the Blance Sheet. The combination of debt and equity is reflective of your risk. Higher levels of debt equate to higher levels of risk. This can eventually cripple a company over the long term. However, too much equity can also be costly since equity carries a higher cost than debt. So the goal is to find the right balance or mix that grows the company at an acceptable level of risk.
One way of determining the right mix of capital is to measure the impacts of different financing plans on Earnings Per Share (EPS). The objective is to find the level of EBIT (Earnings Before Interest Taxes) where EPS does not change; i.e. the EBIT Breakeven. At the EBIT Breakeven, EPS will be the same under each financing plan we have under consideration. As a general rule, using financial leverage will generate more EPS where EBIT is greater than the EBIT Breakeven. Using less leverage will generate more EPS where EBIT is less than EBIT Breakeven.
EBIT Breakeven is calculated by finding the point where alternative financing plans are equal according to the following formula:
(EBIT - I) x (1.0 - TR) / Equity number of shares after implementing financing plan.
I: Interest Expense TR: Tax Rate Formula assumes no preferred stock.
The formula is calculated for each financing plan. For example, you may be considering issuing more stock under Plan A and incurring more debt under Plan B. Each of these plans will have different impacts on EPS. You want to find the right plan that helps maximize EPS, but still manage risks within an acceptable range. EBIT-EPS Analysis can help find the right capital mix for high returns and low costs of capital.