Profit, Profitability

and
Break even analysis

5-ENTREPRENEURIAL FINANCE, SECOND EDITION, CHAPTER 5, PROFIT,

PROFITABILITY, AND BREAK-EVEN ANALYSIS
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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.
·Understand the use of leverage and its relationship to profitability and loss.
·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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 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.

5-ENTREPRENEURIAL FINANCE, SECOND EDITION, CHAPTER 5, PROFIT,

PROFITABILITY, AND BREAK-EVEN ANALYSIS
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 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.

5-ENTREPRENEURIAL FINANCE, SECOND EDITION, CHAPTER 5, PROFIT,

PROFITABILITY, AND BREAK-EVEN ANALYSIS
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 PROFIT versus
PROFITABILITY
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).

Net profit (income)

ROI 
Total assets

5-ENTREPRENEURIAL FINANCE, SECOND EDITION, CHAPTER 5, PROFIT,

PROFITABILITY, AND BREAK-EVEN ANALYSIS
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 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.

5-ENTREPRENEURIAL FINANCE, SECOND EDITION, CHAPTER 5, PROFIT,

PROFITABILITY, AND BREAK-EVEN ANALYSIS
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 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).
Earning power  Net profit margin x Total asset turnover
Net profit (income) Net sales
 x
Net sales Total assets
Net profit (income)
Earning power 
Total assets

5-ENTREPRENEURIAL FINANCE, SECOND EDITION, CHAPTER 5, PROFIT,

PROFITABILITY, AND BREAK-EVEN ANALYSIS
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Financial Leverage
For the small business owner financial leverage is the proportion of the
company that is financed by debt and the fixed 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.

5-ENTREPRENEURIAL FINANCE, SECOND EDITION, CHAPTER 5, PROFIT,

PROFITABILITY, AND BREAK-EVEN ANALYSIS
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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.
◦ Chapter 11 bankruptcy occurs when a business seeks court protection while it
develops a plan to pay off its creditors.
◦ Chapter 7 bankruptcy requires liquidation of all assets of the business, and
payment to the creditors.

5-ENTREPRENEURIAL FINANCE, SECOND EDITION, CHAPTER 5, PROFIT,

PROFITABILITY, AND BREAK-EVEN ANALYSIS
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Table 5-1 Balance Sheet, The Tom Jones Company
The Tom Jones Company
Balance Sheet
As of December 31, 2000
Assets
Current 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

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 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:

FC
BEQ 
P - VC
FC = Fixed costs

P = Price charged per unit

VC = Variable cost per unit

5-ENTREPRENEURIAL FINANCE, SECOND EDITION, CHAPTER 5, PROFIT,

PROFITABILITY, AND BREAK-EVEN ANALYSIS
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Table 5-2 Cost Data for Carl’s Toy Trucks
Cost Category Payment Basis Cost ($)

Rent Monthly 2000.00

Salaries Monthly 5000.00
Employee benefits Annually 7000.00
Insurance Quarterly 1500.00
Property taxes Annually 3000.00
Wood Per truck 1.25
Paint and finishing Per truck 0.25
Labor Per truck 2.50
Packing and shipping Per truck 2.00

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BREAK-EVEN ANALYSIS
(Continued)
Break Even Dollars:
FC
BE$ 
1 - VC
Where VC is Variable Cost expressed as a percentage of sales (revenue).
◦ For retail firm: VC=(Cost of Goods Sold)/(Net Sales)
◦ For manufacturing firm: VC=(Variable Cost of a Unit)/(Selling Price)

5-ENTREPRENEURIAL FINANCE, SECOND EDITION, CHAPTER 5, PROFIT,

PROFITABILITY, AND BREAK-EVEN ANALYSIS
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 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.

5-ENTREPRENEURIAL FINANCE, SECOND EDITION, CHAPTER 5, PROFIT,

PROFITABILITY, AND BREAK-EVEN ANALYSIS
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 Profit and Break-Even
FC  Desired net profit
Total quantity 
P - VC
FC  Desired net profit
BE$ 
1 - VC (as a percentage of the sales dollar)

Desired net profit with break-even analysis in quantity to produce.

◦ VC is variable cost per unit

Desired net profit with break-even analysis in dollars.

◦ VC is a percentage of sales dollar (e.g. Cost of goods sold as a percent).

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 Break-Even Charts

Figure 5-1 Break-Even Chart for Carl's Toy Trucks

700

Total Revenue
600

Profit
Area
500
Dollars in Thousands (000)

400

Total Cost = FC + VC
300

200 Break-Even Point

100
Loss
Area Fixed Costs (FC)

0
0 10 20 30 40 50 60 70
Units Sold in Thousand (000)

5-ENTREPRENEURIAL FINANCE, SECOND EDITION, CHAPTER 5, PROFIT,

PROFITABILITY, AND BREAK-EVEN ANALYSIS
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