Break-even is the floor, not the target

Break-even gets treated as a milestone. Something a business passes on the way up and then stops thinking about. That is roughly the opposite of what the number is for.

The useful question is never whether you are above the line. Most trading businesses are, most of the time, or they would not still be here. The useful question is how far above, how quickly that distance closes when a quiet quarter arrives, and which of the four things you control buys the most of it back.

Where the floor actually sits

Start with what a dollar of revenue leaves behind after the cost of producing it. In the business below, cost of sales runs at 45%, so every dollar of revenue leaves 55 cents to pay for everything that does not move with sales.

That 55 cents has three claims on it, and they stack. Fixed costs first. Then a market wage for whoever runs the business, because if you were not doing the job somebody would have to be paid to. Then the debt, if there is any.

The business turns over $1.2m, so it clears all three. It is above the line, which is where most owners stop looking.

The number above the floor

The distance between what the business does and what it has to do is the margin of safety, and it is the figure worth writing on the wall. Here it is $136,364 of revenue, or 11.4%.

Put plainly: revenue can fall by about eleven per cent before this business stops covering its costs, its owner and its debt. Below that it is not losing money in the accounting sense straight away, but it is no longer paying for everything it is committed to, and something has to give.

Why a small fall in revenue is not a small problem

This is the part that catches people, and it is pure arithmetic rather than bad luck. The costs below the line barely move when revenue does. So every dollar of revenue lost takes its full contribution out of the surplus, and the surplus is a much smaller number than the revenue.

Revenue falls ten per cent and the surplus falls by eighty eight. The margin of safety goes from 11.4% to 1.5%. Nothing went wrong that anyone would call a disaster, and the business has almost nothing left over.

That relationship is why two businesses with identical profit can carry completely different amounts of risk, and it is the first thing worth understanding about your own numbers. The lower the contribution margin and the heavier the fixed costs, the more violently the surplus moves.

Which lever buys back the most room

Four things move the line, and they are not equally available or equally powerful. Each row below is that one change on its own, everything else held still.

Two points of cost of sales is worth $24,000 a year here, which is the same as taking $24,000 off the fixed costs. The difference is that the margin keeps paying as the business grows and the fixed cost saving does not. On $1.5m of revenue those same two points are worth $30,000.

The fixed cost row is worth sitting with. Forty thousand dollars is one modest hire, or a rent review, or a lease on a second vehicle. It moves the break-even line by nearly $73,000 of revenue and takes the margin of safety from eleven per cent to five. Committing to a fixed cost is committing to the revenue that carries it.

When the business was bought with debt

A business bought with borrowed money carries a fourth line that a business built from savings does not, and it is the line least able to be negotiated when trading softens. Staff can be reduced. Marketing can be paused. The facility repayment falls due on the same day for the whole term.

Which is why the third break-even line is the one that matters for a buyer, and why an asking price justified on earnings that only clear the second line is a price built on a business that will not carry the debt used to buy it.

The same figure runs the other way round for a credit team. Cover ratios and margin of safety are two views of one thing: how far the earnings can fall before the commitment is not met. A business with eleven per cent of headroom and one with two per cent may report identical profit and are not remotely the same risk.

Where the number misleads

• It is annual. A business that clears its line comfortably across a year can be well under it for four months of that year, and the four months are when it runs out of money rather than the year.
• It is profit, not cash. Clearing the line says nothing about whether the money has arrived. Stock and unpaid invoices sit between the two, and growth makes that gap wider.
• It assumes the cost split holds. Costs described as fixed are fixed within a range. Grow far enough and the rent, the systems and the supervision all step up at once.
• It ignores tax and capital spending, both of which take cash from the same account and neither of which appears above.
• It says nothing about whether the revenue is achievable. A line of $1.06m is arithmetic. Whether the market will give you that is a different question and a harder one.

What the file needs

To work this on your own numbers, or to put it in front of anyone whose money is involved, five things.

• Revenue excluding GST for a full trading year, and a split by month if the business is at all seasonal.
• Costs separated into those that move with revenue and those that do not, which is the step most sets of accounts do not do for you.
• A market wage for the role you perform, not what you happen to draw.
• Total annual debt service across every facility, principal as well as interest.
• For a business being bought: the same five on the vendor's figures, rebuilt rather than accepted, because the split between fixed and variable is where an optimistic set of accounts hides.

The acronyms, in one place

What we can and cannot tell you

Andorra Advisory Group does not arrange credit and is not a credit representative. We build the analysis and the documents. Where a client wants the finance arranged as well, that is a referral to The Lending Lab Pty Ltd, a separate broking business, disclosed in writing at engagement. Our fee is fixed and payable regardless of whether finance is approved or what the analysis concludes.

So no lender is named here and no policy is quoted. Every threshold is a level commonly seen, and every lender sets its own. We give no taxation advice, no legal advice and no financial product advice. Tax positions belong with a registered tax agent and legal positions with your solicitor.

We also cannot tell you what your market will bear, which is the one input none of this supplies. What the arithmetic does is tell you what has to be true, and how much room you have if it turns out to be slightly less true than you hoped.

General information only. Not credit advice, not a credit assessment, and not an offer of finance. Lending decisions rest with the lender and depend on your circumstances and their criteria.