Whilst it is not possible definitively to determine an ideal level of borrowings, it is possible to make the generalisation that stable businesses can borrow more than cyclical businesses.
Two things can be used to help determine if the company’s borrowings may have a damag- ing effect on earnings:
● calculating earnings at different returns on capital;
● considering the company’s cost structure.
●
Borrowings and returns on capital
Borrowing money can be good for shareholders if the company is expanding, or where the returns are stable, but it can completely destroy shareholder returns if the company is con- tracting. This is illustrated in the following example.
Two companies have total capital of £10 million which is structured slightly differently; Cautious plc has no loans, whereas Optimistic plc has borrowed 50 per cent of its capital. Table 6.1 shows a summarised profit and loss account and earnings per share for both companies at different returns on capital.
In this example, we can see that the earnings per share are better in Cautious plc in a bad year, but worse in every other year. In fact both companies have the same earnings per share when the return on capital reaches 10 per cent; below that, Cautious plc gives a better return for its shareholders, above it Optimistic plc wins. This is illustrated in the Figure 6.1.
6 How much should a company borrow?
The impact of borrowing on capital returns Table 6.1
Cautious plc Optimistic plc
Share capital – £1 shares 10 000 000 Share capital – £1 shares 5 000 000
Loan capital ... Loan capital @ 10% ..5 000 000
Total capital 10 000 000 Total capital 10 000 000
Poor year Average year Good year Poor year Average year Good year
Return on capital 5% 12% 20% 5% 12% 20%
£000 £000 £000 £000 £000 £000
Operating profit 500 1200 2000 500 1200 2000
Interest (500) (500) (500)
Profit before tax 500 1200 2000 0 700 1500
Tax @ 31% (155) (372) (620) 0 (217) (465)
Profit after tax 345 828 1380 0 483 1035
Earnings per share 3.45 8.28 13.80 0 9.66 20.70
(pence) EXAMPLE
The critical thing, then, to think about is what range of returns this business is likely to get. If you think it unlikely that the returns will fall below 10 per cent, it would pay the com- pany to borrow the £5 million. Increasing the borrowings would not necessarily increase the earnings, as unfortunately an increase in borrowings would lead to an increase in interest charges. Interest rates can also rise and fall, the situation would be very different if interest rates rose to 15 per cent. However, it is possible to work out at what level of borrowings and interest rates the shareholders’ real risk would increase, leading to an increase in the required rate of return.
Cyclical businesses can have problems with high levels of borrowing, as their returns on capital can easily range from 5 per cent to 30 per cent at different points in the cycle. We would then need to look at the impact of borrowings on shareholder return over the life of the cycle to be able to calculate optimum borrowing levels.
●
Borrowings and the cost structure
Another thing that influences the amount that a company should borrow is its cost struc- ture. Costs behave in different ways – some costs increase with our sales (e.g. materials), whereas other costs remain fairly constant regardless of the level of sales (e.g. rent). Costs can be classified into those that are variable and those that are fixed. Variable costsare those that move with volume. Fixed coststend not to move in the same way; within a certain level of sales they remain constant. However, sometimes getting an extra order can lead to an increase in the fixed costs – it may, for example, require putting on an extra shift, or even having another factory. This is illustrated in Figure 6.2.
BORROWINGS AND EARNINGS PER SHARE Figure 6.1
Earnings per share
-10 0 20 30 40
0%
10
Cautious plc OptImistic plc
5% 12% 20% 25% 30%
Return on capital
When sales reach 160, the fixed costs increase from £30 000 to £40 000. Fixed costs do increase with volume, but they do not increase proportionately – they move in steps. In some industries, where the company is operating at maximum capacity, small changes in volumes can lead to large changes in fixed costs. We can also see that when the sales fall, the variable costs will also fall, whereas the fixed costs will only fall when we move down to another ‘step’. However, we must not confuse fixed costs with uncontrollable costs. Fixed costs can be reduced. Even seemingly fixed costs like insurance premiums can be reduced simply by changing insurance companies. A significant proportion of a company’s fixed costs are controllable and reducible by management actions.
One thing that we would want to know about any company is the level of income it would need to achieve to cover all of its costs – to be able to break even. Unfortunately, we cannot find this out from the published accounts, but it is important to understand some basic prin- ciples. To illustrate these principles, and how we could calculate break even if we had the right information we will consider the following example.
A company has sales of £100, variable costs of £60 and fixed costs of £30. So, it has made a profit of £10. We know that if sales increase, the variable costs will increase; if they fall, the vari- able costs will fall. In reality, any movement may not be directly proportional, because of the impact of other factors like quantity discounts. However, for the purposes of simplicity in our example, we will assume that variable costs move in direct proportion to the sales. Conse- quently, if sales move to £110, variable costs will rise to £66; if they fall to £90, variable costs will fall to £54. Variable costs are, therefore, 60 per cent of sales. If 60 per cent of our sales go to pay for the variable costs, we have 40 per cent as a contribution towards our fixed costs. Once we have reached our break-even point and the fixed costs have been paid, any sales above this point will generate 40 per cent profit. This is illustrated in Figure 6.3.
6 How much should a company borrow?
COSTS Figure 6.2
£ 000
0 150 200
0 50
Sales
Fixed costs Variable costs 100
20 40 60 80 100 120 140 160 180 200
EXAMPLE
Once the sales and costs lines meet, the company has covered all its costs, if sales are above the break-even point it makes a profit, below this it makes a loss. Looking at the chart, it would appear that the company breaks even when sales reach £75. We can check this arithmetically.
To do this we will use the profit and loss account below:
Sales 100
Variable costs (60) 60% of sales
Contribution 40 40% of sales
Fixed costs (30)
Operating profit 10
The variable costs have been deducted from the sales to arrive at the contribution. (This is also called the gross profit, but we will use the term contribution to avoid confusion with the gross profit that is shown in the published accounts. The gross profit shown in the published accounts has not been calculated by deducting variable costs, and should notbe used to calculate the break-even point.)
The company breaks even when the contribution reaches £30, the level of the fixed costs. We know that contribution is 40 per cent of our sales. Therefore, calculating the break-even point is a matter of simple arithmetic:
Fixed costs... = ..30.. = 75
Contribution % 40%
Unsurprisingly this agrees with the answer we worked out from Figure 6.3.
The company covers all its costs when the sales reach £75. If it sold £100, sales could fall by
£25 before they reach the break-even point. Expressing this as a percentage, the company could afford to lose 25 per cent of its sales. This is referred to as the margin of safety.
BREAK-EVEN CHART Figure 6.3
Thoudsands
20 0
Sales Total costs
Sales-thousands 40
60 80 100 120 140 160 180
0
20 40 60 80 100 120 140 160
Let us now consider a company that has the same total costs of £90 on sales of £100, but with a different cost structure.
Sales 100
Variable costs (30) 30% of sales
Contribution 70 70% of sales
Fixed costs (60)
Operating profit 10
The break-even point is calculated using our formula:
Fixed costs... = ..60.. = 85.7
Contribution % 70%
This business has a much higher break-even point and lower margin of safety (14.3 per cent).
Its profits will be much more sensitive to changes in volume. This is illustrated in Table 6.2.
The profits of the company with the higher contribution and fixed costs are much more sus- ceptible to changes in sales. If sales halve, Company B’s losses are two-and-a-half times greater than those of Company A (Company A will report a loss of £10, compared to Company B’s reported loss of £25). If sales double, without any increases in fixed costs, Company B’s profits are 60 per cent higher than Company A’s (Company A reports a profit of £50, compared to Com- pany B’s profits of £80).
The differences between the two companies can be quantified by looking at their opera- tional gearing. This is usually expressed as the change in operating profits for each percent- age point change in the company’s sales. (To confuse the situation some analysts would also take borrowings into account. This is discussed towards the end of this chapter.)
Operational gearing is calculated by dividing the contribution by the operating profit. The operational gearing for our two companies, using the contribution based on sales of £100, would be:
COMPANY A COMPANY B
Contribution = 40 = 4 = 70 = 7
Operating profit = 10 = 10
6 How much should a company borrow?
The break-even point and the margin of safety Table 6.2
COMPANY A COMPANY B
Lower contribution and fixed costs Higher contribution and fixed costs Sales fall by 10% Sales rise by 10% Sales fall by 10% Sales rise by 10%
Sales 90 110 90.00 110
Variable costs (54) (66) (27) (33)
Contribution 36 44 63 77
Fixed costs (30) (30) (60) (60)
Operating profit 6 14 3 17
EXAMPLE
This reflects our conclusions above. Company A’s sales rise by 10 per cent; their profit rises by 40 per cent (from 10 to 14). When the sales rose by 100 per cent, its profits rose by 400 per cent (from 10 to 50). On the other hand, Company B’s reported profits move by 70 per cent when sales moved by 10 per cent. Therefore, its profits move by 7 per cent for every per- centage increase in its sales. Company B has higher operational gearing than Company A.
The amount of money that a company should borrow is influenced by a combination of two factors: its return on capital and its cost structure.
It is possible to calculate the minimum return on capital that the company needs to achieve to support a given level of borrowing. If the return falls below this level, the bor- rowings will reduce the earnings per share; above it earnings per share will improve. As long as the return on capital is unlikely to fall below this minimum, companies should usually have some level of borrowing to optimise the shareholders’ return.
A company’s cost structure also influences the level of borrowing that a company can support. Companies with high fixed costs have high break-even points. Small changes in their sales will have a disproportionate impact on their reported profits. This is measured by operational gearing. Operational gearing measures how much profits will change fol- lowing a change of 1 per cent of sales.
There are three important learning points from looking at break even and operational gearing. If a company wants to improve its profitability it can:
(1) Improve its contribution percentage (usually called the gross margin); or reduce its fixed costs. We know that share prices move in line with company profit announce- ments. Share prices rise if a company announces a rationalisation programme, as fixed costs will fall. Any reduction in the company’s fixed costs moves straight to operating profit. Equally, they will fall if the company announces that its gross mar- gins have fallen. If Company A’s sales are 100 and the gross margin falls to 30 per cent, the contribution will only cover the fixed costs and it will be at break even.
(2) A company with high fixed costs has a high break-even point. This means that it will make bigger losses if sales fall, or better profits if sales rise, than a company with the same total costs but higher variable costs. Therefore, in times of falling sales, one way to improve reported profits is to switch from fixed to variable costs. This is part of the accounting logic behind outsourcing, which has recently become very popular in the UK. Outsourcing has the effect of exchanging fixed costs for variable costs. In the short run it can improve profitability, although in the long run the company is at the mercy of its contractors.
(3) If a company has high operational gearing and is operating in cyclical markets, it should not borrow too much money. The interest charge will have the effect of increas- ing its fixed costs. If we continue our previous example, Company B can support less borrowing than Company A. This is clearly illustrated in Table 6.3, which assumes that both companies incur interest charges of £5 and sales move by 20 per cent.
SUMMARY