Break-even analysis calculates the sales level at which a business covers its total costs without making a profit or loss. Financial ratios, on the other hand, use financial figures to analyse profitability, liquidity, efficiency and solvency. By analysing them together, Micro, Small and Medium Enterprises (MSMEs) can make informed financial decisions while managing limited resources and changing business costs.
The analysis helps businesses evaluate operating expenses, customer payments, inventory and borrowing in relation to financial performance. Regular analysis also helps identify areas for improvement and supports informed decisions about business operations.
How do break-even and financial ratio analysis work for MSMEs?
The analysis begins by organising relevant cost and financial data, then calculating the break-even point and reviewing key financial ratios. Here is how the analysis works:
Classifying fixed and variable costs
Break-even analysis separates business expenses into fixed and variable costs. The fixed costs, including rent, generally stay unchanged across normal activity levels, while variable costs, such as raw materials, can change with different production and sales levels. Semi-variable costs, such as electricity and telephone bills, are also separated into fixed and variable components for accurate calculations.
Calculating the break-even point
In the case of a single product, the break-even point is calculated using the following formula:
Break-Even Point (Units) = Fixed Costs/Contribution Margin per unit
Here,
Contribution Margin per unit = Selling Price per Unit – Variable Cost per Unit
This can also be calculated as the sales revenue required to cover total costs:
Break-Even Point (Sales Revenue) = Fixed Costs/Contribution Margin Ratio
Here,
Contribution Margin Ratio = (Selling Price – Variable Cost)/Selling Price
For example, a business with fixed costs of ₹1,00,000 sells a product for ₹500 per unit and incurs a variable cost of ₹300 per unit. This gives a contribution margin of ₹200 per unit, for a 40% contribution margin ratio.
Therefore, the business reaches break-even at 500 units (₹1,00,000/₹200) or ₹2,50,000 in sales revenue (₹1,00,000/40%).
Measuring financial health with key ratios
Next, MSMEs can use financial ratios to evaluate their overall financial health. Profitability ratios indicate earnings, liquidity ratios assess short-term obligations, and efficiency ratios track how quickly inventory is sold and receivables are collected. The debt-to-equity ratio indicates the business’s reliance on borrowed funds compared to its owner’s capital.
Interpreting break-even and ratio results
Break-even results are then analysed alongside financial ratios based on the business model, industry and financial trends. Comparing them across periods and with relevant industry benchmarks helps MSMEs identify changes in financial performance. However, factors such as changes in supplier costs, delayed receivables, inventory levels, seasonal sales and the distinction between accounting profit and actual cash flow can affect the results and must be considered during the analysis.
Which financial ratios should MSMEs track?
The following financial ratios can help businesses understand whether they can meet obligations, generate profit and use their resources efficiently:
- Current ratio: It compares current assets with current liabilities to assess short-term liquidity.
- Quick ratio: It excludes inventory and prepaid expenses from current assets to assess the ability to meet current liabilities using more liquid assets.
- Gross profit margin: It measures the gross profit against revenue to understand trading or production margins and is expressed as a percentage.
- Net profit margin: It compares net profit with revenue to determine the total profit left after the expenses are paid.
- Debt-to-equity ratio: It measures the extent to which the business relies on borrowed funds by comparing its debt and equity or shareholders’ funds.
- Inventory turnover: It assesses how efficiently inventory is converted into revenue over a given period.
- Receivables turnover/payment performance: It examines how efficiently credit sales are converted into collections and identifies delayed customer payments.
How can MSMEs use break-even and ratio analysis for business decisions?
MSMEs can apply the findings from this analysis to several areas of day-to-day business planning and financial management, including:
- Pricing decisions: MSMEs can use contribution margins and break-even analysis to assess whether their selling prices can cover the variable and fixed costs incurred.
- Cost management: Businesses can recalculate their break-even point when fixed or variable costs change to understand how cost increases may affect profitability.
- Sales planning: MSMEs can use the break-even level to set sales targets and determine the additional sales required to achieve a desired profit.
- Working capital management: Liquidity and receivables ratios can help businesses monitor their ability to meet short-term obligations and identify delays in customer payments.
- Inventory decisions: Inventory turnover can help MSMEs assess how efficiently they sell stock and identify potential issues with slow-moving inventory.
- Borrowing decisions: MSMEs can use debt-related ratios to assess whether taking on additional debt is appropriate for their existing financial position and repayment capacity.
- Payment monitoring: Payables and receivables trends can help MSMEs monitor payment cycles. For purchases from Micro and Small Enterprise (MSE) suppliers, businesses should also track the payment timelines under Section 15 of the MSMED Act, 2006.
Conclusion
Break-even and financial ratio analysis can help MSMEs make better decisions on pricing, costs, sales and working capital as business conditions change. Reviewing these figures regularly helps businesses identify when they need to reassess their plans or assumptions.
With TallyPrime, MSMEs can maintain their financial records and use the Ratio Analysis report to review their financial performance. This helps them access relevant financial information when making business decisions. Start your free trial today to manage your business finances.
