Effective business management requires careful planning and decision-making about the balance of debt and equity used in financing the business. The EBIT-EPS approach is one method available to managers to guide them in making decisions about capital structure. It refers to the relationship between two numbers: earnings before interest and taxes, or EBIT, and earnings per share, or EPS.To benefit from the EBIT-EPS approach, it helps to understand the basics of how it works, as well as its advantages and drawbacks.
The EBIT-EPS approach to capital structure involves the evaluation of corporate performance at various debt-to-equity ratios in order to determine the ideal ratio for performance.
Business Capital Structure
Capital structure refers to a business's balance of debt and equity financing. Businesses have two options for financing the purchases of equipment, expenses and materials necessary for their operations. They can raise money from investors, which is equity financing, or they can borrow from banks and creditors – leverage or debt financing. Most businesses engage in a degree of both, paying careful attention to the costs associated with either source. Relying too heavily on equity increases the cost to investors and cuts into return. But relying too much on debt puts the business in a more precarious position and comes with the substantial costs of interest.
Understanding the EBIT-EPS Approach
The EBIT-EPS approach is one tool managers use to decide on the right mix of debt and equity financing in a business's capital structure. In the EBIT-EPS approach, the business plots graphs of its performance at different possible debt-to-equity ratios, such as 40 percent debt to 60 percent equity. In a basic graph, the earnings per share as a data point is plotted for each level of earnings before interest and taxes at different debt-to-equity ratios. The graph is then analyzed to determine the ideal level of debt-to-equity for the business.
Analysis for Risk and Return
Once the relationship between EBIT and EPS is plotted for different capital structures, the investor can analyze the graph, focusing on two key challenges. The level of EBIT where EPS is zero, called the break-even point, and the graph's slope, which visually represents the company's risk. A steeper slope conveys a higher risk – greater loss per share at at lower EBIT level. A steeper slope also means a higher return, and that the company needs to earn less EBIT to produce greater EPS. The breakeven point is also important because it tells the business how much EBIT there must be to avoid losses, and varies at different proportions of debt to equity.
Drawbacks to the Approach
The EBIT-EPS approach is not always the best tool for making decisions about capital structuring. The EBIT-EPS approach places heavy emphasis on maximizing earnings per share rather than controlling costs and limiting risk. It's important to keep in mind that as debt financing increases, investors should expect a higher return to account for the greater risk; this is known as a risk premium. The EBIT-EPS approach does not factor this risk premium into the cost of financing, which can have the effect of making a higher level of debt seem more advantageous for investors than it actually is.