Effect of capital structure on EPS, EBIT-EPS Analysis

The Link Between Capital Structure and EPS

As we've discussed before, a company's capital structure – the mix of debt and equity it uses to finance its operations – has a significant influence on its Earnings Per Share (EPS). EPS, a key measure of profitability, shows how much of a company's earnings are allocated to each outstanding share of stock. The choices a company makes about how much debt it uses versus equity directly affect this number. Debt, with its fixed interest payments, can amplify both gains and losses to EPS. If a company uses debt to generate profits greater than its interest costs, it can lead to higher EPS due to leverage. However, if profits fall short of interest obligations, debt can drastically reduce EPS. Equity financing avoids the risks of debt but can dilute the ownership of existing shareholders, potentially limiting the EPS if the company's earnings don't increase proportionally.

EBIT-EPS Analysis: A Tool for Decision-Making

To navigate the complexities of capital structure choices, companies use a tool called EBIT-EPS analysis. EBIT, or Earnings Before Interest and Taxes, represents a company's profit before considering the impact of financing choices (interest) and taxes. EBIT-EPS analysis explores how different levels of EBIT affect EPS under various capital structure scenarios. It helps companies visualize how EPS changes as their operating profits vary, allowing them to compare different financing plans and assess which might be more beneficial. Essentially, this analysis shows how EPS would look under different scenarios (e.g., more debt vs. more equity).

How EBIT-EPS Analysis Works

The process of EBIT-EPS analysis involves several key steps. First, the company considers different potential capital structures – for example, one that involves more debt and another with more equity. Then, the company projects its potential earnings at various levels of EBIT, calculating how these profits are affected by interest expenses on debt under each capital structure. The next step involves factoring in taxes, because the interest on debt will reduce the total amount that the company will have to pay on taxes. Finally, the company calculates EPS under each capital structure at each projected level of EBIT by dividing the earnings that are available to shareholders by the total outstanding shares. By comparing EPS for each capital structure scenario at different EBIT levels, the company can understand the potential trade-offs of various financing strategies and identify the capital structure that’s most appropriate based on their expectations about future earnings.

Interpreting EBIT-EPS Analysis

The results of EBIT-EPS analysis are often visualized on a graph or a table. The graph shows how EPS changes under each capital structure as the level of EBIT increases. Companies can use the graph to identify the 'indifference point'— the level of EBIT where EPS is the same for two different capital structures. A company might choose a capital structure with higher leverage if they expect their EBIT to be higher than this indifference point, but they might opt for a lower-leverage capital structure if they expect to have a lower EBIT. The analysis can also reveal which capital structure is most sensitive to fluctuations in EBIT, helping management to understand potential financial risks. For example, if the EPS drops sharply when the EBIT declines, the capital structure with more debt could be considered more risky than one with more equity that doesn’t fluctuate as drastically.