EBIT-EPS analysis gives a scientific basis for comparison among various financial plans and shows ways to maximize EPS. Hence EBIT-EPS analysis may be defined as ‘a tool of financial planning that evaluates various alternatives of financing a project under varying levels of EBIT and suggests the best alternative having highest EPS and determines the most profitable level of EBIT’.
Concept of EBIT-EPS Analysis
The EBIT-EBT analysis is the method that studies the leverage, i.e. comparing alternative methods of financing at different levels of EBIT. Simply put, EBIT-EPS analysis examines the effect of financial leverage on the EPS with varying levels of EBIT or under alternative financial plans.
It examines the effect of financial leverage on the behavior of EPS under different financing alternatives and with varying levels of EBIT. EBIT-EPS analysis is used for making the choice of the combination and of the various sources. It helps select the alternative that yields the highest EPS.
We know that a firm can finance its investment from various sources such as borrowed capital or equity capital. The proportion of various sources may also be different under various financial plans. In every financing plan the firm’s objectives lie in maximizing EPS.
Advantages of EBIT-EPS Analysis
We have seen that EBIT-EPS analysis examines the effect of financial leverage on the behavior of EPS under various financing plans with varying levels of EBIT. It helps a firm in determining optimum financial planning having highest EPS.
Various advantages derived from EBIT-EPS analysis may be enumerated below-
(i) Financial Planning
Use of EBIT-EPS analysis is indispensable for determining sources of funds. In case of financial planning the objective of the firm lies in maximizing EPS. EBIT-EPS analysis evaluates the alternatives and finds the level of EBIT that maximizes EPS.
(ii) Comparative Analysis
EBIT-EPS analysis is useful in evaluating the relative efficiency of departments, product lines and markets. It identifies the EBIT earned by these different departments, product lines and from various markets, which helps financial planners rank them according to profitability and also assess the risk associated with each.
(iii) Performance Evaluation
This analysis is useful in comparative evaluation of performances of various sources of funds. It evaluates whether a fund obtained from a source is used in a project that produces a rate of return higher than its cost.
(iv) Determining Optimum Mix
EBIT-EPS analysis is advantageous in selecting the optimum mix of debt and equity. By emphasizing on the relative value of EPS, this analysis determines the optimum mix of debt and equity in the capital structure. It helps determine the alternative that gives the highest value of EPS as the most profitable financing plan or the most profitable level of EBIT as the case may be.
Limitations of EBIT-EPS Analysis
Finance managers are very much interested in knowing the sensitivity of the earnings per share with the changes in EBIT; this is clearly available with the help of EBIT-EPS analysis but this technique also suffers from certain limitations, as described below
(i) No Consideration for Risk
Leverage increases the level of risk, but this technique ignores the risk factor. When a corporation, on its borrowed capital, earns more than the interest it has to pay on debt, any financial planning can be accepted irrespective of risk. But in times of poor business the reverse of this situation arises—which attracts high degree of risk. This aspect is not dealt in EBIT-EPS analysis.
(ii) Contradictory Results
It gives a contradictory result where under different alternative financing plans new equity shares are not taken into consideration. Even the comparison becomes difficult if the number of alternatives increase and sometimes it also gives erroneous result under such situation.
This analysis cannot determine the state of over-capitalization of a firm. Beyond a certain point, additional capital cannot be employed to produce a return in excess of the payments that must be made for its use. But this aspect is ignored in EBIT-EPS analysis.