Manu explains Break Even Analysis and its relevance in evaluating businesses for term loans to new probationary officer, Vinu, using a practical example with numbers.

Vinu: Hi Manu, I've been reading about Break Even Analysis and how it's important for bankers to use it when evaluating businesses for term loans. Can you explain the concept to me?

Manu: Absolutely, Vinu. Break Even Analysis is a financial tool that helps businesses determine the point at which their revenue will cover their costs. It takes into account fixed costs, variable costs, and selling price to calculate the Break Even Point, which is the number of units a business needs to sell to cover its costs.

Vinu: That makes sense, but why is it important for bankers to use this analysis when evaluating businesses for term loans?

Manu: By analyzing a business's Break Even Point, we can get a better understanding of their cash flow and their ability to cover their expenses, including loan payments. If a business has a high Break Even Point, it may indicate that they are not generating enough cash flow to cover their costs and loan payments. On the other hand, if a business has a low Break Even Point, it may suggest that they have a better chance of generating a profit and paying back the loan.

Vinu: I understand the concept, but I'm having a hard time visualizing how it works in practice. Can you give me an example with numbers?

Manu: Sure, let's say we're evaluating a small manufacturing business that's applying for a term loan. The business has fixed costs of ₹500,000 per year and variable costs of ₹200 per unit. The selling price of their product is ₹500 per unit.

To calculate the Break Even Point, we divide the total fixed costs by the contribution margin, which is the selling price per unit minus the variable cost per unit. In this case, the Break Even Point would be 1,666.67 units.

Vinu: I see, so the business needs to sell 1,666.67 units to cover their fixed and variable costs.

Manu: Exactly. By evaluating a business's Break Even Point, we can get a better understanding of their cash flow and their ability to cover their expenses, including loan payments.

Vinu: That makes more sense now. Thank you for explaining that to me, Manu.

Manu: You're welcome, Vinu. As you continue your training as a probationary officer, you'll learn about other tools and techniques we use to evaluate creditworthiness, but the Break Even Analysis is a fundamental concept to understand. Don't hesitate to ask if you have any more questions.