How to Use Economic Value Added When Your Business Has Debt
In very large businesses, economic value added (EVA) analysis gets really computationally burdensome. Although there are multiple potential problems, you should be familiar with one common complication: debt.
Here's the deal: If a business can restructure its debt, bank loans, credit lines, mortgages, and so forth, borrowing can be used to boost EVA. Accordingly, and quite helpfully, another EVA model, which is slightly more complicated, enables you to recognize this extra wrinkle.
If your firm can freely restructure its debts, you may want to make two adjustments to the EVA analysis. First, you may need to use an all-encompassing cost of capital. An all-encompassing cost of capital considers both the cost of equity and the cost of any debt. Second, you use an adjusted net income number that includes not only the amounts paid to the shareholders, but also the amounts paid to lenders.
Calculating an all-encompassing cost of capital is the first step. For the sake of illustration, suppose that a business uses capital from three sources: trade vendors, a bank (which loans money at 10 percent), and the owner's equity.
Estimating the All-Encompassing Capital Charge
| Trade vendors ($20,000 @ 0 percent) |
$0 |
| Bank loan ($100,000 @ 10 percent) |
10,000 |
| Owner's equity ($200,000 @ 20 percent) |
40,000 |
| Adjusted capital charge |
$50,000 |
None of the numbers is difficult to figure out:
Trade vendors: The trade vendors provide debt, but the firm doesn't have to pay a charge to those creditors. So that portion of the capital charge is zero.
Bank loan: This $100,000 bank loan charges 10 percent. That bank loan, then, carries a $10,000 capital charge. In other words, in order to use the bank's capital, the business pays $10,000 a year.
Owner's equity: This final component of the capital charge is what the business owes the owners. In this example, the owner's equity capital charge is shown as $40,000. This capital charge is calculated by multiplying a cost of capital percentage, 20 percent, times the owner's equity (20 percent of $200,000 equals $40,000). The adjusted capital charge, therefore, equals $50,000.
The second step is to add back the interest charges paid to lenders in order to achieve an adjusted income number. Therefore, if you want to compare the funds that the business generated and that are available to pay capital sources, you need to add back the interest expense.
Finally, there's a pot of money left over at the end to pay creditors and owners. And the pot of money includes both the $10,000 of interest expense and the $50,000 of net income.
After you've figured out an all-encompassing cost of capital and an adjusted income amount, you can calculate the EVA in the usual way. In this example, you use the following formula:
adjusted income ($60,000) - the weighted cost of capital charge ($50,000)
The result equals $10,000, which is the EVA amount.
Accounting Glossary
accounting equation
The equation Assets = Liabilities + Equity, which demonstrates the two-sided nature of accounting and is useful for explaining the concept of double-entry accounting (or double-entry bookkeeping).
Accounting Glossary
accounting period
The time period for which financial information is being tracked in a business, such as monthly, quarterly, or annually.
Accounting Glossary
accounts receivable
An account that records the amounts that customers owe to a business.
Accounting Glossary
adjusting entry
A correction made to a bookkeeping account that adjusts for accounting errors or other necessary changes at the end of the accounting period.
Accounting Glossary
cash flows
Used to describe the source or sources of cash or how cash is used.
Accounting Glossary
Chart of Accounts
A list of all the accounts used by a business, including what types of transactions go into each account.
Accounting Glossary
debit
An accounting entry that increases an asset or expense account, and decreases a liability or income account.
Accounting Glossary
dividends
A portion of a company’s profits paid by share of common stock on a quarterly or annual basis.
Accounting Glossary
FASB
Financial Accounting Standards Board. FASB is the highest-ranking authority in the private (non-government) sector of the U.S. for making pronouncements on GAAP and for keeping accounting standards up-to-date.
Accounting Glossary
Federal Unemployment Tax
In the U.S., the fund that used to be known simply as Unemployment. Employers contribute to the fund, and states also collect taxes to fill their unemployment fund reserves. (The acronym FUTA means Federal Unemployment Tax Act.)
Accounting Glossary
fidelity bonds
A type of insurance — typically carried by employers for their employees — that helps guard against theft and reduce the risk of loss.
Accounting Glossary
FIFO
First-in, first-out. A method for costs of goods sold in which a business charges out product costs to cost of goods sold expense in the chronological order in which the goods were acquired.
Accounting Glossary
fungible
Describes a product that is interchangeable and virtually indistinguishable from another product.
Accounting Glossary
General Ledger
A summary of all of a business’s accounts and transactions.
Accounting Glossary
IASB
International Accounting Standards Board. The IASB (based in London) is the main authoritative accounting standards setter outside the U.S.
Accounting Glossary
Journals
The location in which bookkeepers keep records (in chronological order) of daily company transactions.
Accounting Glossary
LIFO
Last-in, first-out. A method for costs of goods sold that selects the last item you purchased first, and then works backward until you have the total cost for the total number of units sold during the period.
Accounting Glossary
LLP
Limited liability partnership. A legal structure that state laws offer to qualified professionals in which all the partners have limited liability.
Accounting Glossary
PC
Professional corporation. A legal structure that state laws offer to qualified professionals who otherwise would have to operate as an unlimited partnership liability.
Accounting Glossary
petty cash
A cash account that businesses keep on hand for unexpected expenses.
Accounting Glossary
revenue
Monies that are collected in the process of selling a company’s goods and services.
Accounting Glossary
salvage value
The amount that an asset is worth after it has been fully depreciated.
Accounting Glossary
statement of cash flows
A financial statement that summarizes a business’s cash inflows and outflows during an accounting period.
Accounting Glossary
transactions
Economic exchanges between a business or other entity and the parties with which the entity interacts and makes deals.
Accounting Glossary
worker’s compensation insurance
A type of insurance carried by employers that covers its employees in case they are injured on the job.
