Understanding Economic Value Added in Business - dummies

Understanding Economic Value Added in Business

By Stephen L. Nelson

Economic Value Added (EVA) analysis measures how profitable it truly is to run a business instead of selling it. It states in a formula something you already know in your gut: If you’re a business owner and you can make more money by selling your business and reinvesting the proceeds, then hey — you’re not doing yourself or your family any favors by running your own business.

The purpose of EVA analysis is simple: You want to see whether you’re earning a profit by owning your own business.

To make sure that you’re on track with your analysis, you typically want to consider several things:

  • How good are the numbers? Do your income statement and balance sheet values really describe your profit and the value that you may be able to sell for and then reinvest?

    You should compare your owner’s equity value with what you think you would get if you sold your business.

  • How good is the cost of capital percentage? The capital charge calculation relies heavily on the cost of capital value. Many people think that a small business (any business with sales less than, say, $50 million) should produce returns annually of 20 to 25 percent. That seems to be a good range of values to use in EVA analysis.

  • What about psychological income? In the case of an owner-managed business, it’s okay to factor in psychological income. If you really love your work, you know owning your own business is about more than just an economic profit.

  • Have fluctuations occurred? Another important point is that in many small businesses, profits fluctuate. You can’t, therefore, look at just a single, perhaps terribly bad year and decide it’s time to pack up. Similarly, you also shouldn’t look at just a single blowout year and decide it’s time to buy the villa in the south of France.

  • Is your business in a special situation? Everybody admits that EVA analysis is really tricky and may be impossible in certain situations. For example, most people who love EVA analysis readily admit that EVA analysis doesn’t work very well for a start-up business. The income statement just doesn’t produce an accurate measure of the value being created by the company.

Your EVA calculation is only as good as your inputs and assumptions. The trend or pattern in EVA values is probably more important than a particular value. And that’s especially true for business owners. In the end, you can’t lose sight of the big picture, which is answering the question, “Am I really making money by running my own business?”