Economic Value Added Analysis in Action - dummies

Economic Value Added Analysis in Action

By Stephen L. Nelson

EVA analysis has two variations. The simple version of EVA analysis is called an equity-based EVA, and you can use the information that you create with QuickBooks to perform this type of EVA analysis.

Take a gander at a couple of financial statements — a simple income statement, and a simple balance sheet. These two financial statements provide much — and maybe most — of the information that you need to perform EVA analysis for your business. In fact, just go ahead and suppose that these two financial statements describe your business.

A Simple Income Statement
Sales revenue $150,000
Less: Cost of goods sold 30,000
Gross margin $120,000
Rent 5,000
Wages 50,000
Supplies 5,000
Total operating expenses 60,000
Operating income 60,000
Interest expense (10,000)
Net income $50,000
A Simple Balance Sheet
Cash $25,000
Inventory 25,000
Current assets $50,000
Fixed assets (net) 270,000
Total assets $320,000
Accounts payable $20,000
Loan payable 100,000
Owner’s equity
S. Nelson, capital 200,000
Total liabilities and owner’s equity $320,000

Essentially, EVA includes a charge for the capital that you’ve invested in a business. To see whether you’re actually making money, you deduct this charge from your net income.

A positive EVA amount indicates that your business truly produces an economic profit; in other words, a positive EVA amount indicates that even after your firm pays wages to employees, interest to lenders, and a return to shareholders, some money is left over. This leftover money is the economic profit.

The capital charge equals the cost of the capital (specified as an interest rate or annual return percentage) multiplied by the capital invested in the business period. The capital invested in your business equals, essentially, your owner’s equity. The cost of capital return percentage equals the return that you could earn in a similarly risky investment in something else.

From the example data, calculate each of these amounts by using the following steps:

  1. Calculate the capital charge.

    For the sake of illustration, suppose that you earn a 20 percent return on the money that you’ve invested in the business described. To calculate an EVA in this situation, use the following formula:

    capital charge = 20% @@ts $200,000 (of owner’s equity)

    The result of this formula is a capital charge of $40,000. That’s the amount that should be returned to the shareholder. (In the case of a small business owned and operated by an entrepreneur, the shareholder is the owner/entrepreneur.)

  2. Subtract the capital charge from the net income.

    The net income equals $50,000. To calculate the EVA, use the following formula:

    net income ($50,000) – capital charge ($40,000) = EVA

    The result — $10,000 — equals the EVA.

Therefore, by using the data from the example business and assuming a 20 percent cost of capital, this business delivers an economic profit. After paying each stakeholder his or her fair share, the firm also has leftover money — an economic profit — of $10,000.