The Purpose of Economic Value Added Analysis - dummies

The Purpose of Economic Value Added Analysis

By Stephen L. Nelson

The purpose of EVA analysis is simple: You want to see whether you’re earning an economic profit by owning your own business. You can use the information that you create with QuickBooks to help with your EVA analysis.

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

  • How good are the numbers? This is an important point.

    Do your income statement and balance sheet values really describe your profit (one of the numbers used in your calculation) and the value that you may be able to sell for and then reinvest (another important value used in your calculation)? You’re always going to have to accept some imprecision in your numbers. That’s a fact of life. But a lot of imprecision in those two numbers corrupts the results.

    You should compare your owner’s equity value with what you think you would get if you sold your business. If your owner’s equity value (the amount shown on your balance sheet) is wildly different from the cash-out value, you probably should use the cash-out value in your EVA analysis rather than the owner’s equity value.

  • How good is the cost of capital percentage? The capital charge calculation relies heavily on the cost of capital value. This is a tough number to come up with, quite frankly.

    If you owned a billion-dollar business, you’d probably need a team of PhDs to come up with a number for you (and clearly, this isn’t feasible for a small business). Therefore, you should use a range of values. 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. You may also be interested to know that for a large company, the cost of capital rates run from approximately 10 to 12 percent. So you clearly don’t want to be that low.

    Finally, note that venture capital returns — those returns delivered by the most successful, fastest-growing small businesses — often run 35 to 45 percent annually. It seems, therefore, that the cost of capital rates used in your EVA analysis should be considerably less than this. At least for most businesses, the cost of capital rates should be considerably less than 35 to 45 percent.

    Try a range of rates when you perform EVA analysis. For example, try 15 percent as your cost of capital; then try 20 percent, 25 percent, and 30 percent. The calculations, after you have the profit number and the owner’s equity number, are pretty simple after all. It’s really not difficult to calculate several estimates of EVA.

  • What about psychological income? In the case of an owner-managed business, it’s okay to factor in psychological income. You can’t ignore the economy. A viable healthy business — especially if it’s yours — should deliver a nice profit over time and pay for the capital that it uses.

    Having said that, however, if you really love your work, don’t sell your winery and go to work for the local big-box retailer. (Not that there’s anything wrong with wearing an orange vest and spending all day on concrete floors.) 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. Therefore, you can’t look at just a single, perhaps terribly bad year and decide that it’s time to pack up. Similarly, you shouldn’t look at just a single blowout year and decide that it’s time to buy the villa in the south of France.

    EVA analysis works when the inputs reflect the general condition of the business: the general level of profits, the general amount for which you could cash out, the general cost of capital estimate, and so on. If something screwy happens one year to push one of these inputs way out of whack, the results returned by your EVA analysis become pretty undependable.

  • 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 in a start-up business situation.

    Most of these people also admit that EVA analysis doesn’t work very well when a firm is growing very quickly. In both of these cases, the problem is that the income statement just doesn’t produce an accurate measure of the value being created by the company. As a result, it’s impossible to really figure out what sort of economic profit the business has created.

    Again, this should make intuitive sense. You may very well expect that in the first year or two, the business produces a loss or very meager profits. And that’s totally okay.

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?”