﻿ ﻿Economic Value Added Analysis - Financial Management - QuickBooks 2017 All-In-One For Dummies (2016)

# QuickBooks 2017 All-In-One For Dummies (2016)

### Chapter 2

IN THIS CHAPTER

Understanding the logic of EVA

Checking out a simple example of EVA in action

Exploring some important points about EVA

Looking at a more complicated EVA example with debt

Here’s a curious fact: Even if your QuickBooks profit and loss statement shows a profit, you may not actually be making any money. How can this be? Ah, to really answer this question, you need to use a tool called Economic Value Added analysis (EVA), which was developed by (and is a trademark of) Stern Stewart & Co., a management consulting firm.

In this chapter, I discuss what EVA does and how you can use the information that you create with QuickBooks to perform the EVA analysis. This is neat stuff but a bit theoretical. Fortunately, when you boil EVA down to its essence, it’s quite practical.

Introducing the Logic of EVA

Economic Value Added analysis 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, reinvesting the proceeds, and then getting another job someplace else, hey — you’re not doing yourself or your family any financial favors by running your own business.

Let me walk you through an example to show you mathematically why this is the case. Suppose that after you pay yourself a fair salary, your firm makes \$20,000 in additional profits. Further suppose that you can sell your firm to a competitor for \$200,000, invest the proceeds in a stock mutual fund, and earn about \$20,000 a year in profits. (Yes, I know that the stock market doesn’t promise 10 percent annual returns, but neither does your business. So just suppose that these numbers are right for the purposes of this discussion.)

In this simple example, running your own business doesn’t really make sense. Sure, you’re making a salary. And sure, you’re earning a return on the money that you and your family have invested. But you aren’t getting anything more than that. You may as well just sell your firm, reinvest the money in the stock market (just one option), and get a job working for the phone company.

Don’t get all bummed out on me here; I’m not trying to talk you into selling your business. I just want to explain how to use a powerful tool, EVA, to better manage your business.

Seeing EVA in Action

EVA analysis has two variations; I explain the simple version first. If I start with the simple version, you may better understand all the little nuances and subtleties of the EVA model from the very start. When you’re finished with the simple version of EVA analysis — called equity-based EVA — you’re ready to move on to the more complicated EVA model.

Before I proceed with this discussion, take a gander at a couple of financial statements. Table 2-1 shows a simple income statement, and Table 2-2 shows 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.

TABLE 2-1 A Simple Income Statement

 Sales revenue \$150,000 Less: Cost of goods sold 30,000 Gross margin \$120,000 Operating expenses 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

TABLE 2-2 A Simple Balance Sheet

 Assets Cash \$25,000 Inventory 25,000 Current assets \$50,000 Fixed assets (net) 270,000 Total assets \$320,000 Liabilities Accounts payable \$20,000 Loan payable 100,000 Owner’s equity S. Nelson, capital 200,000 Total liabilities and owner’s equity \$320,000

If you’re uncomfortable interpreting either income statements or balance sheet financial statements, you may want to review the material covered in Book 1, Chapter 1 . In that chapter, I describe how financial statements work.

If you’re not sure how to produce a financial statement by using QuickBooks, refer to Book 4, Chapter 2 . In that chapter, I describe how to prepare QuickBooks financial statements, including income statements (also known as profit and loss statements ) and balance sheets.

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.

An example of EVA

From the example data in Tables 2-1 and 2-2 , calculate each of these amounts by following these 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 in Tables 2-1 and 2-2 . To calculate an EVA in this situation, use the following formula:

capital charge = 20% × \$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 shareholders. (In the case of a small business owned and operated by an entrepreneur, the sole shareholder is the owner/entrepreneur.)

2. Subtract the capital charge from the net income.

In Table 2-1 , 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, when you use the data from the example business detailed in Tables 2-1 and 2-2 and assume a 20 percent cost of capital, you find that 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.

Another example of EVA

To continue this example, suppose that the capital charge is really \$50,000 (calculated by multiplying a 25 percent cost of capital percentage by the \$200,000 of capital or owner’s equity). In this case, what does the EVA equal? The answer is zero. In other words, if the business makes \$50,000 of profit (refer to Table 2-1 ), but the shareholders require a \$50,000 return on their investment (calculated as 25 percent multiplied by \$200,000), the business produces no EVA.

Does the preceding scenario make sense to you? The math may seem a little unwieldy, but don’t get too tangled up in the computations. My guess is that you understand in your gut what EVA analysis does. If you really did own a business like the one summarized in Table 2-1 and Table 2-2 , you know that you should be earning a fair return on the money that you and your family have invested. And if you’re earning only the same amount of money that you could earn in any other business — say, a stock mutual fund — you’re not really getting ahead.

That’s all EVA analysis really does. It makes sure that you’re getting at least a fair return (ideally, more than that) on your investment.

Reviewing Some Important Points about EVA

The purpose of EVA analysis is simple: You want to see whether you’re earning an economic 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? 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, I recommend that you 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. First try 15 percent as your cost of capital, for example; 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, I think 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, I’m the last guy to say that you should 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.) My point is that in my opinion, owning your own business is about more than just an economic profit.

· Have fluctuations occurred? Another important point is that in many small businesses (and in all the small businesses that I’ve owned and managed), 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, in my opinion.

· Is your business in a special situation? Everybody admits that EVA analysis is really tricky and may be impossible in certain situations. Most people who love EVA analysis readily admit that EVA analysis doesn’t work very well in a start-up business situation, for example. 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?”

In very large businesses, EVA analysis gets computationally burdensome. Although I don’t go into great detail about potential problems in this chapter, 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 that’s slightly more complicated enables you to recognize this extra wrinkle. In this section, I provide a couple of examples of how this slightly more sophisticated EVA model works.

The first example of the modified EVA formula

If your firm can freely restructure its debts, you may want to make two adjustments to the EVA analysis:

· You may need to use an all-encompassing cost of capital. An all-encompassing cost of capital considers both the cost of equity (this is what I did earlier in the first part of this chapter) and the cost of any debt.

· 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 lends money at 10 percent), and owner’s equity. Table 2-3 shows an approach to estimating the capital charge that needs to be compared with the net income when this other debt is considered.

TABLE 2-3 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

Let me walk you through the numbers in Table 2-3 , although none of them is difficult to figure out:

· Trade vendors: The trade vendors provide debt — \$20,000 in the balance sheet shown in Table 2-2 — but the firm doesn’t have to pay a charge to those creditors. In effect, any implicit charge that the firm pays to trade vendors is already counted in the amount that you pay those vendors for the products or services that they supply. 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 Table 2-3 , the owner’s equity capital charge is shown as \$40,000. (This is the same \$40,000 capital charge discussed earlier in the chapter.) This capital charge is calculated by multiplying a cost of capital percentage, 20 percent, by the owner’s equity (20 percent of \$200,000 equals \$40,000). The adjusted capital charge, therefore, equals \$50,000.

Finally, there’s a pot of money left over at the end to pay creditors and owners. And that pot of money, as shown on the income statement in Table 2-1 earlier in this chapter, 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.

It’s no coincidence that the simple EVA formula and the more complicated EVA formula return the same result. EVA shouldn’t change because you use a more complicated formula — as long as both the simple and complicated formulas are correct. (They are.) So what’s up? The more complicated formula lets you see how changes in your debt affect the EVA.

Another EVA with debt example

Here’s another example of the modified EVA approach. Suppose that you, the business owner, go down to the bank and take out another \$100,000 loan. Then suppose that the business pays this amount out to the business owner (you) in the form of a dividend. If this transaction occurred at the beginning of the year, you get the income statement and balance sheet shown in Table 2-4 and Table 2-5 (reflecting the additional loan).

TABLE 2-4 A Simple Income Statement

 Sales revenue \$150,000 Less: Cost of goods sold 30,000 Gross margin \$120,000 Operating expenses Rent 5,000 Wages 50,000 Supplies 5,000 Total operating expenses 60,000 Operating income 60,000 Interest expense (20,000) Net income \$40,000

TABLE 2-5 A Simple Balance Sheet

 Assets Cash \$25,000 Inventory 25,000 Current assets \$50,000 Fixed assets (net) 270,000 Total assets \$320,000 Liabilities Accounts payable \$20,000 Loan payable 200,000 Owner’s equity S. Nelson, capital 100,000 Total liabilities and owner’s equity \$320,000

In other words, the only differences between the description of the business in Tables 2-1 and 2-2 and its description in these two tables are that the firm has \$100,000 more debt and \$100,000 less owner’s equity, and the extra debt produces another \$10,000 a year of interest expense. That’s pretty straightforward, right? All I’ve really talked about is using more debt and less owner’s equity.

Table 2-6 estimates the capital charge for this new, more highly leveraged firm. Once again, let me walk you through the components of the capital charge. The trade vendors, who supply \$20,000 of trade credit in the form of accounts payable, don’t charge anything, so there’s no capital charge for their contribution to the firm’s capital structure. In the new, more highly leveraged firm, the bank loan charge has gone way up. Now the firm is carrying a \$200,000 loan. With 10 percent interest, the capital charge on the loan rises to \$20,000 annually.

TABLE 2-6 Estimating the New Capital Charge

 Trade vendors (\$20,000 @ 0 percent) \$0 Bank loan (\$200,000 @ 10 percent) 20,000 Owner’s equity (\$100,000 @ 20 percent) 20,000 Adjusted capital charge \$40,000

The final owner’s equity capital charge also changes: It drops. With the decrease in owner’s equity to just \$100,000, the 20 percent capital charge decreases to \$20,000 a year.

When you add up all the bits and pieces, you come up with an adjusted capital charge of \$40,000. Remember that this is the capital charge for the new, more highly leveraged business.

For this new, more highly leveraged business, the EVA changes. The adjusted income for the business is \$60,000 (calculated as the \$40,000 of net income plus \$20,000 of interest expense). You can calculate the EVA by subtracting the \$40,000 capital charge from the \$60,000 of adjusted income. The result equals \$20,000 of EVA. The EVA doubles, obviously, when the business is more highly leveraged.

This second example shows why the more complicated EVA formula can be useful. The example recognizes more explicitly how EVA results when a firm produces income in excess of the capital charges.

Presenting Two Final Pointers

I want to share two final pointers with business owners who may want to use EVA analysis to think about the economics of their businesses. (My first point is pretty basic, but I think it’s probably the most important thing to take away from this chapter.)

· EVA analysis is most useful to business owners and managers — or at least to owners and managers of small and medium-size firms — as a thinking tool. In other words, even if you don’t scratch out the numbers on the back of an envelope, EVA makes sense as a way to think about how you should run your business and whether it makes sense to make changes. Comparing your firm’s net income with the amount that you could earn by selling and then reinvesting the capital elsewhere is a useful concept.

I have a literary agent friend who likes to say, “Listen to the universe.” I think that his suggestion, especially as it relates to the economics of running a business, is pretty darn good. You should listen to the economy when you think about your business, and EVA provides a tool for you to do that. For a business to make sense, it needs to return a fair share to each of its stakeholders: wages to employees; interest and debt service payments to lenders; a return to shareholders who invested capital; and then, as a practical matter, a little something left over for you, the owner. Indeed, in order for a business to make sense, it needs to pay more than just its capital charge.

· Although you can use EVA analysis to evaluate a business in its entirety, EVA analysis isn’t limited to that application. You can use EVA analysis, with a little bit of fiddle-faddling, to evaluate a business unit, a particular product line, your managers, and so forth.

This is really neat if you think about it. You can use EVA analysis to break your business into different profit activities. By using EVA analysis to look at the economic profit of these different profit activities, you can probably find those activities that should be emphasized because they produce an economic profit, and you can identify those activities that should be discontinued (perhaps) because they don’t produce an economic profit. You can evaluate customers and managers the same way.

If you want to do this more granular EVA analysis, work with a chart of accounts that supports more detailed income statements and balance sheets. In other words, if you’re going to break your business into two business units, use a chart of accounts that lets you easily see the income statement for each business unit. In a similar fashion, use a chart of accounts for your balance sheet that lets you see the capital investment for both business units. Remember that any line item that you want to appear on an income statement or balance sheet needs its own account in the chart of accounts. Book 2, Chapter 1 describes how to create your QuickBooks Chart of Accounts list. That chapter can also address any questions that you may have about how to set up additional income statement accounts and balance sheet accounts.

And Now, a Word to My Critics

I may as well admit something here. Some people — I hope only a few — aren’t going to like my simplistic approach to EVA.

The following are the points that I simplified, but you can take this information and delve deeper into EVA analysis:

· More work is involved in this process, per the textbook theory of EVA, than what I describe here. In a perfect world, you should take the net income number off the QuickBooks income statement and fiddle-faddle with it so that you get a better, more accurate, more cash-flow-centric measure of income.

· Owner’s equity isn’t the world’s greatest measure of the fair market value of the capital invested in a firm. It would be great if a firm could follow the textbook approach described by the creators of EVA analysis (Stern Stewart & Co.) and work with good estimates of the market values of a firm’s equity and debt. But you know what? That’s a lot of work for an often-modest increase in precision, especially if you’re paying some consultant the big bucks to come up with better market values for your equity and debt.

· My rough-and-tumble approach to the capital charge of owner’s equity (my suggestion that you simply use a range of values from 15 to 30 percent) is sort of financial heresy. MBAs and PhDs probably would be much more comfortable using something complicated, such as the capital asset pricing model. Unfortunately, that’s a complicated statistical model that, quite truthfully, scares me half to death. And yes, you probably could come up with a more precise rate of return percentage — if you put in a lot more effort.

So I’m guilty. I admit that I’ve made several simplifications in the EVA model. Before the judge passes sentence, however, I want to suggest two extenuating circumstances that the judge should consider:

o Small-business EVA works differently from big-business EVA. Remember that EVA is a tool to help managers think like shareholders. In the case of a small-business owner using QuickBooks, however, the manager and the shareholder are one person. The dual role implies that this person can more loosely apply the EVA model and still get the benefits of EVA-type thinking. Some of the machinations involved in very sophisticated EVA analysis stem from the fact that management is independent of shareholders. This simply not the case with a \$1 million manufacturing business or a \$10 million distribution business.

o Precision costs money. Employing someone who’s very sophisticated in the wizardry of finance may not be worth the additional cost. Think about the typical small-business owner using QuickBooks as his or her accounting tool. A firm that produces \$10,000 of EVA (as in the examples used in this chapter) shouldn’t spend \$10,000 or \$20,000 on consultants to get a super-precise measure of income or the perfect cost of capital measurement. In my opinion, a firm that produces \$100,000 in EVA also shouldn’t have this expenditure.

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