Regardless of industry, every executive keeps an eye on the same financial reports, particularly the Balance Sheet and Income Statement (P&L). For decision-making around capital, the P&L is often top-of-mind. But what about the Balance Sheet when it comes to capital? Should it be part of the equation? Concentrating solely on the cost side of financial reporting can drive decisions that are short-sighted and may have a negative impact on an organization’s overall performance.
Even if you want to consider both, it’s not easy. You’re comparing apples to oranges, P&Ls to Balance Sheets. So how do you turn a Balance Sheet into an apple? The answer is one simple metric: Economic Value Add (EVA).
EVA demystifies the Balance Sheet by turning it into an operating cost. With EVA, it’s easy to compare the effect of reducing working capital versus reducing costs, as both can be shown as a value add.
EVA = (Sales-Operating Costs) - (Net Assets*Cost of Capital)
Take a company with $100K in sales, $85K in operating costs, $100K in net assets and a weighted average cost of capital of 10%. Their EVA is $5K.
EVA = (100-85) - (100*.10) = 5
They’ve set a goal to increase the EVA profit by $1K, upping it from $5K to $6K. Using the EVA calculation, it’s easy to compare the options: reduce working capital or raw materials cost? See our Economic Value Add (EVA) Infographic [link infographic].
Reducing raw material costs, or operating costs, shows…
… that a $1K reduction in Raw Material Costs yields a $1K improvement in EVA
Applying the same logic and reducing working capital, or net assets, shows…
… that the same $1K improvement in EVA requires a $10K reduction in working capital
Withdrawing $10K from working capital would increase EVA profit by $1K, which is the same result that reducing raw material costs by $1K would provide. EVA now provides empowered-decision making down the line with incentives for managers to look at how to increase profitability without raising capital: from streamlining processes and cutting costs to adding customer value and raising prices. While the concept of increasing profit without increasing capital isn’t new, EVA is unique in its ability to conflate P&L statements and balance sheets into one.
With its simplicity and ease of application, EVA frees organizations to make decisions from the vantage point of a single metric. The power of EVA is its ability to bring assets and liabilities into the same sphere through operating costs. Balance sheets and P&L statements no longer need to be viewed as separate reports. With EVA, they fuse into one calculation of economic profit and loss. Returning to the need to compare apples to apples, EVA makes turning those oranges into apples easy.