Economic Value Added (EVA) – Part 1

In this week’s video I talk about one of the most important metrics in business… watch to find out more!

VIDEO SUMMARY

In this video we are going to start talking about EVA or Economic Value Added. The first step to understanding EVA is to understand a concept called Productivity, so that’s what this video is about. Productivity is perhaps the most important concept in business. And I want to make sure you really understand what it means, because there is a lot going on in this concept.

There are different metrics to calculate productivity, but it is always based on two things: Some measure of value created, compared to the assets used to create that value. So imagine I used these supplies, and this equipment, and these people, and I generated X. Higher levels of productivity, means I would generate greater levels of X from the same amount of supplies, equipment, and people. We can abstract this even further and take supplies, equipment, and people and represent them with a dollar value. It takes so much money as an input, to generate a certain level of output. Value created divided by assets used to create value, gives you a productivity factor. You might be 2 to 1, or 10 to 1. I can take $1 and turn it into $2 or $10.

If you know your productivity factor, and your business is scalable. You know what the results are going to be if you run more cash through the business. If your productivity is 2 to 1, and your currently starting with 1M and generating 2M. You know, if someone invests in your business an additional 1M, you will then be starting with 2M and you can generate 4M. This is an extremely simplistic example. It’s always more complicated than this to scale a business. But this is the general concept behind understanding your productivity. How much are you producing from your current assets?

The problem for finance people, is that a productivity value is not displayed on the financial statement. What you get, in financial statements is an income statement, and at the bottom you see Net Income. Net income is your profit/loss for the period. Net income is helpful to know, but we want to look deeper. Because let’s say your business generates 1M per year. Is that good or bad productivity? You don’t really know. Let’s compare two businesses with 1M in revenue. One business has 500k in assets and the other business has 1B in assets. Which business is more productive. The business with 500k in assets has a 2 to 1 productivity ratio, while the company with 1B in assets has a 1/1000 to 1 productivity ratio. So to come up with these productivity ratios, what you have to do is take information from your income statement and balance sheet and smoosh them together to come up with an understanding of your productivity.

The powerful thing is when you figure out these productivity factors, you can use them to compare companies. You can easily see one company’s productivity versus another. But not only companies, you can compare sectors, and see what sector is generating a lot of value. And on a higher level you can look at countries. You can see the productivity of one country compared to another. And it gives you are really good understanding of how well capital is being utilized.

Thinking in terms of productivity is different for some people. You need to think like an owner. Let’s say you have 1B dollars. You want to put your 1B in capital to work as effectively as possible. Let’s bring back the two companies we discussed earlier. You have the 500k company and the 1B company. So here is your choice. You could invest your 1B in the Billion dollar company and know you are going to get a 1/1000 of a return on your investment. Or you could invest in growing the 500k company and get a 2 to 1 return, or double your money from 1B to 2B. Do you see how valuable this information is?

I love talking about productivity. It is so important for every organization to understand your productivity, your competition’s productivity, and understand how you are going to improve your productivity metrics.

So to recap: I gave you a definition for productivity. We talked about why it is important. I told you how it relates to your financial statements. And finally discussed how it is useful for comparing businesses.

In the next video, we are going to talk about EVA and the specific approach EVA takes to calculating productivity.

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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.