Economic Value Added (EVA) and Infinite Banking
Economic Value Added (EVA) is a little-known, but impressively effective measure to boost your profitability.
Coca-Cola, AT&T, Quaker Oats, CSX, and Briggs and Stratton helped the term rise to prominence when they adopted EVA in the 80s and 90s. Focus on this insightful accounting measure resulted in an overwhelming increase in business value, stock price, and profits.
Because of attention to increasing EVA, Quaker Oats shifted their production schedule. Rather than using big sales promotions to spike production at each quarter’s end, they leveled out with more consistent production. Then, instead of requiring large warehouse volume they more efficiently used their real estate, by stocking more consistently. With fewer warehouses and staff, they reduced costs. This put their company on the map as they launched into long-term sustainability.
CSX implemented Economic Value Added by shrinking labor and fuel costs, along with the number of containers, trailers and locomotive fleet. At the same time, they boosted freight volume, significantly enhancing profits.
In each case, the shift to improving EVA had more invested capital working harder, more of the time. This increased the productivity of each dollar at work.
Over time, different consulting firms have called this profit measurement by different names. But Stern Stewart & Co. of New York City popularized the term Economic Value Added.
What does it mean and why does this matter to you? Well, if you want to put more dollars in your pocket, there’s a better way than spending a bunch of money and believing the expansion will create additional production that generates revenue and hopefully turns a profit.
In today’s article, we’ll answer:
- What is Economic Value Added?
- Why is it important to me and my business?
- How do I determine the cost of capital?
- What should I do to increase my EVA and profitability?
- What is the connection between the Infinite Banking Concept and Economic Value Added?
- How does Infinite Banking improve EVA?
Economic Value Added will help you accurately assess and increase your real profitability. It will also increase the value of your company and give you a competitive advantage in your market. This conversation will show you how.
Where Economic Value Added Fits into the Cash Flow System
Profit maximization is just one part of the bigger picture of building time and money freedom.
That’s why we have created the 3-step Business Owner’s Cash Flow System. It’s your roadmap to take you from just surviving, to a life of significance, purpose and financial freedom.
The first step is keeping more of the money you make by fixing money leaks, becoming more efficient and profitable.
Then, you’ll protect your money with insurance, legal protection, and Privatized Banking.
Finally, you’ll put your money to work, increasing your income with cash-flowing assets.
When you increase your cash flow from current income, it’s like you have more gas feeding your financial freedom machine. And this accelerates your results.
So, let’s get more gas flowing into your Cash Flow System, shall we?
What Is Economic Value Added?
Economic value added (EVA) is a measure of a company’s financial performance based on the residual wealth calculated by deducting its cost of capital from its operating profit, adjusted for taxes on a cash basis.Investopedia
Here, the magic is in the details. More specifically, in the understanding of the term cost of capital.
What made EVA such a savior was the profound insight that cash has a cost. Therefore, we should treat it accordingly.
Without EVA, companies were accounting for a cost of debt capital, but treating equity capital as free. And understandably so! While interest expense shows up on your Profit and Loss Statement, the cost of cash is mysteriously absent. It appears nowhere on your financial statements, not even your balance sheet.
However, recognizing the true cost of cash and consequently raising the bar on the returns it should produce was the key to exponential profitability increase.
The Disparity in the Expectations of Debt Financing and Cash Purchases
Under the lens of Economic Value Added, all capital, whether debt or corporate cash, is called to account for its cost and productivity.
There was a recognition that purchases made with debt financing required more oversight and higher standards than those made with cash.
Think of how a bank decides whether to extend a loan. They evaluate the risk level of the business, based on the likelihood that invested capital will be returned, at interest.
Asset purchases made with debt capital are expected to produce sufficient profitability to be capable of repaying more than the loan. The standard for being able to borrow another person’s money is that the loan dispersal requires an assessment of the risk involved. If the endeavor or investment didn’t show promise that it could make more money than the loan and be able to repay the loan at interest, it would fail the test and be declined for a loan.
Yet, most people frequently use their cash or corporate cash, with less scrutiny, because they see it as free.
But just because paying cash doesn’t come with interest attached doesn’t mean it’s free. There’s a correlated opportunity cost any time you could have put that cash to work in something more productive.
View Cash as Investor Capital
This discrepancy is much easier to see if you think of yourself as a shareholder or investor in your business.
An investor wouldn’t invest if they knew they’d get their money back in the future, but nothing extra. If they did, they’d be losing money. When they get their money back later, it’s worth less, due to inflation. But also, if they could have invested in a similar company to yours, and received appreciation and dividends, their opportunity cost would be the money they could have earned if they’d picked the better investment.
An investor would require an increase in the value of their capital investment through appreciation or dividends. Likewise, the bank would expect more to be paid back through interest. So, why would you consider using your cash if you won’t get more money back than you put in?
When you pay cash for something in your business, the return on investment should be sufficient to repay you more than your investment. If you launch a marketing campaign, hire a customer service person, purchase inventory, or invest in a self-storage unit, you want to know that your use of capital will be productive enough to repay you, at interest.
Then, you’ll be compensated fairly for the use of your capital by receiving appreciation of your investment and dividends. Stated another way, any time you use corporate cash or owner’s equity, you should be getting a return OF your capital, plus a return ON your capital.
The Interest Principle
It comes back to the interest principle:
You’re always paying interest.
You either pay interest when you finance, or you give up the interest you could have earned when you pay cash.
Economic Value Added is an inside look at the real cost of capital that treats corporate cash the same as borrowed cash.
It’s a savvy view of your business operation that recognizes the cost of all capital and requires all capital infusion to produce profit accordingly.
Why Is Economic Value Added Important to Me and My Business?
If you required greater productivity of every dollar you invested in your business, how much more profitable would it become?
Essentially, [EVA] is used to measure the value a company generates from funds investedInvestopedia
intoit. If a company’s EVA is negative, it means the company is not generating value from the funds invested into the business. Conversely, a positive EVA shows a company is producing value from the funds invested in it.
Think of all the capital you have tied up in your entire operation. This includes all assets that have a useful life after the purchase, such as equipment, computers, and working capital like cash, inventory, and receivables.
Require every infusion of cash into your business, whether your own or corporate cash, to create returns.
When you consider the return on invested capital, each independent department, piece of equipment, or investment should be producing enough profits to repay the principal, on a schedule, at interest.
In recognizing that your capital has a cost, you’ll be more discriminating as to which expenses are worthy of your cash, making wiser financial decisions. You’ll also exercise more oversight of that capital as you raise the bar on profitability, demanding your cash produce more than its cost.
How Do I Determine the Cost of Capital?
For those of us normal people, it’s enough to recognize that equity capital isn’t free, even though you don’t have to pay for it directly.
You can then attach an interest cost to cash and require your business to repay cash at interest. Better yet, set a schedule for repayment of the cash at interest, committing to a timetable for achieving results.
For those mathematical wizards and accounting geniuses, let’s get a little more concrete.
Here’s an EVA calculation found in this avant-garde 1993 Fortune article, titled The Real Key to Creating Wealth.
Operating Profit – Taxes = Net Operating Profit After Taxes – (Weighted average cost of capital X total invested capital) = EVA
Interestingly enough, it’s possible to show positive operating profits, but negative EVA. And since EVA is a more accurate assessment of profitability, the company that endeavors to maximize it will consistently outperform a competitor who’s not paying attention to this data.
What Should I Do to Increase My Economic Value Added and Profitability?
Maybe you realize that you’re falling behind or want to improve your margins by upping the ante.
Here are three ways to recalibrate and up level your profitability.
- One way would be to earn more profit without using more capital.
- A second method would be to maintain your production while using less capital.
- A third strategy would be to invest capital in high-return projects.
What Is the Connection Between the Infinite Banking Concept and Economic Value Added?
EVA is all about the cost of financing, and the Infinite Banking Concept is the best financing strategy we know of to reduce the cost of capital.
To do that, first we’ll revisit the idea of opportunity cost with each purchasing method.
The cost of debt financing (using someone else’s money) is the interest you’ll pay.
The cost of paying cash is all future interest you could have earned because your money is gone forever.
There’s a third way to pay for something: keep your cash and finance at the same time. You’ll continue earning interest on your own cash, even while you pay interest on the borrowed money.
If you keep cash, you can be the bank. You maintain capital, earn compound interest, and never interrupt or reset your compounding.
The most effective way to be your own bank is to utilize the Infinite Banking Concept. You store your capital in a dividend-paying high cash value whole life insurance policy. The cash value continues to grow with uninterrupted compounding, even when you use your cash in another opportunity.
This is the superpower of Infinite Banking … the ability to use your own money, but never stop its compound growth. And since compound growth is something that only gets better with time – aging like a fine wine – you reap the reward of
And if that isn’t good enough on it’s own, it does even more!
How does Infinite Banking improve EVA?
But the multi-dimensional power of Infinite Banking is that it improves your net operating profit in another crucial way.
Instead of removing your cash value (and resetting the compound growth curve), you collateralize it through policy loans.
These loans are then paid back, at interest. Because you pay back more than you took out, the collateralization process requires you to think through your capital’s cost. You’ll be more apt to ensure the profitability of your decision because you need to make enough money to repay your policy loan.
Undeniably, your decisions to deploy capital with Infinite Banking, whether for expenses or opportunities, will factor in your ability to repay. This will lead to making wiser, more productive, and more profitable financial decisions.
While you can pay back policy loans at any pace, schedule, or not at all, we always advise you to have a plan and a timetable to repay loans. That positions you to ensure it will be a profitable endeavor.
For example, your child may borrow from the family bank to pay for college, with a commitment to repay principal and interest for the use of the capital. They may think through the cost-benefit analysis more thoroughly, weighing the cost of education against their expected post-graduation salary in that career.
Or you could pay for an investment property, business equipment, inventory, knowing that how you used that capital must produce cash flow sufficient to repay principal and interest.
In any case, you’re treating your cash like corporations do by requiring your money to earn a rate of return and committing to paying for the cost of the capital.
Loaning Personal Capital To Your Business
Here’s another way Infinite Banking can be used to improve your EVA and net operating profit. You can personally own the life insurance policy and loan the cash value to your business. Your business can then repay you at interest.
The interest the business pays back to you is a deductible expense.
Within limits, you can then receive the interest personally back into your policy without it being taxable income.
Since we aren’t tax professionals, please consult with your CPA or tax strategist to ensure you do this correctly.
Your Next Steps to Using Economic Value Added
To maximize your profitability, start by valuing and respecting the cost of capital. Treat your own money as equally, if not more valuable, than someone else’s money.
When you use shareholder equity, company cash, investor capital, or policy loan from your Infinite Banking policy, require profitability from that venture. Then, set up a contract for repayment as a loan, on a schedule, at interest.
Utilize the Infinite Banking strategy to store capital, allowing you to be the bank. You’ll continue earning interest, minimizing the cost of capital because you’re not interrupting the compounding.
To determine the best way to implement Economic Value Added, increase your profitability, lower your cost of capital, and utilize the Infinite Banking strategy, book a call with our advisor team today.
Success leaves clues. Model the successful few, not the crowd, and build a life and business you love.
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