Economic value analysis is a wealth metric companies use as opposed to accounting income or profit. The most common analysis tool for this process is economic value added, a standard form created several years ago. The use of economic formulas to value a company helps stakeholders determine the true physical value of a business. In short, the balance sheet is often the more important financial statement than the income statement. Consultants are often necessary to help a company complete economic value analysis.
Accounting is a method companies use to keep score, tracking the movement of dollars in the company. The higher the dollars — in terms of profit — the better the score for the business in the current market. The biggest issue here, however, is that accounting profit is simply a made-up number. It only represents the difference between sales revenue, cost of goods sold, and expenses, with the final figure having no physical representation. A company’s true wealth can only be measured from the use of this type of analysis.
No single formula exists to compute a company’s economic wealth. A basic formula may be total assets less total liabilities; the difference is the actual wealth a company retains for itself. Other formulas or metrics may apply to other parts of the physical assets of the business. In fact, a company’s economic wealth as determined by economic value analysis may be closely related to its market value. The market value of a company is often the figure that a willing party would buy the company for in the open market.
Cash flow is typically a big part of a company’s economic value analysis. Not only is cash king in business, but it is also the biggest wealth factor a company generates through normal operations. Economic profit uses cash flow as its primary measurement tool for keeping score. Discounted cash flow models, net present value formulas, and free cash flow all work their way into economic value analysis. Those who compute economic profit or wealth attempt to value all cash flows in current value to assess a company’s true value.
It can be difficult for a company to accurately assess its economic wealth on its own. The formulas used may be foreign to internal stakeholders, or the processes are simply too complex to figure out without proper education. Consultants can help take an objective look at a company and use the proper formulas for economic value analysis. Consultants may also have benchmarks so they can compare one company’s performance against another. Either way, the objective look can provide a true figure for economic wealth.
