Are you running an economically viable business?

AT the outset of this article, let's define economic viability. My simple question to the CEO is: Are you generating economic profits well above the Cost of Capital? Let's look at the technical definitions:

- By Saminda Weerasinghe, CFA

Economic Value Added (EVA) = Net Operating Profit After Tax-(Invested Capital x Weighted Average Cost of Capital)

Residual Income = Net Income - (Equity Capital × Cost of Equity)

The above formulas help to understand whether your business has earned profits or net income exceeding the attributable economic charges.

Now that we have established the basic technical understanding, let's dive into creating the right strategic mindset to make this a reality-driving strategy based on economic benefits. This mindset enables the CEO, CFO, and the Board of Directors to make business decisions driven by economic objectivity.

Based on my experience, here are a few points that might help achieve this:

Understanding the proper cost of capital and its impact on business valuation

Most businesses operate with a focus on cash flows, but how effectively do we monitor the economic utilisation of those funds?

Was a thorough financial feasibility study conducted? Was the optimal debt/equity mix established?

The ideal debt/equity mix is where the project delivers the highest economic benefit, valuation, and internal rate of return (IRR).

Do we evaluate projects post-implementation to see if they are still on track to meet the targeted IRR? If not, how often do we make tactical adjustments to cost structures and pricing to steer them back on course?