Are you running an economically viable business?

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

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:

Economic Value Added (EVA) = Net Operating Profit After Tax – (Invested Capital × 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? 

If a project demonstrates better economic performance and approaches a higher IRR, the company’s valuation should increase (assuming all other factors remain constant). Conversely, if it underperforms, valuation declines. Increased valuation reflects increased shareholder value. How do we best monetise this value—through dividends, share buybacks, or strategic sell-downs? 

Regarding dividends/share buybacks, were they declared after carefully evaluating growth opportunities beyond the company’s cost of capital? 

Monitoring recurring working capital and debt

Recurring working capital fully funded by short-term debt can be risky. The most effective way to assess the economic viability of such debt-spiralling strategies is to periodically analyse the business using DuPont Analysis—a method that examines Return on Equity (ROE) through three key components: profitability margin, asset turnover, and leverage.

ROE = Net Profit Margin × Asset Turnover × Leverage Factor

Increasing leverage (through debt) can boost ROE, but only up to the point where profitability margins start to decline. This analysis enables us to understand the diminishing returns of debt rolling while strategically managing asset efficiency.

If the CEO, CFO, or Board views the business through this lens, debt can be managed proactively, preventing it from becoming a burden on shareholder returns.

Establishing a top-down mindset

A top-down approach involves analysing the current macroeconomic environment and forecasting its impact on the business. For example, understanding how rising interest rates, inflation, or exchange rate fluctuations affect key business elements.

How often do we model the sensitivity of these macro factors in financial feasibility studies or budgets? Are we assessing the susceptibility of our business model to macroeconomic changes through sensitivity and scenario analyses? 

This practice helps us avoid decisions driven solely by gut feeling or subjectivity, enabling more rational and resilient strategic choices during uncertain times.

Growth through M&A and the expansionary mindset

Organic growth alone may not deliver acceptable shareholder returns. Management should seek to outperform current market equity returns (or other opportunity costs) through M&A activities. 

Creating higher economic returns via acquisitions isn’t straightforward. It involves not just increasing revenue and profitability, but also leveraging financial engineering techniques like leveraged buyouts, private equity, and establishing exit strategies—such as IPOs, share buybacks at pre-agreed multiples, convertible bonds, or preferred equity with clear exit mechanisms.

In my experience, the economic viability of these projects often depends on achieving one or two key elements, whose success probabilities are less than 100%. As a result, the overall project valuation becomes a probabilistic expected present value.

Incorporating “real options” in project evaluation

To move beyond this uncertain approach, understanding “Real Options” is crucial. 

Options are financial derivatives designed to reduce uncertainty in asset purchase or sale, providing the right—but not the obligation—to buy or sell at an agreed-upon exercise price. The cost of an option reflects perceived uncertainty and is calculated using advanced models like Binomial Option Pricing or Black-Scholes. 

Management can apply similar “Real Options” principles to high-capital, high-uncertainty projects—quantitatively considering and incorporating options to delay, abandon, switch, or expand projects. This flexibility allows adaptation to changing environments and optimisation of returns.

It is complex to bundle many strategic finance approaches in one article; my goal here is to plant an initial seed within the executive team—to foster a mindset that becomes an integral part of strategic decision making.

(The writer is a Chartered Financial Analyst. He is the CEO of a mid-sized exporter and a strategy/investment advisor to companies. He can be contacted through: https://www.linkedin.com/in/saminda-weerasinghe-cfa-a3333358/. The reader can gain access to the writer’s previous Daily FT articles from the below links: https://www.ft.lk/opinion/Corporate-strategy-meets-national-policy-Path-to-sustainable-recovery-for-Sri-Lanka/14-777012; https://www.ft.lk/opinion/Exporters-Are-you-on-top-of-your-game/14-775679.)