Economic value added (EVA) aims to measure the true economic profit of an enterprise rather than just an accounting profit. The EVA measures the extent to which the earnings of the enterprise exceed the minimum rate of return due to shareholders and lenders, on the assumption of a comparable risk.
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Definition of Economic Value Added
Economic value added (EVA) is a method of measuring the financial performance of an enterprise. The EVA is calculated by multiplying the enterprise's capital by its cost of capital and deducting the resulting figure from the net operating profit after tax (NOPAT). It is, therefore, a measure of economic profit as it shows the excess profit over the amount of earnings required by the enterprise to maintain its capital. This indicator can determine if the enterprise is really creating wealth. In looking at how EVA relates to financial ratio analysis, this aim of measuring economic profit is important.
The cost of capital is the annual return required by the lenders and shareholders of the enterprise in return for providing the capital. The return to each of these contributors of capital is computed in a different way. The return to lenders is set out in the loan agreement while the return to shareholders is reflected in the dividend policy of the enterprise. The return to each of these groups will be taken into account in computing the weighted average cost of capital, which can be used to arrive at the amount to be deducted from NOPAT in arriving at EVA.
The use of the net operating profit after tax is essential in arriving at the economic profit because by using the NOPAT, the calculation attempts to look at the actual funds available to the enterprise from its operations, rather than just its accounting profit. Having established these available funds, the EVA then deducts a charge relating to the maintenance of the invested capital of the enterprise. This is based on the concept that capital has a cost, and that the cost of maintaining the capital should be accounted for as an expense to arrive at the economic profit. The economic profit represented by the EVA is the profit after actual outgoings such as tax and after deduction of the funds required to maintain capital. The resulting economic profit may be used as a measure of the real performance of the enterprise in that accounting period.
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Adjustments to Net Operating Profit
The accounting results of the enterprise need to be adjusted in arriving at the net operating profit after tax. As mentioned above, the EVA aims to first compute funds available to the enterprise from its operations and adjusts certain amounts shown in the financial statements. Beginning with the earnings before interest and tax (EBIT) adjustments are made to capitalize some expenses that should in economic terms represent assets. For example operating leases where the accounts would normally show the leasing payments as expenses in the profit and loss account, without showing any asset on the balance sheet.
To arrive at the NOPAT, the actual cash taxes paid, as opposed to the tax figure shown in the accounts, are then deducted from the adjusted EBIT. The use of the cash payments of taxes means that the computation can arrive at the cash return that has been generated by the enterprise's operations in the period. In examining how EVA relates to financial ratio analysis, it is important to note that this computation differs from the gross or net accounting profit that is used in many financial ratios.
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EVA and Financial Ratio Analysis
Continuing on with how EVA relates to a financial ratio analysis is to look at profits and the price of utilized capital.
Owing to the adjustments made to the accounting profit and the deduction from profit of the price of capital employed in the enterprise, EVA is clearly different from the financial and accounting ratios commonly encountered in analyzing the performance of enterprises. The distinctive feature of EVA is that it is an economic measure of performance and looks at the true economic profit. It could be used as a measure of management performance, enabling comparison of performance with competitors regardless of how the enterprise or its competitors are financed.
Unlike many accounting ratios, EVA will not be affected by the existence of any off balance sheet financing such as operating leases, because adjustments are made for this when computing the net operating profit after tax. The EVA could, therefore, be a useful measure for determining management performance and establishing management bonuses. By setting the goals of an organization in terms of EVA, rather than a traditional accounting measure, greater motivation might be achieved from management because their performance will be measured independently on how the business operations are financed.
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Advantages and Disadvantages of EVA
By arriving at economic profit, EVA recognizes that capital is not free but has a price attached to it. By computing this price and deducting it from the funds generated by the enterprise, EVA measures the funds generated after allowing for the price paid for the capital employed by the operation. It overcomes the limitation of measures such as the earnings per share that look at earnings without fully taking into account the economic return to all providers of capital.
However, this measure of economic profit also has its limitations. For example, the calculation of the invested capital may not be accurate if the enterprise is using substantial intangible assets that may not be reflected in the value of invested capital. The result would be that the economic profit is overstated, while any attempt to adjust the capital invested to take into account the value of the intangible assets would involve estimates that would not necessarily be accurate. The EVA is most useful when applied to traditional industries that are using substantial tangible assets, such as manufacturing, rather than high technology, software development or service oriented enterprises that use intangibles to a greater extent.
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"Economic value added" on Value Based Management retrieved at http://www.valuebasedmanagement.net/methods_eva.html
"Financial ratio analysis" on Business Diagnostics retrieved at http://www.businessdiagnostics.com.au/financial-ratio-analysis