Economic Value Added - EVA explained

Economic Value Added

Economic value added (EVA) is a financial measure of what economists sometimes refer to as economic profit or economic rent. This phrase is used because EVA measures the economic rather than the accounting profit created by a business.

To make it more understandable we can say that,the difference between economic profit and accounting profit is essentially the cost of equity capital.

If the earnings of the business are able to meet this obligation and some earnings are left for the exclusive use of a business, that “leftover portion” is called EVA, which is “positive.”

EVA is “negative” if the company’s earnings do not compensate the opportunity cost for equity shareholders.

This means that the firm’s earnings (profits) are inadequate to compensate the equity capital at the required rate of return, as determined by the market.

If EVA is consistently negative, investors may move their funds elsewhere, believing that the company cannot generate adequate returns.

How to Calculate Economic Value Added (EVA)

1. Calculating economic value added (EVA) is fairly easy. In normal accounting practice, we subtract the financial charge in the form of interest on debt capital from EBIT to arrive at EBT.

2. From EBT, the tax on profit is deducted to arrive at EAT. In turn, subtract the dividends payable to preference shareholders to arrive at the earnings (profits) available for distribution to equity shareholders.

3. From these earnings (profits), subtract the financial charge (return on investment) to equity shareholders at the market-determined rate.

4. If the earnings can fully absorb this charge and some earnings remain in the business, the leftover balance is treated as EVA (positive).

5. If the market-determined rate of return is not fully absorbed by the earnings (profits) of the business, the unabsorbed portion is treated as EVA (negative).

6. When Economic Value Added (EVA) is negative, the finance managers have to take measures to correct the situation, ensuring a positive EVA in the future.

How to Transform Negative EVA Into Positive EVA

1. Generate more revenue without using more capital and by improving operating profit margins or asset turnover ratios.

2. Sell under-utilized assets, thereby reducing the capital invested in the business. This will have a two-fold positive impact, improving the asset turnover ratio and reducing capital cost.

3. Redeploy the capital invested to projects and activities with higher operating performance compared to existing projects and activities.

4. Change the company’s capital structure for positive leverage advantages.

Regarding the last point, this could involve altering the firm’s capital structure by substituting lower-cost debt for higher-cost equity. Of course, this measure may lower net earnings, but it would improve EVA by lowering the total cost of debt and equity.

EVA and Finance Managers

EVA as an economic measure informs financial managers about the profitability status of their company. It enables them to take the necessary steps to improve the company’s position if EVA is nil or negative.

If EVA is positive, the question of how to improve it further is also a consideration that interests most professional managers.

Benefits of EVA

1. It is simple, which means that anyone can understand the concept.

2. EVA is a powerful representation of corporate performance.

3. It can be used as a powerful motivational and communication tool.

4. The power of EVA is derived from its focus on shareholder value and its expression of performance as a relative term.

5. EVA adapters tend to have greater asset dispositions and faster turns.

Limitations of EVA

1. The major weakness of EVA is its single-period focus (i.e., its value can be calculated only for a single period at a time).

2. EVA cannot capture all the long-term implications of decision-making.

3. Strict reliance on EVA can distract managers from other important issues

How Does EVA Work?

When calculating EVA, the following three factors should be considered:

Net operating profit after tax (NOPAT): This is the annual cash flow available to cover the cost of raising all equity and debt capital on an after-tax basis.

Economic book value (EBV) capital: This is an estimate of the total capital utilized by an enterprise for a period, including debt and equity.

The enterprise’s cost of capital: This is the appropriate risk-adjusted rate applied to any one of the divisions or to the entity.

Adjustments need to be made to arrive at figures for NOPAT and EBV. These adjustments are necessary to ensure accurate figures, which will form a good basis for calculations.

Accounting Adjustments

Among the most common and important are:

1. Expenditures on R&D, promotion, and employee training should be capitalized.

2. Depreciation charge is added back to profit and instead, a charge for economic depreciation is made. This reflects the true change in the value of assets during the period, unlike accounting depreciation.

3. Accounts such as provisions, allowances for doubtful debts, deferred tax provisions, and allowances for inventory should be added back to capital implied.

4. Non-cash expenses should be added back to profits and to capital employed.

5. Operating leases should be capitalized and added back to capital employed.

6. Tax charge will be based on cash taxes, rather than the accruals-based methods

How to Calculate Economic Value Added (EVA)

Based on return on assets as calculated using:

EVA = NOPAT – Required Return on Assets,

where,

Required return on assets = Assets employed x cost of capital.