The concept of Economic Value Added (E.V.A.).
Economic Value Added (E.V.A.) can be defined as the measure of the financial performance of a company in relation to the remaining wealth calculated by taking away the cost of capital from the economic profit also known as the operating profit. EVA seeks to show a company’s excess profit over the amount of earnings that the company needs to maintain its capital and whether there is any wealth created. The economic profit is usually adjusted for taxes on the basis of cash. EVA can be deduced as follows:
EVA= Net Operating Profit after Taxes (NOPAT) – [Capital * Cost of Capital]
The cost of capital refers to the yearly return needed by the shareholders as well as the lenders of the business entity in exchange for providing capital. Each of the returns of the contributors is calculated differently. Lenders’ returns are shown in the loan agreement whereas that of the shareholders is shown in the company’s dividend policy. Both returns to the lenders and that of the shareholders are used in the computation of weighted average cost of capital. This is in turn used to derive the amount supposed to be deducted from the NOPAT when calculating EVA.
NOPAT plays a vital role in calculating economic profit because this equation makes an attempt to look at the actual finances that are available to the company from its operations as opposed to the accounting profit only. After establishing the funds available, EVA then deducts a charge that relates to the cost of capital maintenance. This has its basis on the concept of capital having a cost meaning that that cost of maintaining capital must be accounted for as an expense in order to acquire economic profit. Economic profit here is that profit achieved after such outgoings as tax and subtracting the funds used to maintain capital. This profit reflects the measure of the business entity’s real performance at the end of that particular accounting period.
As opposed to financial ratio analysis, EVA is not affected by any financing that is not in the balance sheet, for example operating leases. This is because adjustments for this are made during the computation of NOPAT. EVA is, therefore, an important measure in the determination of the performance of the management as well as in the establishment of management bonuses. It plays an essential role in providing motivation if company goals are established in its terms as opposed to traditional accounting measures. A unique characteristic of EVA is that it focuses on true economic profit. This is what distinguishes it from financial ration analysis.
An advantage of EVA is that by deriving economic profit, it reveals that capital has a price. Calculating this price and deducting it from the funds produced by the company enables EVA to give a measure of the funds arrived at after allowing for the price of the cost of capital that has been used. EVA is not bound by such limitations as the measure of Earnings per share that only consider the earnings and tend to ignore economic returns to the contributors of capital.
Works Cited
Das, B., & Pramanik, A. K. (2009). Economic Value Added. New Delhi: Deep & Deep Publications.
Grant, J. L. (1997). Foundations of Economic Value Added. New Hope: Frank J. Fabozzi.
Raiyani, J. R., Raiyani, J. R., & Bhatasna, R. B. (2011). Financial Ratios and Financial Statement Analysis. New Delhi: New Century Publications.
