Financial Statement Analysis (FSA) and Economic Value Added (EVA) are tools to ascertain the financial health of the organization and its capacity to generate shareholder ‘value’ respectively. The term “Economic Value Added (EVA)” is a registered trademark of Stern Stewart & Co, a consulting firm which implements the EVA concept for large companies.
Economic Value Added (EVA) sharpens the view of corporate governance by redefining its goal. It has long been accepted that companies should seek to maximise profits. Economic Value Added (EVA) uses accounting information to improve decisions and motivate employees. According to Erik Stern, president international of Stern Stewart, “Although EVA is based on accounting, when implemented the system must be simple and operational or it is irrelevant. EVA is not a metric but a way of thinking, a mindset. While the language is technical, the lifestyle is operational.” Central to the concept is the idea of opportunity cost. Capital is used in each division of the organisation. That division is required to earn a rate of return based on the amount of capital it uses and the cost of that capital. The firm’s cash flow is subtracted from the required profits, based on the rate of return, to give economic profits.
Calculating EVA (Economic Value Added)
There are four steps involved in the calculation of EVA (Economic Value Added), which are as follow:
1. calculating the net operating profit after tax (NOPAT);
2. calculating total invested capital (TC);
3. determine a cost of capital (WACC); and
4. calculating EVA – NOPAT – WACC% * (TC)
The first step, calculating NOPAT, requires conversion of the company’s accrual to cash accounting. Under some accounting regimes, a step by step add-back of cash items is required if cash statements are not available. For publicly traded US companies and others which follow US GAAP, one can simply refer to the required statement of cash flows, one of the four required financial statements. Non-public and small companies may not fall under GAAP requirements, so the add-back may be required. The same applies to non-US accounting where statement of cash flows is not required. Many large firms, however, will include it voluntarily with their financial statements.
Need for EVA (Economic Value Added)
There is a long history in economics of preferring “economic” over “accounting” profits. The difference is that the former subtracts opportunity costs, in particular, a “fair” rate of return on investment. Accounting profits do not. In its basic form, EVA is the Net Operating Profit After Taxes (NOPAT) minus the money cost of capital. Money cost of capital means the rupee value of that cost rather than a rate of return. It adds back to the accounting profits the amortisation of goodwill or capitalisation of brand advertising. There are other similar adjustments of intangibles which EVA considers important. Shareholders of the company receive positive value added when the return from the capital employed in the business operations is greater than the cost of that capital.
The EVA concept believes that for every performance measure there is a corresponding wealth measure. For example the P/E ratio is the wealth measure that corresponds to return on equity. Market capitalisation (price × number of shares) corresponds to free cash flow, while total shareholder return corresponds to cash flow return on investment.
To calculate NOPAT, EVA starts with income before income taxes and minority interests. Then it adds interest expense to get Earnings Before Interest and Taxes (EBIT). Next, it makes two adjustments. First, it adds and subtracts non-cash items to put EBIT on a cash basis. An alternative would be to take the information from the firm’s cash flow statement, if available. Then, it capitalises expenses which it believes should be treated as investments. The effect of this is to move certain expense items to the
Examples of converting accrual information to cash are adding increases in LIFO reserves. Another is adding increases in the allowance for bad debts. An example of capitalising debt/equity equivalents is to convert operating to capital leases. It takes an off-balance sheet type of financing (the operating lease) and puts it back onto the converted balance sheet. The preferred way to do this is to take the present value of the lease payments for the period of the lease.
The interest rate for the discounting is usually available from the company – its ratio of lease payments for the year to total lease obligations. If not available, a reasonable discount rate can be estimated based on the firm’s cost of debt and equity capital. Next, in converting to a cash basis, the company subtracts cash taxes paid. One can do this by subtracting increases in deferred tax liability and adding tax subsidy on deductible expenses. The result is cash operating taxes.
A key step is to determine the weighted average cost of capital and multiply it times the capital that the company uses. This is the “opportunity cost” concept that is at the heart of the economic profits approach. Estimating the cost of debt is relatively straightforward. The exception is if the debt is not publicly traded and therefore hard to value (such as CDO debt). In the absence of such problems, the standard way is to look at debt costs on the income statement and divide by the total debt outstanding on the balance sheet. Another way is to estimate the cost of debt from the company’s debt rating from rating agencies such as Moody’s or Standard and Poor’s.
The EVA (Economic Value Added) concept is not a new one. It is a basic part of accounting and finance. The key to it all is successful implementation. That is, calculating the numbers and then committing management to act on them, such as to increase funding to divisions with positive EVA, and to harvest (sell) divisions with negative EVA.
Another important implementation is to reward or punish managers for generating positive or negative EVA. Incentive schemes based on the EVA are shown to be more motivating than other company-wide or accrual-based incentives. According to Stern, “EVA attempts to bring the concept of the franchisee into the corporate world. Most franchises outperform company operated businesses. Ownership makes a difference. EVA-based compensation mimics the ownership mindset and encourages the company manager to take decisions as would the franchise owner.”
Orpurt gives his take on implementation: “EVA is an incentive system so employees need a reward for creating and sustaining it. Successful implementation requires a substantial commitment by managers and employees at all levels of an organisation.”