Economic Value Added EVA

EVA suddenly seems to be the corporate buzzword, a veritable mantra in business circles.

What is EVA?
How is it superior to numerous other tools we have read and heard about? What is EVA? EVA is an acronym for Economic Value Added. It is defined as ‘net operating profit less an appropriate charge for the opportunity cost of all capital invested in the enterprise’. Let us proceed to take apart the definition a word at a time and understand the significance in its entirety.

EVA = Net operating profit after tax - Capital charge Capital Charge = WACC * Net funds employed Net Funds Employed = Net fixed Assets + Net working capital

Any organization (leaving aside non-profit ones) wants to make a profit. Profit, put in simple terms, is income minus expense. However, the catch here is that there are various categories of expenses to be taken into account, so let us organize them.
There are, of course, the standard expenses incurred during the normal course of operation of business, which includes the material cost and various overheads including the electricity charges, traveling and conveyance expenses, telephone expenses, factory operating or office running expenses etc to name a few. Let us call them the first level expenses.
Apart from these, there are secondary expenses, like amortization, depreciation expenses, and taxes on profit made.

Net operating profit is the operating income (not including other income categories like sale of assets etc) minus all first level and secondary expenses.

It must be noted here that the obligations of an organization does not end with accounting for its first level and secondary expenses. The enterprise has borrowed money from financial institutions (debt) and its shareholders (equity), and these constitute the sources of funds for the organization. It doesn’t take any accounting knowledge to figure out that these are the actual owners of the firm, and they expect a certain rate of return based on the risk of their investment.

Hence let us proceed to deduct this expectation, also known as capital charge, from the net operating profit, to get a clear indication of the actual wealth created by the organization. The capital charge can also be represented as the combined expected rate of return of debt and equity (also called Weighted Average Cost of Capital) on the net capital invested in the company. The net capital can once again be broken down into long term assets as well as the working capital requirements for the business.

What does EVA Signify?
The focus of organizations has undergone a shift from mere profit maximization to value maximization. There is a clear distinction between the two. Profit, as simple as it might sound, is a net effect of a number of accounting methods and conventions; it is not a clear indicator of an organization’s performance. The number of accounting scandals in recent times is a standing testimony to this fact. Value maximization on the other hand, has an obvious wider coverage. Two important doctrines are taken care of - It takes into consideration the expectation which the shareholders or the owners of the company have. The expectation of the shareholders is a function of the risk borne by them. The more the risk, the more the return is expected. If you invest your hard earned money in the share market, you obviously expect more return than that given by a fixed deposit, because you are taking a greater risk.

It imbibes the time value of money in its working, which stated in simple terms, means that the value of money keeps decreasing over time; Rs. 100 in your pocket now has more value than Rs. 100 in your pocket ten years from now.

This leads to a very interesting concept that borrowed money, unless optimally utilized, leads to wastage and value erosion. Shifting this to an organization scenario, money is borrowed through debt and equity channels, and is utilized in generating long term assets and working capital, which is essentially the capital invested in the enterprise for which capital charge has to be paid. Let us understand this with the help of an example.
Company ABC made a sale of Rs. 100 L in November, with a net operating profit of Rs. 20 L. The money due, however, was not collected from the customers till after one year from the date of invoicing. The capital charge on receivables will lead to diminished actual earnings, though there is no indication of the same by merely looking at the profit figure.

By combining the profit parameter which emerges out of the operations of the company after taking into account all the expenses in that period of time; with components from the balance sheet(Balance sheet indicates the magnitude of resources deployed for running the business), EVA gives a complete picture of an organization’s accomplishment.

A positive EVA indicates a healthy enterprise, there is no ambiguity about it. Simple to understand and measure, it inspires enough confidence in shareholders to be used as a universal performance measurement tool. It leads to an accurate reflection of the intrinsic value of any firm in its share prices, and when linked to a reward/compensation system, can motivate the employees to maximize their contribution to value creation. By emphasizing on increasing productivity and sales, cutting down on expenses, controlling working capital and making judicious well planned capital investments, EVA covers the entire gamut of business activities and offers all employees a role to play. Splutters of independent improvement initiatives organized haphazardly in random areas of working will not result in any discernable value creation, EVA will help in prioritizing them and attacking the weakest link of the chain to make maximum contribution with minimum effort. It can be perceived as a kind of ‘business compass’ that will help immeasurably in the decision making process, be it day to day or important strategic ones.

We hold in our hands a tool of unfathomable potential, its constant measurement and positive growth can spur the organization on to great heights and result in value creation not merely for the shareholders, but for all stakeholders. It is now left to all of us to grasp its importance and incorporate it into our working, to create an effective and efficient work environment.

What do the pioneers say?
“EVA has been a great tool for the people of our organization. Using EVA, we've seen our business grow and we've seen our people grow in their commitment and contribution to the company. EVA is the backbone of our company-wide incentive and bonus system, and in the last two years, we've increased the wealth of our employee-owners by over $100 million. If you ask them, they would agree that EVA works at Herman Miller.”
-President and CEO, Herman Miller

The Fortune magazine has called it “today’s hottest financial idea and getting hotter…he real key to creating wealth”. John Blystone, Chairman, president and CEO of SPX corporation insists that ‘EVA and turnarounds are a match made in heaven