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EVA: A better financial reporting tool
Economic Value Added (EVA) is a financial performance measure being adopted by many companies in corporate America. This new metric, trademarked by Stern Stewart and Company, is a profit measure bad on the concept of true economic income which includes the cost of capital for all types of financing. EVA provides a more comprehensive measure of profitability than traditional measures becau it indicates how well a firm has performed in relation to the amount of capital employed. This article summarizes the EVA concept of measuring profitability, the EVA calculation and the benefits of adopting an EVA framework.
The EVA Concept of Profitability
EVA is bad on the concept that a successful firm should earn at least its cost of capital. Firms that earn higher returns than financing costs benefit shareholders and account for incread shareholder value.
In its simplest form, EVA can be expresd as the following equation:
EVA = Operating Profit After Tax (NOPAT) - Cost of Capital
NOPAT is calculated as net operating income after depreciation, adjusted for items that move the profit measure clor to an economic measure of profitability. Adjustments include such items as: additions for interest expen after-taxes (including any implied interest expen on operating leas); increas in net capitalized R&D expens; increas in the LIFO rerve; and goodwill amortization. Adjustments made to operating earnings for the items reflect the investments made by the firm or capital employed to achieve tho profits. Stern Stewart has identified as many as 164 items for potential adjustment, but often only a few adjustments are necessary to provide a good measure of EVA.[1]
Measurement of EVA
Measurement of EVA can be made using either an operating or financing approach. Under the operating approach, NOPAT is derived by deducting cash operating expens and depreciation from sales. Interest expen is excluded becau it is considered as a financing charge. Adjustments, which are referred to as equity equivalent adjustments, are designed to reflect economic reality and move income and capital to a more economically-bad value. The adjustments are considered with cash taxes deducted to arrive at NOPAT.
EVA is then measured by deducting the company's cost of capital from the NOPAT value. The amount of capital to be ud in the EVA calculations is the same under either the operating or financing approach, but is calculated differently.
The operating approach starts with asts and builds up to invested capital, including adjustments for economically derived equity equivalent values. The financing approach, on the other hand, starts with debt and adds all equity and equity equivalents to arrive at i
nvested capital. Finally, the weighted average cost of capital, bad on the relative values of debt and equity and their respective cost rates, is ud to arrive at the cost of capital which is multiplied by the capital employed and deducted from the NOPAT value. The resulting amount is the current period's EVA.
The remainder of this article summarizes the financing approach becau it emphasizes the significance of capital employed and illustrates how accounting rules impact the calculation of EVA. Exhibit 1 on page 33 shows a sample calculation of EVA.
EVA Calculation and Adjustments
As stated above, EVA is measured as NOPAT less a firm's cost of capital. NOPAT is obtained by adding interest expen after tax back to net income after-taxes, becau interest is considered a capital charge for EVA. Interest expen will be included as part of capital charges in the after-tax cost of debt calculation.
Other items that may require adjustment depend on company-specific activities. For exa
mple, when operating leas rather than financing leas are employed, interest expen is not recorded on the income statement, nor is a liability for future lea payments recognized on the balance sheet. Thus, while interest is implicit in the yearly lea payments, an attempt is not made to distinguish it as a financing activity under GAAP.
