eva & other performance measures

e.v.a

Economic value added &

Other latest performance measures

PREPARED BY:Nouman mustafa shaikh

WHAT IS IT?

A latest performance management technique developed by the Stern Stewart Organization.

PURPOSE

A performance measure to calculate value addition in shareholder’s wealth by calculating economic profits rather than accounting profits in any financial year.

ECONOMIC VALUE ADDED

WHY IS IT USED?

To give a true picture on how company is performing despite of showing profits in its F.S.

Investors are more interested in cash flows rather than accrual based accounting profits i.e. real cash increase in share holder’s wealth.

Investors expect the returns based on co’s cash flows and not on accounting profits (Financial statements includes cost of debt finance but ignore cost of equity finance).

Investors want to see the company’s performance in relation to its competitor’s.


HOW IS IT USED?

Adjusting operating profits by adding back all the accounting distortions which are subjective in nature and reflected in Statement of Comprehensive Income under IFRS principles.

By redefining the meaning of several ordinary expenditures to valuable expenditures (E.g. R&D costs, M & A Costs, Depreciation, Provisions, operating lease etc.), as they create value addition to the Co’s operations.

By taking into cost of equity and cost of debt financing i.e. Company’s Weighted Average Cost of Capital (WACC).


FORMULA

EVA=NOPAT – Capital Charge

Where,

NOPAT=Net Operating Profit after Tax (Adjusted)

Capital Charge= (WACC x Capital Employed)


Eva (accounting adjustments)EXPENDITURE COMMENTS

Value-Building Expenditures Expenditure on marketing and promotions, research and development, and staff training which will generate value for the business in future periods should be capitalized. If any such expenditure has been charged as an expense in the income statement, it should be added back to profit, and also added to capital employed in the year in which the expenses were incurred.

Depreciation The charge for depreciation in the income statement should be added back to profit, and a charge for economic depreciation (natural fall in value) made instead. The value of non-current assets (and therefore capital employed) should also be adjusted to reflect the revised charge. Economic depreciation reflects the true change in value of assets during the period.

Provisions Provisions, allowances for doubtful debts, inventory write-downs, and deferred tax provisions are deemed to represent over-prudence on the part of financial accountant, and lead to the true value of capital employed being understated. Therefore they should all be added back to capital employed. Any movements in provisions recognized as income or expenses in the income statement also need to be removed from NOPAT.

Non Cash Expenses All non-cash items (e.g goodwill) are treated with suspicion, on the basis that if the costs were ‘real’, cash would have been paid for them. Any non-cash expenses should be added back to profits, and to capital employed.

Operating Leases Operating leases should be capitalized and added to capital employed. Otherwise, the inconsistency in treatment between operating and finance leases means that firms can take advantage of operating leases to reduce the capital employed figure, and in doing so increase EVA. In effect, EVA treats all leases as finance leases. Any operating lease charges in the income statement should be added back and removed from NOPAT. In principle, depreciation should then be charged on the assets acquired under finance leases. However, remember that accounting depreciation is replaced with economic deprecation when calculating EVA.

ECONOMIC VALUE ADDED NOPAT

$ $ Profit after tax XXX Add Back: (a)

Value Building Expenditures XX Depreciation Non-Cash items (Goodwill amortization etc.) XX Provision XX Operating Lease XX

Less: (b) Economic Depreciation (Natural Fall in Value) (XX) Decrease in Provisions (XX)

Net Operating Profit After Tax (a-b) XXX

ECONOMIC VALUE ADDED CAPITAL EMPLOYED

$ $ Total Assets in SOFP(@ Replacement Cost/NBV) XXX Add Back: (a)

Cumulative amortized goodwill XX Operating Leases XX Research & Development Cost XX Marketing & Advertisement Cost XX Staff Training Cost XX Provisions XX

Less: (b) Non-interest bearing liabilities

(XX)

Economic Value of Capital Employed (a-b) XXX

Click here for EVA MODEL

ECONOMIC VALUE ADDED WEIGHTED AVERAGE COST OF CAPITAL

WACC= (M.Ve/M.Ve+M.Vd) x Ke + (M.Vd/M.Ve+M.Vd) x Kd(1-t)

Where,

M.Ve=Market Value of EquityM.Vd= Market Value of DebtKe= Cost of EquityKd(1-t)= Tax Adjusted Cost of Debt

ECONOMIC VALUE ADDED MEASURING PERFORMANCE OF CO.

EVA= Adjusted NOPAT – (WACC X Capital Employed)

Positive EVA suggests that the Co. has earned over and above the capital invested in a given period, hence there is an increase in shareholder’s wealth.

Negative EVA suggests that the Co. has not performed well and hence shareholder’s wealth has decreased.

ECONOMIC VALUE ADDED ADVANTAGES:

An absolute measure with which real wealth of Shareholders is known in monetary terms.

Closer to cash flows since all the accounting distortions are adjusted.

Realization of Co’s value added activities such as capitalization of marketing & advertisement costs thus encouraging decision makers to spend more on these costs since they add value to the co.

Can be used for benchmarking purposes (Saudia Cargo Vs. Dnata etc.).

MARKET VALUE ADDED

Sum of all EVAs since inception.

or

Market Value of Equity-Book Value of Equity

USES:

To check whether shareholder’s wealth have increased or decreased.

Can be used to assess company’s performance in the industry.

Other performance Measures

RETURN ON CAPITAL EMPLOYED

Return on Capital Employed (ROCE) (%) = (PBIT/Average Capital Employed) X 100

USES: Measures profit earned in relation to capital injected by shareholders.

Used for benchmarking with competitors.

Evaluates whether Co. is making profitable use of its current investment.

Evaluates performance of co. in relation to last year. (Current year Vs Previous year).


RETURN ON INVESTMENT

Return on Investment (ROI) (%) = (PBIT/Capital Employed) X 100

USES:

Measures return on investments employed by shareholders.

Evaluates performance of co. in relation to last year. (Current year Vs Previous year).

Used for benchmarking with competitors.

Can be compared with return required by shareholders.


EARNINGS BEFORE INTEREST, TAX AND DEPRICIATION ALLOWANCE

EBITDA= Annual Profit After Tax + Interest Charge + Tax+ Depreciation allowance.

USES:

Similar to operating cash flows and can be used to assess the proportion of operating profits converted to cash flow.

Can be used to assess company’s profits without major distortions as it eliminates the effects of accounting and financing decisions.

Facilitates comparison with similar sized companies for benchmarking purposes.


THANK YOU

eva & other performance measures

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