EVA is still based on an accounting based concept, hence it still suffers the following:

• like other accounting rate of returns for example like the ROI. Using the normal accounting convention of the historical costs concept, asset values are quoted on historical costs unaffected by inflation, the true rate of return is not able to be properly ascertained,

• EVA is distorted by the fact of the upfront normal depreciation being small at the beginning of a project and big at the end of the project. Therefore companies with a lot of new investments have lower EVA than their true profitability would imply and companies with a lot of old investments have bigger EVA than their true profitability would imply. The extent of this challenge depends on the asset structure (the relative proportions of current assets, depreciable assets, un-depreciable assets) and on the length of the investment period. This pattern is similar to the ROI where when we examine a single project the ROI is a poor estimator or the true rate of return, since at the beginning of the project when the capital base is big, the ROI is small and then at the end when the capital base is small then the ROI is big.

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• In my earlier article, we have compared EVA with earnings per share and return on investment/assets and found that both the traditional ratios do not reflect the true cost of capital- there is no hinge whether shareholders value have been created or destroyed,

• EVA is extremely easy to compute- just extract the data from both the income statement and the balance sheet and put in some adjustments to derive the EVA,

• EVA is easy to understand like the net present value (NPV) concept wherein EVA( particularly future EVA) if positive, increases shareholders’ wealth and a negative EVA is vice versa,

• EVA is easy for layman besides accountants to understand its concept as it is logical and comply with the economic terms of “economic profit” ,

• EVA is part of Return on Investment re deploys assets turnovers and utilization which ordinary managers can easily relate to,

• EVA is also really the discounted free cash flows of a business,

• EVA is an all round performance metric which measures the operating profit, business investment and the cost of capital as a financing cost .

• As EVA is a performance metric principally for gauging the creation or not of the shareholder value, it therefore should complements very greatly the Value-based management (VBM) methodology.

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This article looks at the Economic value added formula and computation and how to further improve the performance of same.

To  improve EVA, let’s re-look at its formula:

EVA=Net Operating profits after tax – (Capital Employed x Cost of capital)

Hence, we can improve EVA by reviewing the components or drivers of EVA:

NOPAT IMPROVEMENT:

• NOPAT is involves with revenue and profit growth. So to improve EVA we need to try to improve the returns with no or with only minimal capital investments.
  We should try to improve the business gross margin and looks at areas for effective cost spending or reduce costs where wastage might exist.

• Also don’t forget that the effective tax rate (ETR%) is also very important as the higher the overall ETR compare to the normal corporate tax rate , the more cash flow would have being drained off from the business.

Some areas to look at :- various tax incentives offer like re-location, export incentives, industrial building allowances, free trade zone to reduce the overall business effective tax rate.

CAPITAL EFFICIENCY IMPROVEMENT:

• Capital employed is essentially the total assets minus any non-interest bearing liabilites

In Economic value added calculation, we notice that the higher the capital employed, the higher will be the capital charge which relates to the inefficiency of the capital employed. Hence, we need to re-look into areas pertaining to the returns versus quantum of capital investments and the utilization or turnover of the assets (capital).
Like the way to improve return on assets ratio, we should turn to improving higher assets turnover whether in terms of stocks, debtors and also by making fixed assets more productive will enhance EVA. This is again assuming that there is no or with only minimal capital investments.

To improve capital efficiency hence improving EVA, we should attempt to:

• Invest new capital only in projects, equipment, machines able to cover capital cost while avoiding investments with low returns
• Identify where capital employment can be reduced
• Identify where the returns are below the capital cost;
• Divest those investments when improvements in returns are not feasible

COST OF CAPITAL

The next driver in EVA calculation is the Cost of Capital. Cost of capital is a barometer to measure the financing efficiency. Normally, most companies would have certain level of gearing. Hence, by optimizing gearing with the right instruments, rates and quantum should to a certain extent lower the weighted average of cost of capital.

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However, Economic value-added (EVA) as a financial performance indicator is showing encouraging support amongst many top-notched organization. Using the EVA analysis, management particularly the Board of Director are able to know whether shareholders value has been increased or decreased. ONLY with the increase in shareholders value, wealth has been created for the shareholders/investors.
Incidentally, EVA as a performance metric for creating shareholders wealth is closely tied in with the Value-based management (VBM) as they share the same principle of realigning business practices towards increasing shareholders wealth.

In simple term, the economic value added definition is:

=after-tax operating profit remaining after deducting a charge for the capital employed in the business:

EVA=Net operating profit after tax(NOPAT)-(Capital employed x Cost of capital) 

[ NOPAT is a measure of the operating profit of an organization whilst capital employed is a measure of its business investment and cost of capital is the financing cost similar but not identical to borrowing costs.]
As this represents real profit, positive EVA enhances shareholder value whilst negative EVA reduces shareholder value.

Economic value added (eva) is a better performance metric as it can overcomes the following limitations presently affecting the traditional earnings per share and return on assets:-

• Earnings per share tell us nothing about the cost of generating those profits. If the cost of capital (loans, bonds, equity) is, say, 17 percent, then a 16 percent earning is actually a reduction, not a gain, in economic value. These profits also increase taxes, thereby reducing cash flow, which drain economic value of the company.

• Return on assets is a more realistic measure of economic performance as it attempts to relate how much profit a business generates relative to its asset lives, but again this metric ignores the cost of capital. A company might have a high profitable year with high return on assets but it might not be a surprise if its cost of capital can be higher than its ROA %.

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