Earnings per share, Returns on Assets are normally used as the key performance metric/indicators for measuring the financial performance of an organization.
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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