Monika Jančovičová, Kristína Kováčiková
3 ECONOMIC VALUE ADDED (EVA) AS A FINANCIAL INDICATOR
In 1991, the New York consulting firm Stern Stewart & Co developed a fully integrated framework for financial management and incentive pay. The heart of this framework is economic value added "EVA®".
It is a registered trademark of Stern Stewart company, but in our thesis EVA® is displayed without the ® symbol, but it continues to be seen as a registered trademark of Stern Stewart & Co (Maříková, Mařík, 2005).
EVA is a measure of value creation for shareholders. Performance of value for shareholders of a company is a decisive factor in determining whether an enterprise can succeed or not. It is also an excellent metric for tracking profitability and using of the company‘s capital. As a result, the indicator EVA was soon accepted as one of the most useful analytical tools for assessing company’s financial performance. EVA has been widely adopted by the management to decide on increasing the productivity, where to invest new capital and which non-performing assets to liquidate (Stewart, 2013).
According to the Eva indicator the main objective of the company is to maximize economic profit, not the accounting one. The principle of the economic value added is based on economic profit, which is the difference between revenues and costs, and the costs are considered ordinary expenses and cost of capital.
The cost of capital includes not only the cost of debt but also the cost of equity.
Economic value added means the value added by economic activities of enterprises above the cost of capital, which is bound in their assets. Economists and the EVA method therefore recognize the achievement of real profit to the level when it reaches the minimum required rate of return for all investors, therefore, creditors and equity holders.
EVA talks about how much the company has produced above the minimum requirements of the owners.
Therefore, it helps to determine whether the enterprise earns income only for the survival or even increases its value.
The concept of economic value added is then used because of the value generated beyond these demands;
a company can invest in its further development and thus in increasing its value (Zikmund, 2011).
3.1 Calculation of the EVA indicator
EVA measures the economic profit, which is formed by the difference between the return on capital and economic costs, which include not only the accounting costs but also the opportunity costs. This difference and thus economic profit can be expressed as follows:
EVA = NOPAT – WACC x Capital where
NOPAT = Net operating profit after taxes
WACC = Weighted average cost of capital (cost of equity and cost of debt), C = invested capital
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At first sight it is a simple-looking indicator, but problems arise at a closer look at the individual components of the formula. For correct construction of this indicator, it is necessary to correct identify these components.
3.2 Quantification of the NOPAT
Net operating profit (NOPAT) is an operating profit after tax, which company generates from main business activities. In determining the NOPAT, this should be considered:
what profit will be considered as the initial one, while the most appropriate one in our circumstances is considered the economic profit or loss and the ordinary profit or loss. In order to use the economic profit or loss and the ordinary profit or loss in quantifying the value of EVA, it is necessary to take into account only the items that have operating characteristics, which often depends on the subjective opinion of the analyst (expert),
what tax rate to use – it is recommended to use the effective tax rate, which represents the share of income tax on gross profit.
3.3 Quantification of the average cost of capital
Determining the amount of the average cost of capital is quite difficult. This is mainly because the average cost of capital includes not only the cost of debt, but also the cost of equity. In Slovakia, the calculation of the average cost of capital (WACC) is used in the following structure (Decree no. 492/2004):
WACC=(1-DS) . NPK . PK
CK + NVK . VK CK TC = D+ E
where
DS = income tax rate, which is established under the law on income tax for valuation of companies. The income tax rate is appointed in decimal form in the calculation,
Npk = costs associated with the use of debt capital as a percentage, that is, interest and other expenses paid by the lender. The costs are appointed in decimal form in the calculation,
D = the amount of debt capital in euros. It consists of the components of foreign liabilities, which are for the purpose of calculating the interest rate, long-term bank loans, conventional bank loans, borrowings, issued bonds, notes, leases, rents payable and other liabilities,
Nvk = cost of equity as a percentage, that is expected and acquired profit share by owner for capital contribution to enterprise. The cost of equity is appointed in decimal form in the calculation.
E = equity volume in euros.
TC= total capital (the sum total of equity and debt capital).
When quantifying the cost of debt capital, the procedure is simple, as it is based on loan agreements and it is a weighted arithmetic mean of the interest expense calculated from all loans provided to company.
In calculating the EVA indicator, the problematic variable is the cost of equity capital. This is defined in decree as expected and acquired profit share by owner. In practice, it is not easy to determine the cost of equity capital. Literature provides us with several guides, how to quantify the cost of equity capital, but to
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choose the right one depends on the particular enterprise, environment in which it is situated and general situation. The most used methods include modular models, the capital asset pricing model (CAPM), dividend discount model and the like (JAKUBEC, KARDOŠ, KUBICA, 2011).
3.4 Quantification of net operating assets
Net operating assets are the assets which companies need for their main economic activities. The starting point for the calculation of net operating assets is the balance sheet, of which:
must be excluding non-operating assets,
must be activating the items not reported in the balance sheet, at market prices, must be reducing the assets by non-interest bearing debt capital.
Most modern methods of evaluating business performance, including the method of economic value added tries to bring the entries in the books of their real value. The starting point for the calculation of economic value added as the accounting model based on data and values from the balance sheet and profit and loss account. Traditional accounts are unsuitable, because accounting is focused primarily on the needs of creditors.
The economic value added has been developed in terms of the US and therefore adjustments based on generally accepted accounting principles in the US (US GAAP). To be useful, it is necessary to know the basic differences between them and the Slovak accounting regulations.
Stern Stewart & Co. is using a list of modifications which includes more than 160 items. A complete list of modifications, however, is a trade secret of the company. Treatment generally can be summarized into four types of conversions:
operational conversion - operating profit and capital must be free of costs and benefits, which do not serve to achieve and maintain revenues from core business
conversion of financial resources - defining sources of financing used to invest
tax conversion - based on the fact that foreign funding has to be taken into account only the cost of capital shareholder conversion - in the calculation of net operational assets is calculated with the assets which are not included in the balance sheet (MAŘÍKOVÁ, MAŘÍK, 2005).
Required values indicator EVA in practice:
EVA > 0 Firstly, it is important that the values of the indicator moved in the positive. If the EVA is greater than zero means that the company creates value, which is reflected in the growth of Shareholder Value. Net operating profit after tax cost of capital thus not only covers, but even exceeds them. The pattern is as follows:
𝑁𝑂𝑃𝐴𝑇
𝑁𝑂𝐴 > 𝑊𝐴𝐶𝐶
EVA = 0 In this case, the net operating profit after tax covers full capital requirements in the form of cost.
EVA < 0 The cost of capital exceeds the profit from operational activities, the costs are not fully covered by earnings. It destroying enterprise value monster.
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Despite extensive elaboration of issues at a theoretical level, many businesses still does not have the information whether constitutes value and what their actual cost of capital is. Through calculating EVA can be not only the management company, but also its owners, work towards finding whether the invested capital acceptable rate of return, or can stakeholders learn to what extent the company value form or vice versa, it destroys. Economic value added is used in a number of areas where its calculation requires a number of adjustments to obtain relevant input data. After reaching concrete results from the calculation of quantities EVA, it comes the important part management - managing the value of this indicator. If you are in business actions within the application of value-oriented management done correctly, the company can deliver a substantial improvement in its performance and a long successful existence in a competitive environment.
4 CONCLUSION
Performance and competitiveness are nowadays the most important words among companies. They are indispensable for the survival of the company, if the company is not competitive in the market, it will not generate sufficient performance to satisfy its shareholders. The companies measured their performance using traditional performance measures for years. In 1982, a new concept of economic value added was introduced, which offered a new way to create value for shareholders. It gives shareholders a better way to measure the real economic performance of the company and to bring a closer alignment of management and shareholder objectives. It is mainly used as an alternative way in comparison with the traditional methods of financial analysis. Its quality implies the possibility to remove deficiencies in methods, which have been used so far for these purposes.
Acknowledgement
This contribution is the result of the project VEGA (1/0857/16) Zvyšovanie konkurencieschopnosti malých a stredných podnikov prostredníctvom zavádzania inovácií v globálnom hospodárskom prostredí, in extent 50% and the project VEGA (1/0404/16) Finančné výzvy po poslednej finančnej kríze a možnosti rozvoja slovenského kapitálového trhu.
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Contact information Ing. Monika Jančovičová
Ekonomická univerzita v Bratislave Fakulta podnikového manažmentu Katedra podnikovohospodárska Dolnozemská cesta 1
852 35 Bratislava
Phone: +421 902 535 750
e-mail: jancovicova.monikaa@gmail.com Ing. Kristína Kováčiková
Ekonomická univerzita v Bratislave Fakulta podnikového manažmentu Katedra manažmentu
Dolnozemská cesta 1 852 35 Bratislava
Phone: +421 904 382 998
e-mail: kristinakovacikova.kk@gmail.com
DOI ID: https://www.doi.org/10.7441/dokbat.2017.18