The Role of EVA in Financial Statement Reporting
Economic Value Added (EVA) is an imperative tool used to examine financial statements within its many uses from a commercial standpoint. It is the most successful performance tool used by many companies and their consultants in order to improve the company’s financial status.
The metric consists of various financial theories and valuation principals which are important to a company’s analysis but factors like marketing and deployment laid by Stern Stewart have made the theory more popular.
Corporate consultants claim that this tool is useful for financial management, to focus on how much capital is employed and how much revenue has been generated from it. However, as the theory has gained so much popularity, few problems have also been found.
Why use EVA?
EVA measures money in the dollars a business earns after deducting the capital employed. EVA financial statements can improve results, reporting and success because focusing on growth with EVA comes with many benefits.
A firm can manage its assets by simply using EVA which holds the organization for each and every dime they spend, whether it appears on the income statement and balance sheet or not. EVA creates its own financial statement stating all the costs clearly making the senior management aware of each and every dollar they spend. This means the focus is totally on the key responsibility which is increasing shareholders’ wealth and instead of finding ways to increase EVA, firms’ total attention diverts towards increasing extra shareholder value.
EVA also helps improve the company’s financial statement creating an opportunity for senior management to make long-term decisions.
Why shareholders use EVA
Economic Value Added (EVA) is the ideal financial performance measure that realistically captures the true economic profit of a business organization. In this respect, EVA holds an important part in modern economics and finance and receives wide acceptance among practitioners. In fact, EVA is the performance measure that is most directly linked to value addition of shareholders wealth over a particular period of time.
It is important to note that shareholders tend to be very choosy when it comes to their interests in business organizations; thus, they always expect management to develop strategies to enhance growth of their shareholding value. In this perspective, EVA gives credence on how much economic value a business adds to the investments of its shareholders.
EVA vs Traditional Accounting
Compared to other traditional performance measures, EVA is exceptional in the sense that unlike these conventional measures, EVA does not depend on information generated from the accounting department.
It is important to note that accounting, more often than not, generates historical information that tends to be distorted. In this respect, information gathered from accounting cannot be relied to give a true reflection of the true value or status of a business/company. EVA, however, adjusts data generated from the accounting department in order to make it more economically viable. Under the traditional accounting framework, most businesses might appear profitable even when they are running losses.
As Peter Drucker noted in an article in the Harvard Business Review, a business operates at a loss until it reports profit figures that exceed the total cost of capital. It is important to note that a business can pay tax in order to fool its shareholders that it is making profits; in essence, this is falsification of performance data, which, unfortunately, is not a rare practice in the corporate world.
One of the advantages of EVA is that it is able to correct this error by explicitly acknowledging the fact that any employment of capital must be paid for. Most importantly, EVA adjusts all distortions that might happen in the conventional accounting department to produce falsified performance statistics.
One of the factors that make EVA a superior measure of value creation is the fact that it recognizes the cost of capital employment and, therefore, riskiness of any business enterprise. Thus, EVA is one of the performance measurement tools with high demand from shareholders and business owners. Notably, just like conventional performance measures, EVA is based on items such as equity capital, interest bearing debt, and net operating profit. However, the point of departure between EVA and conventional performance measures is that EVA incorporates the cost of equity.
Indeed, due to its superiority in capturing true performance of an enterprise, EVA comes with added advantages for shareholders.
- Firstly, EVA ensures optimum capital structure by making an enterprise properly levered.
- Secondly, EVA can be used in controlling operations at group-level.
- Thirdly, EVA can also be used to harmonize the interests of both shareholders and ordinary employees of an organization.
- Fourthly, bonus schemes that are based on EVA tend to produce positive results within an organization. In most companies, bonus schemes tend to motivate managers to exceed performance expectations. Even after bonus pay out, return for shareholders remains high for organizations employing EVA-based bonus schemes.
Problems with EVA
The problem with EVA is that it does not ignore the market perception of the value of growth opportunities; in addition, EVA also does not provide a realistic explanation on real growth opportunities which may be important to an investor before taking an investment decision.
EVA works better for companies which deal with a large assets line and minimum growth opportunities. The larger the asset base of a company, the more chances there are to generate large EVA. Small division companies are considered to be highly competent but with fewer assets are unlikely to rank at the top in the EVA stakes.
Transiting value added measurement and value creation requires dedication and serious commitments. Creating economic value requires extensive training and education to all those involved in the corporation and executing these corporate strategies can be costly and very time consuming.
EVA is based on a financial theory and is not different from a measure like free cash flow. It consists of a few basic pillars which one should follow:
- The company cannot create a value until it generates enough level of return for shareholders.
- Accruals are less reliable than cash flows.
EVA works better with companies whose tangible assets are directly proportional with market value of assets. If there is one single performance number, EVA will give nearly an accurate result as it will contain all the information, but researchers have argued that relying on only one metric can be very risky.
There are also concerns that EVA is a short-term measure of an organization’s performance. Additionally, it is impossible to measure the true EVA of long-term investments objectively because future returns of a business can only be subjectively estimated and not objectively measured.
Moreover, EVA compiled periodically fails to give true estimation of the value added to shareholders’ investments due to inflation among other factors. Furthermore, organizations tend to use conventional financial ratios to predict distress in performance; absence of incremental value in EVA limits its ability to predict performance distress.
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