Economic Value Added
We have been evaluating the manner in which the organization is currently operating. It has been brought to my attention that we are not currently utilizing the economic value added (EVA) process. This memo will discuss the EVA process and we will touch a bit on the MVA process (Market Value Added). EVA is an estimate of the wealth increment to owners from the current years’ operations; measured as adjusted accounting income minus estimated cost of capital for the investment (Atkinson, 2012, p. 472). The EVA process was developed by Stern Stewart as a way to measure a company’s true economic standing. EVA is used by all sorts of enterprises, from non-profit organizations to major corporations and governmental departments. It is, therefore, a measure of economic profit as it shows the excess profit over the amount of earnings required by the enterprise to maintain its capital (Hann, 2011).
EVA is calculated through mathematical equations. The equations are:
- EVA = (r-c) x Capital
- EVA = (r x Capital) – (c x Capital)
- EVA = (NOPAT – c) x Capital
- EVA = operating profits – a capital charge
Where: r = rate of return, and c = cost of capital. Capital is interest bearing debt (cash invested). NOPAT is net operating profit after taxes. The cost of capital is the minimum rate of return on capital required to compensate debt and equity investors for bearing risk (De Freitas, 2002).
Utilizing this system is a costly and timely process. However, it is well worth the finances. Utilizing the EVA process creates a single statement / report for managers to easily review all of the costs for being in business. This also helps in holding managers accountable for every penny they spend in daily operations. These statements / reports are prepared in a common language and can be beneficial to making budgets, fixing budgeting issues and even employee evaluations. Companies can raise EVA by utilizing all of its potential when it comes to establishing organizational goals.
EVA is a beneficial tool in organizations, but it can not be used to replace other financial ratio analyses. The tool is used to enhance the current financial ratio analysis to assist in decision making when it comes to the enterprises capital. EVA is not affected by balance sheets in the financial end of the accounting department. EVA is a useful measurement for determining management performance. When looking at the organization, EVA is not necessarily enough. The EVA process does not account for investment decisions such as employee training programs. To adjust for this issue we should also consider adding in market value added (MVA). MVA measures what the organization is worth to outside investors.
The mathematical equation for MVA is:
- MVA = [(Shares outstanding x Stock price) + Market value of preferred stock + Market value of debt] – Total Capital
When calculating EVA and MVA the amount of the equity equivalent reserves for certain accounts must be determined (De Freitas, 2002).
One of the key elements to a manager position is to make decisions that are best financially suited for an organization. This means increasing capital. Utilizing these tools: EVA and MVA give managers the information necessary to run a business in an organized fashion that produces an earning rate of return that exceeds other returns. For EVA and MVA to be utilized completely and benefit the organization, all employees at all levels must buy into the plans.
As for why we have not been utilizing these process’… This I do not have a clear answer. However, in evaluating the way we currently operate, these tools can be very beneficial as discussed in this memo. We would not be replacing any of our current financial ratio analysis; we will simply be incorporating another process in which to function in a more organized manner. With EVA in place we can measure earnings per share and have a clearer understanding of the larger picture of how profitable the organization is.