Memo to CEO on Eva Concept - Coursework Example

What is EVA? The method for determining a company’s true financial performance pioneered by Stern Stewart & Co. adjusts financial reporting to include the cost of capital expenses. Stern Stewart & Co.’s economic value added metric deducts the cost of capital from the net profit after taxes. A company operating successfully, with no accumulation of excess capital or assets may not be performing as well as ratio analysis projects. EVA takes into account the cost of raising capital, as well as normal operating expenses, showing both the current financial health of the company and the economic impact on wealth generation for stockholders and other investors.

EVA shows the total net worth of the company after subtracting operating expenses and expenses like dividends to shareholders and lien holders. The resulting numbers provide a solid depiction of the company’s current financial health, though not with the detail offered by ratio analysis. How to Calculate EVA Determining EVA is much less involved than other financial performance tracking methods. The formula for producing a final numerical value is EVA = NOPAT - c * capital. NOPAT stands for net operating profits after taxes, and the “c” refers to the weighted average cost of capital.

Using this simple formula, companies can get a quick glimpse at their total performance. Adding an EVA calculation to an existing financial report is quick, given the financial tracking already in place. Existing documents, tax return, profit and loss statements, ledgers and so on, provide all the needed information to generate a concrete number using the EVA formula. One of the benefits of incorporating EVA in financial reporting is the ability to gain a clear understanding of performance, divorced from any questionable accounting adjustments.

Large companies like Enron managed to show positive numbers on financial ratio analysis, even when barely solvent. Including EVA removes that element of risk when generating financial reports. Another benefit to including EVA calculations is the ability to tailor compensation more closely to results. When used to show economic profit after a management change, taking into account the economic profit at the time of the switch, the change in final EVA from then and now show the amount of company profits attributable to the specific management employee or team.

Of course, many other factors may influence the final profit outcome, but EVA gives upper management a way to quickly respond to clear improvements implemented on a department level. Showing the Company in the Best Light with EVA Although EVA does not allow for some of the accounting adjustments which make ratio analysis unreliable when used by unethical financial officers, there are still ways to improve the final number. Ultimately, when improving the EVA, a company must either increase total profits or lower total expenses.

Restructuring debt can make a big impact on total economic profit. For example, if a company earns $7.8M net after taxes, with a weighted average cost of capital at 6.3% and a total invested capital of $26.3M. The formula would then read 7.8 - .0063 * 26.3 = $7.6, showing a company with very strong economic profit. Of course, the total for invested capital would typically be expected to be much higher. Included in that