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The purpose of all businesses must be to build value for its shareholders.
This is the premise of EVA, or Economic Value Added, one of the
trendiest yardsticks in recent years in the measurement of a business'
value creation.
Proponents of EVA quote many success stories of companies that
have successfully implemented EVA financial management system and
transformed the organisations to focus on creating shareholder value.
These include Coca-Cola, AT&T and locally, the Singapore Technologies
Group.
So what exactly is EVA? Is it suitable for growing businesses,
especially the SMEs, and if so, how can they embrace EVA?
EVA made easy
EVA is the after-tax cashflow generated by a business minus the
cost of the capital used to generate that cashflow. Proponents of
EVA said that there is growing evidence that it is EVA, not earnings
and return on equity ("ROE"), that determines the value of a firm.
EVA represents real profit versus paper profit from traditional
financial statements. To understand EVA and the difference between
EVA and accounting profits, let's take a look at the financial statements
of ABC Company Pte Ltd.
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|
|
Income Statement (In S$)
|
| Sales |
100,000 |
| Operating Expense |
(90,000) |
| Net operating
profits |
10,000 |
| Interest |
(3,000) |
| Depreciation |
(2,000) |
| Profit before
tax |
5,000 |
| Tax (at 26%) |
(1,300) |
| Profit after
tax |
3,700 |
|
|
Balance Sheet (In S$)
|
| Fixed Assets |
25,000 |
| Current Assets |
25,000 |
| Total Assets
|
50,000 |
| Share Capital
|
15,000 |
| Reserves |
15,000 |
| Shareholders
Fund |
30,000 |
| Debts |
20,000 |
| Total Capital |
50,000 |
|
Based on the above financial statements, ABC has an EPS of 12 cents,
ROE of 12% and ROA of 7%. If we use EVA and assuming that the cost
of capital (equity and debts) of ABC Pte Ltd is 15%, ABC will show
a negative EVA of $100 as follows:
| Net Operating Profits
|
$10,000 |
| Tax at 26% |
$(2,600) |
| Net Operating
Profits After Tax (NOPAT) |
$7,400 |
| Less Cost of Capital
(15% of $50,000) |
$(7,500) |
| EVA |
$(100) |
A negative EVA means that ABC has not generated sufficient net
operating profits after tax ('NOPAT') to cover the cost of shareholders'
funds. In conventional financial statements, no cost is imputed
on the use of shareholders' monies. Another major difference between
accounting profits and EVA is the elimination of accounting distortions
and accounting estimates such as depreciation, goodwill and provisions
in the calculation of NOPAT. In that sense, EVA profits represent
the real profits of the business.
For most, if not all SMEs, the management and the shareholders
are the same, which means that the interest of shareholders and
managers is the same as far as the building of value is concerned.
As a business and financial concept, EVA is very powerful. It helps
the business owner focus on how to use less capital to make more
profits. This is particularly important to growing businesses. A
growing business that embraces EVA in its decision making will allocate
its scarce capital resources to those business activities that generate
the highest EVA.
Practical difficulties
In practice, implementing EVA in the accounting framework of many
growing businesses can be a challenge and an uphill task. Many growing
businesses already face difficulties in generating timely financial
statements and interpreting them, let alone try to eliminate accounting
distortions and determine the cost of capital. On the other hand,
start-up and dot.com companies usually have to fight for survival
and raise additional funds to support their operations and growth
plans. It is difficult for them to focus on shareholder value creation
in the near term; and their shareholders have to sacrifice EVA returns
in the near term for future growth prospects.
EVA and growing businesses
These practical difficulties should not however, preclude growing
businesses from thinking EVA. It is important to distinguish between
embracing the concept of EVA into business and implementing the
EVA financial management system. Embracing EVA into business involves
a change in the business mindset, and requires businesses to exercise
discipline to deploy resources to those activities that produce
the highest margins. However, if implementing the EVA financial
management system does not involve a change in mindset to focus
on creating shareholder wealth, the system is only a useless tool.
The fundamentals
In conclusion, whether you decide to implement EVA as a performance
measurement is irrelevant. Growing businesses should focus on the
fundamentals of improving NOPAT and lower its cost of capital. If
you are doing any of the following, you are already embracing EVA
and practising it:-
| • |
Manage and shorten your working capital
cycle by reducing stockholdings and improving collections. This
will reduce borrowings and borrowing costs. |
| • |
Re-engineer your business model and processes
to focus on high-margin activities. Many businesses tend to
get distracted and focus on generating top line revenue at very
thin or worse, zero operating margins. Such a move can overwork
your resources, create morale problems and result in a liquidity
crisis. |
| • |
Manage your cost structure judiciously to
stay competitive. Managing a cost structure is different from
a cost cutting and containment exercise. Blindly cutting costs
can hinder the operational efficiency of a business. Any short-term
financial gains from cost-cutting can reduce or worse, destroy
the business' long term structural and operational capacity
and capability. |
| • |
Tap on cheaper sources of financing through
various financing and investment schemes provided by the government
and venture capital companies for asset financing, working capital
financing, product development and innovation financing, as
well as seed capital financing. You may approach the EDB, PSB
or call us at Stone Forest Consulting for assistance. |
EVA can be a hype or a powerful concept that gives growing businesses
the competitive edge. Used in the right context, it can guide growing
businesses in every decision from the boardroom to the shop floor.
It can be used as a performance measure and reward managers for
increasing EVA. It makes everyone in the organization focus on producing
greater wealth for shareholders, customers and themselves.
Year published : 2000
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