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The aim of an organization is to create wealth for its shareholders, "shareholders value is the key driver of corporate performance in both public and private companies (Michael D. Shapiro august 2007)
Corporate performance is the overall indicator of showing the level of increase or decrease in shareholders or lenders investment.
"It's simply put as the as the industry of raising debt and equity for an organization (Webster's new world investment dictionary)
How can we then establish the practices of Economic Value Added Stern Stewart& Company, a global consulting firm helps client company's measure and create shareholders wealth through the application of modern financial theory. He argues that Economic Added Value (EVA) is the one true path to corporation greatness as measured by shareholders value. (Michael D Shapiro august 2007).
Al Ehrbar states "the real magic in EVA comes from changing behaviour throughout an organization, and that depends crucially on using it as the basis for incentive compensation"
WHAT IS (EVA) AS A MEANS OF ETABLISHING CORPORATE FINANCE?
Stern Stewart Economic Value Added is financial methods used to calculate the true economic profit of an organization this can be calculate as the net operating after taxes profit minus the charge for the profits opportunity cost of the capital invested.
EVA is also an estimate of the amount by which earnings exceed or fall short of the required minimum rate of return for shareholders or lenders at comparable risk.
Adian Berry( 1995 financial accounting an introductory pg 54)the Economic Value of an item is the value of the expected earnings from using the item, discounted at an appropriate rate to give a present day value.
This definition brings us to the various arguments of the use of EVA on the true value of a company's wealth creation and profits.
Ehrbar has argued that "the true value of a company begins with the realization that the firms operating income after tax needs to be offset by the cost of capital used to create that income in order to arrive at the operating Economic Added Value (EVA
) to the owners" (Michael D Shapiro, august 2007 economic value added can it apply to a S corporation medical practise?)
Stern Stewart maintains that the implementation of complete EVA based financial management and incentive compensation system gives managers both better information and superior motivation to make decisions that create the greatest shareholders wealth in any publicly owned or private organization.
Connecting performance to profit according to Stewart Stern is a short-term approach, because EVA puts into consideration long and short term adjustment to increase profit for an organization not just in the short term but also the long run. E.g. a firm investing in research and development or restructuring of a part the organization, these are not to be seen as expenses but assets as they are investments made to increase overall profit. EVA directly addresses this shorter decisions, it's linked to long-term results of wealth maximisation.
Studies have shown that companies that adopt EVA as a performance measure outperformed their peers by 8.5% annually, and for those companies operating a declining market this jumps to over 12% per annum. (Student accountant ACCA P4&P5 October 2007)
The Stewart company has maintained that the aim or goal of Economic Value Added (EVA)is to evaluate a firms market value directly in way similar to residual income the is a financial performance measure integrating and economic concepts(Ohslon 1995).
According to AL Ehrbar "of all the variables within the control of top management and the board of directors, the one with the greatest impact on the success or failure of any organization is the system of rewards and incentives that shapes and directs the behaviour of employees... when EVA becomes the singular focus for all decision , it establishes clear and accountable links between strategic thinking ,capital investment ,daily operating decisions and shareholders' value"(Ehrbar.A...the real key to creating wealth).
We can say hence that EVA is an integral part of the growth and the creation of wealth for an organisation, Stern et al (ed2001) suggested that "when fully implemented EVA will be the "centrepiece of an integrated financial management system that incorporates financial decision making"
There are various arguments on the advantages of Economic Added Value based approach to performance measurement.
1) Profit are shown the way shareholders count them
2) Shareholders wealth is in agreement with the decisions taken by the organization.
3) Creation of a universal language
4) Simplicity of the concept for managers.
Profit the way shareholders count them (student accountant October 2007 ACCA P4&P5): this will be easy if we actually know what shareholders will require as their profit is just a % of returns on their money invested after taxes. Peter Drucker has suggested in Harvard business review articles that "until a business returns profit that is greater than its cost of capital it operates at a loss "Ducker observes that such organizations return less to the economy than they consume in resources and that instead o creating wealth they are destroying wealth."
Economic added value argues that when capital is employed by an organization it should be recognised and paid for. All cost should be taken into consideration including equity. Economic Value Added shows the amount of wealth an organization has created or destroyed in each reporting period" (ACCA student accountant October 2007 P4&P5) thus we can say that share holders get what they have expect of their invested funds.
Shareholder wealth in agreement with the decisions taken by the organization:
It is argued that Economic added value helps managers to incorporate to basic
Principles of finance into their decision making. The first is that the
primary financial objective of any company should be to maximise the
wealth of its shareholders. The second is that the value of a company
depends on the extent to which investors expect future profits to exceed
or fall short of the cost of capital. Stern et al argue that a sustained
increase in EVAâ„¢ will precipitate an increase in the market value of
an organisation. They further suggest that the adoption of an EVAâ„¢
approach has proved effective in virtually all types of organisation,
from emerging growth companies to those organisations involved in
'turnaround' situations. They believe that the current level of EVAâ„¢ isn't
what really matters since the current performance of an organisation is
already reflected in its share price. It is the continuous improvement in
Economic value added that bring continuo increase in shareholders wealth
(ACCA October 2007 P4&P5)
The simplicity of the EVA makes it easy for non accounting skilled managers to understand .this involves profit and the deduction of capital employed either as a whole or in parts. By assessing a charge for using capital, EVAâ„¢ raises managerial awareness of the need for care in the management of the balance sheet as well as the income statement, and helps them to properly assess
the tradeâ€‘offs between the two. EVA can be used to calculate effective performance periodically.
According to Stern Stewart & co the impact of EVA is to:
is to create a universal language for business and planning management.
Various tools are used by different organizations to express financial goals and objectives .organizations may evaluate based on assets or against a budgeted profit level. This various techniques of calculating and evaluating performance make it much difficult to arrive at a specific or consistent method of evaluating performance. "Economic Value Added eliminates this confusion by using single financial measures that links the decision making with a common focus." (ACCA student accountant October 2007 P4&P5)
Thus a uniform method or approach is created for the organization. it gives room for proper supervision of management decisions, hereby creating value added for its shareholders. EVA helps operating people to see how true profitability can be influenced (especially if it is actually broken down into parts that can be easily influenced)
It improves profitability usually through the improved capital turnover -some companies have usually done lots of work in cutting down costs but there is still more work to do in improving the use of capital
"Better balance between profit generation and asset management" (Stern Stewart & co 2000).EVA helps to weigh the creation of profits against that of managing asset. Also links the gap between operations and strategy with financial results for the organization and proper accountability for delivery values to share holders.
In assessing EVAâ„¢, one should recognise that it is an annual measure
performance with a historic perspective. The use of EVAâ„¢ represents
an attempt to measure whether the management of an entity has used
available funds in order to 'create' or 'destroy' value.
Under accounting conventions, retained profits are arrived at only
after a significant number of expenses and non-cash adjustments have
been made. It is arguable, however, that these might be perceived as
being similar to investments.
Investments in intangibles, such as promotional activities, research
and development, and employee training and development, are written
off in the income statement under conventional accounting rules. Each of
these items could be regarded as constituting discretionary expenditure
by management. Thus, in the calculation of EVAâ„¢ they would be added
back to capital employed on the premise that such expenditures would
have otherwise been available to be paid as dividend, or to reduce the
level of debt finance employed. Likewise, the amount of expenditure on
such items would be added to or deducted from the net profit or loss for
In calculating EVAâ„¢, depreciation and amortisation during the
period are added back to the capital employed. This is because, when
the assets were acquired, the funds expended would otherwise have
been available to the organisation and could have been returned to
shareholders. Under EVAâ„¢ principles, it is the historic cost of non-current