To measure the financial performance of a company is an important challenge. Investors need to know how a company perform to be able to make a sound investment. The purpose of this study was to determine to what extent EVAâ„¢ is used as a performance measure by organisations. Furthermore, this investigation focused on why EVAâ„¢ is implemented or not implemented in companies and in which sectors it is most likely to be implemented. This study also seeks to determine why companies using EVAâ„¢ decided to implement EVAâ„¢.
A literature review was conducted on what EVAâ„¢ entails, the reasons for implementing EVAâ„¢ or not implementing and how EVAâ„¢ is calculated. A focus group was held with people from practice discussing EVAâ„¢ and challenges surrounding the implementation of EVAâ„¢. The aim of this research project is to embark on the development of a research flagship for the Department of Management Accounting at UNISA. The need to measure financial performance and different metrics used need to be investigated to establish the best measure for each sector. It was established that various performance metrics are used in practice and that it depends on the nature of an organisation. Management need to understand their organisation to be able to implement the proper performance metric for their specific organisation. It is recommended that companies do a thorough analysis of their organisations, especially in the larger companies, to assist them in making an informed decision on the proper performance metric for their company.
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The definition of Economic Value Added (EVAâ„¢) is a measure of a company's financial performance based on the residual wealth calculated by deducting cost of capital from its operating profit (adjusted for taxes on a cash basis) (Stewart, 1990). The true benefits of EVAâ„¢ materialise when management understand what profitability is all about and when they get motivated to improve profitability (Evanomics, 2011). The goal of all companies is to create value for the shareholder. Evanomics (2011) continue to state that when long-term EVAâ„¢ is maximised, the company will be maximising its own value.
According to Stewart (1990) EVAâ„¢ may be viewed as a measure of value as well as a measure of performance. EVAâ„¢ can be used to:
communicate with investors, and
budget for capital expenditure (Stewart, 1990).
Damodaran (2001) suggested that a company need to maximise a variable correlates with the value of the company. There are various variables which can be employed:
Earnings or return on investment - an accounting variable
Market share - a marketing variable
Cash flow return on investment (CFROI) - a cash flow variable
Economic Value Added (EVA) - a risk-adjusted cash flow variable (Damodaran, 2001)
EVAâ„¢ was developed to compensate shareholders with a return on their investment for the risk they have take (Mäkeläinen, 1998). Investors may become frustrated with companies with a high profit and large capital costs. Therefore EVAâ„¢ may intend to provide the investor with a more acceptable measure of a company's performance.
To avoid the problems surrounded with the trademark of the EVA-concept, it is often called Economic Profit (EP) (Mäkeläinen, 1998). Mäkeläinen (1998) continue to state that the concept of "EVA" is well accepted and often all residual income concepts are called EVA although they are not measured in the same manner as defined by Stern Stewart & Co. Hence, hybrid metrics exist and are used by companies.
According to Pietge (2003) the concept of integrating a total capital charge (EVAâ„¢) is by no means new. Residual income or economic profit which also requires a charge for equity capital has been used for decades. Pietge (2003) continues to state that the use of accounting adjustments in order to calculate EVAâ„¢ and its ability to evaluate performance at divisional level, are criticized. Therefore, performance metrics may need to be free of adjustments and may need to be able to measure performance at divisional level.
Statement of the research problem
EVAâ„¢ is one of a number of measures available to determine an organisation's performance. The measure decided on by an organisation will be determined by what a business is trying to manage and the performance being measured.
Always on Time
Marked to Standard
This purpose of this study was to determine to what extent EVAâ„¢ is used as a performance measure by organisations. Furthermore, this investigation focused on why EVAâ„¢ is implemented or not implemented in companies and in which sectors it is most likely to be implemented. This study also seeks to determine why companies using EVAâ„¢ decided to implement EVAâ„¢.
The following sub problems were identified and investigated:
What organisations understand under the definition of EVAâ„¢
How organisations calculate EVAâ„¢
Deviations from the Stern Stewart EVAâ„¢ model and hybrid forms of EVAâ„¢ used by organisations.
Other methods of calculating economic profit of companies were also investigated through this study that if organisations do not use EVAâ„¢, which other methods do they employ.
In order to obtain background information on the above-mentioned research questions that could also be used to discuss the results of the research conducted for the purposes of this study, a detailed literature review was conducted. This review consisted of a theoretical overview as well as an empirical overview and is provided below.
The goal of all companies is to create value for shareholders. However, how is value measured?
According to McClure (2011) companies and their consultants use EVAâ„¢ as the most successful performance metric. Financial theory justifies this metric and the metric is consistent with valuation principles. Both of the aforementioned are important to investors when they analyse companies' performance.
EVAâ„¢ as well as earnings per share (EPS) and P/E ratios are scrutinised by investors and analysts. Companies can change their focus from company performance to divisional performance with the use of EVAâ„¢ (Stewart, 1990).
EVAâ„¢ is recognised as a strong indicator of a company's share performance. As a result of this companies with a high EVAâ„¢ should perform more strongly that those with a poorer EVAâ„¢ given a period of time. If EVAâ„¢ is expected to drop this acts as a signal to investors, as does an expected rise in EVAâ„¢, as EVAâ„¢ indicates to investors a yield above WACC (Correira, Flynn, Uliana and Wormald, 2007). Hence, this will meet the requirements of both equity and debt investors.
EVAâ„¢ provides an estimate of an organisation's economic profit, the value created over and above the required return of the company's shareholders, therefore, reflecting the earned profit of the organisation less the cost of financing the organisation's capital. Hence, shareholders gain when the return from the capital employed is greater than the cost of that capital. One of the ways this amount can be calculated is by making adjustments to GAAP book values and deducting the opportunity cost of equity capital.
EVAâ„¢ may be distinguished from other financial performance measures such as net profit and earnings per share (EPS) by determining the profits remaining after the capital costs of a company - both debt and equity - are deducted from the operating profit (McClure, 2011). Hence, profit should account for the cost of capital when calculating shareholder value.
EVAâ„¢ is an estimate of true 'economic' profit or the amount by which earnings exceed or fall short or the required minimum rate of return shareholders and lenders could get by investing in other securities of comparable risk.
To understand the difference between EVAâ„¢ and net income, an example can be used based on a hypothetical company, Mariefoo. The company earned R200 000 on a capital base of R2 million through the sales generated by one of their large divisions. Other accounting metrics suggest that Mariefoo is performing excellent. The company offers a return on capital of 10%. However, Mariefoo has only been operating for a year, and the market for their products carries substantial uncertainty and risk. Debt obligations together with the required return that investors need in an early-stage project add up to an investment cost of capital of 13%. Hence, although Mariefoo's company reflects accounting profits, the company in effect lost 3% last year for its shareholders.
Another example: if Mariefoo's capital is R200 million, including debt and shareholder equity, - and the cost of using the capital (interest on debt and the cost of underwriting the equity) is R26 million a year, economic value will only be gained for Mariefoo's shareholders when profits are more than R26 million a year. Therefore, if Mariefoo earns R40 million, the company's EVAâ„¢ will be R14 million. EVAâ„¢. A hidden opportunity cost exists for investors to compensate them for forfeiting the use of their own cash. EVAâ„¢ includes this hidden cost of capital whereas conventional measures ignore it. Hence, EVAâ„¢ measures profit the way shareholders define it (McClure, 2011.
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EVAâ„¢ is a registered trademark which refines residual income by including adjustments to the divisional financial performance measure for distortions introduced by GAAP. It is used mostly in companies with divisions and is derived at by starting with divisional profits plus or minus accounting adjustments less a cost of capital charge on divisional controllable assets. The divisional profit should be calculated before notional interest charges. Other adjustments are made to replace historic accounting entries with an amount that approximates economic profit and asset values. There are one-hundred-and-sixty possible adjustments which can be made, however, most organisations will need to make at least ten adjustments e.g. the capitalisation of many discretionary expenses such as R&D, marketing and advertising to ensure that costs and benefits match. These adjustments are made to derive managerial information closer to economic reality (Correira et al. 2007, Drury, 2007).
The adjustments to the definition of EVAâ„¢ are made only in those cases that pass the four tests (Correira et al., 2007, Drury, 2007):
Is it likely to have a material impact on EVAâ„¢?
Can the managers influence the outcome?
Can the operating people readily grasp it?
Is the required information relatively easy to track or derive?
EVAâ„¢ = Net Operating Profit after Tax - (Capital x Cost of Capital)
The above appears straightforward and simple, but calculating EVAâ„¢ can be deceiving. Firstly, NOPAT almost never represents a dependable indicator of shareholder wealth. NOPAT might show profitability according to the generally accepted accounting principles (GAAP), however accounting profits seldom reflect the remaining amount of cash year end for shareholders. Calculating the WACC is even more complex. WACC is a function of the capital structure (proportion of debt and equity on the balance sheet); the volatility of stock is measured through its beta, and the market risk premium. A slight change in these may result in large changes in the final WACC calculation (McClure, 2011).
EVAâ„¢ Uses (advantages)
It is claimed that by implementing a complete EVAâ„¢-based financial management and incentive compensation system, managers will obtain superior information - and superior motivation - to make decisions that will create the greatest shareholder wealth in any publicly owned or private enterprise. Further advantages include inter alia (Correira et al.,2007):
Evaluate (and rewards) corporate and divisional managers on the wealth created in the division, consequently aligning the interest of managers with those of the shareholders.
Good approximation of managerial performance and behaviour in organisations best interest.
Makes managers aware that capital has a cost - assisting in decisions of disposal of under-utilised assets that do not cover costs, makes managers care about managing assets as well as income, and help to assess the trade-offs between the two.
Senior managers concentrate on the delivery of shareholder value (maximise the wealth of its shareholders.)
ROI and hence EVAâ„¢ measures are surrogates for changes in market value/share value.
Conceptually simple and easy to explain to non-financial managers.
EVAâ„¢ links decision making with common focus - how to improve EVAâ„¢?
EVAâ„¢ provides a common language for all employees and allows management decisions to be modelled, monitored, communicated and compensated in a single and consistent way - always in terms of the value added to shareholders investment.
This approach has proved effective in virtually all types of organisations, from emerging growth companies to turnarounds. This is because the current level of EVAâ„¢ is not really important. Current performance is already reflected in share prices. It is the continuous improvement in EVAâ„¢ that brings continuous increases in shareholder wealth.
300 Organisations (Drury, 2007) world-wide were identified as having adopted EVAâ„¢ during 1997 including Coca-Cola, GE, AT&T, ICL, Boots and the Burton Group. SABMiller is a South African company that implemented EVAâ„¢ system for performance measurement.
However EVAâ„¢ remains a single period return therefore management may not be inclined to invest in this project due to the short-term effects of EVAâ„¢.
Liapis (2010) provided a comprehensive overview of the adjustments required to calculate EVAâ„¢ in order to transform the accounting framework into an EVAâ„¢ framework. Liapis (2010) suggests adjustments on non-operating items, non-recurring events, on the cash basis, and on the economic basis.
The major adjustments include adjustments for:
Marketable securities and other non-operating assets. These are included in the balance sheet, but excluded from EVAâ„¢ capital as they are not operational. Income derived from these is also excluded for EVAâ„¢ purposes.
Operating leases. In the balance sheet, these are treated as off-balance sheet future commitments, and rental expense is charged to expenses in the income statement. In EVAâ„¢ capital, the operating leases are capitalised and added to both assets and debt. In NOPAT, imputed interest on additional debt is added to NOPAT.
Recognised goodwill. In the balance sheet the net goodwill is recognised as an asset. In the income statement, an amortisation expense is charged to earnings. In EVAâ„¢ capital the cumulative amortisation is added back to goodwill, and in NOPAT no amortisation occurs.
Unusual gains or losses. In the balance sheet, these are written down which reduces the asset balance by historical cost. In the income statement, gains and losses are included in earnings. In EVAâ„¢ capital, gains reduce capital and unusual losses are added back. In NOPAT, gains and losses are not included.
Research and development/marketing. In the balance sheet, there is no capitalisation recognised, and in the income statement, research and development and marketing expenses are expensed as incurred. In EVAâ„¢ capital such expenses are capitalised if economic life exceeds accounting cycle. In NOPAT, the capitalised expenses are amortised over the economic life of the asset. (Liapis, 2010)
Sharma and Kumar (2010) did a comprehensive literature review of articles dealing with the theory and application of EVAâ„¢ over the past 15 years. They classified the literature on EVAâ„¢ into seven sub-themes:
EVAâ„¢ and stock returns, which includes articles on the relationship between company performance and EVAâ„¢, and EVAâ„¢ compared to other performance measures.
EVAâ„¢-MVA (market value added) relationship, which includes literature investigating the correlation between EVAâ„¢ and MVA, and EVAâ„¢ as proxy for MVA.
Managerial behaviour and performance management, focusing on literature on wealth creation, management incentives and performance evaluation.
Concept, criticism and implementation, which covers literature on EVAâ„¢ as tool to facilitate financial management and financial strategy formulation.
Value management and value based management, including the creation and measurement of value.
Discounting approaches, which investigates the relationship between EVAâ„¢ and NPV (net present value), and the impact of inflation, and reconciliation between EVAâ„¢ and other variations of discounted cash flow valuation.
Literature survey - studies covering comprehensive literature survey are covered in this category.
According to Sharma and Kumar (2010), the majority of research (more than 50% or articles reviewed) was conducted on the relationship between EVAâ„¢ and stock returns. It therefore appears that the majority of research focuses on the value of EVAâ„¢ as an indicator of value to external investors, as opposed to EVAâ„¢ simply being a tool for internal performance measurement, perhaps on a divisional basis within the organisation.
An overview on the literature on the topic indicates that EVAâ„¢ is more appropriate and applicable in a capital intensive environment. Deo and Mukherjee (2009) did research on the perception of Fortune 1000 firms of EVAâ„¢, and found that 90% of respondents agreed that EVAâ„¢ is more appropriate in capital intensive organisations such as manufacturing rather than in an environment where organisations rely on intellectual capital.
Silverman (2010) also investigated the appropriateness of EVAâ„¢ in a high technology environment. He found that calculated equity values based on EVAâ„¢ were significantly lower than the market values of the same organisations, even in cases where research and development costs were adjusted and capitalised. In certain cases the market value was almost double the intrinsic value of these organisations.
Kaur and Narang (2009) did EVAâ„¢ calculations on a sample of 104 prominent organisations in India, and found that almost 50% of the sampled companies clearly destroyed the wealth of its shareholders. Although Kaur and Narang (2009) suggested methods of improving the EVAâ„¢ of these organisations, their finding could also indicate that EVAâ„¢ is not a reliable measure of performance and value. Methods suggested included the lowering of an organisation's cost of capital, improved operational efficiency, selling off unproductive assets and optimising the debt/equity ratio of the organisation. However, if one assumes the accuracy of the collective wisdom of investors in these organisations, Kaur and Narang's (2009) findings may also be an indication that EVAâ„¢ may not be the best indicator of value and that alternative metrics should be investigated.
Chari (2009) did a comprehensive literature review on different performance measures used by companies, focusing on a comparison between EVAâ„¢ and other performance measures. Her most important findings are the following:
The nature and number of accounting adjustments done for calculation of EVAâ„¢ is tailored to suit the needs of the company that is implementing it. No two companies calculate EVAâ„¢ in the same manner. This view is advocated and practiced by its proponents also (Chari 2009).
On the question of superiority of EVAâ„¢ over other measures arising due to accounting adjustments, the studies conclude that out of the total 165 adjustments, only 5-6 accounting adjustments contribute to significant difference in EVAâ„¢. The others are immaterial (Chari 2009).
Only six of the ten studies reviewed concluded that EVAâ„¢ as a measure of performance was superior to others.
Holler (2008) investigated the information content of the value-based measures RI (residual income) and EVAâ„¢, and two standard indicators used by investors, earnings and cash flow from operations, to address the question: "Have value-based measures recently gained superiority to traditional measures in explaining contemporaneous stock returns or firm value?". Holler (2008) found that earnings and its closest value-based measure, residual income or RI, continue to outperform EVAâ„¢ as indicator of organisation value, and that EVAâ„¢ was probably not superior to other measures as indicator of wealth. In addition, the number of accounting adjustments required for EVAâ„¢ calculations could be regarded as a significant disadvantage of using EVAâ„¢ as performance measure.
Deo and Mukherjee (2009) did research on how Fortune 1000 organisations view EVAâ„¢. Deo and Mukherjee (2009) received only twenty-one usable responses despite sending multiple reminders. This may be an indication that a huge number of organisations are not committed to EVAâ„¢, as one would expect that an organisation using EVAâ„¢ would also show interest in completing a research questionnaire on EVAâ„¢.
Deo and Mukherjee's research identified the following strengths of EVAâ„¢:
EVAâ„¢ is a reliable internal measure
EVAâ„¢ provides correct incentives for allocating resources
EVAâ„¢ is better than traditional accounting measures.
With regard to weaknesses, the following were identified:
EVAâ„¢ is not for all organisations.
The computational process of EVAâ„¢ is complex
EVAâ„¢ is a short-term measure
EVAâ„¢ is more effective when used with other measures.
A team of 8 people from Unisa's Department of Management Accounting and the Bureau of Market Research joined expertise in this research project. Qualitative research, and here specifically focus groups (Morgan, 1997) was chosen as the preferred method of research. The method was chosen since the team wanted to engage in a discussion with stakeholders in the field in order to arrive at an in-depth understanding of the reasons why EVAâ„¢ is implemented or not whereas a questionnaire may only result in specific answers and no discussion. The research team is investigating why EVAâ„¢ is not implemented in companies and in which sectors it is most likely to be implemented.
A focus group was organised for the 16th of February 2011 to establish the following from focus group participants:
What do you understand under the definition of EVAâ„¢?
Do you use EVAâ„¢ or any other method similar to EVAâ„¢?
If yes, why do you use EVAâ„¢?
If you use EVAâ„¢, how do you calculate it?
If no, which method do you employ?
In which sector according to your experience is EVAâ„¢ more efficient?
Mr's Ho, Luksmidas, Heyns, 4 people from Statistics South Africa attended the focus group together with the research team.
A Dictaphone was used to record the discussion and was distributed via CD to the research team members. The members listened to the recording and identified 24 themes. After the original themes were identified they were categorised into 5 main themes and the remaining themes were indicated as sub themes. After again listening to the recording, details from the discussions were added to the themes and subthemes.
Results of study
The results of the study were categorised into 5 themes that surfaced during the focus group.
Theme 1: Measures to determine performance
It is evident from the focus group discussion that there are a large number of measures available to determine organisational performance. Such measures include inter alia economic value added (EVAâ„¢), economic profit (EP), free cash flow (FCF), cash flow return on investment (CFROI, originally developed by HOLT Value Associates) and combinations or hybrids of the mentioned measures.
The measure decided on will be determined by what a business is trying to manage and the performance that is measured. The performance measure selected should ensure that the objective of the business (who or what is measured) is attained.
According to Luksmidas (2011), the main uses of performance measurements are to increase shareholders value and manage the performance of people and divisions.
Ho (2011), having had more than 10 years' worth of experience in value based management and shareholder value analysis sphere, noted that calculating the economic value using FCF would result in the same answer as compared to using EVAâ„¢.
The availability of data; management's needs; the nature of the business and the sector in which the business operates will influence the performance measure selected by the business. Therefore some measures might fit certain organisations better. The overall picture needs to be taken into account, where buy-in from the whole business needs to be obtained for the measure selected.
Theme 2: Calculation of EVAâ„¢
The basic calculation of EVAâ„¢ involves determining the Net Operating Profit after Tax and then deducting a capital charge, based on the market value of operating assets. In the discussion of the calculation of EVAâ„¢ and economic profit (Stewart, 1990), we can differentiate between three different aspects of the calculation:
Determining the asset base
Determining the WACC
Calculation of profit
The focus group agreed that the basic EVAâ„¢ definition of using net operating profit after tax is correct. There were, however, various views on the specific adjustments required, and it was evident that the huge number of adjustments suggested by Stern and Stewart are not always considered when calculating EVAâ„¢ or then, economic profit, in the workplace.
With regard to depreciation, the response was that depreciation should not be excluded from the calculation of net operating profit after tax, even though it did not involve cash flow. Where there is an increase in the value of an asset, for example fixed property, the asset should ideally be re-valued and the increase in value should be reflected in the net operating profit. It was admitted, however, that it was not practical to revalue assets on an annual basis and that a five year term for revaluation was probably more practical.
Theoretically long-term expenses such as research, training and marketing should be excluded from net operating income and capitalised for EVAâ„¢ purposes. This is not always practical, according to the views of the participants. In some cases, the consultant calculating the economic profit will agree with the client whether these expenses should be capitalised or not. Research expenditure was singled out as a very difficult item, because the expected financial benefits arising from the research are not always certain and therefore do not necessarily justify the item being capitalised.
In terms of traditional EVAâ„¢, interest on long-term loans should not be included in the calculation of net operating profit after tax (Stewart, 1990), and the interest saving on this interest should therefore also be excluded. Some of the participants, however, confirmed that they did not do this adjustment when calculating economic profit. They simply used net profit after interest and taxation before deducting a capital charge.
Other adjustments, such as 'smoothing of lumpy cash flows' could also be considered for years where there are significant unexpected and one-off cash flow items.
Determining the asset base
The consensus was that the asset base used in the calculation of EVAâ„¢ and economic profit consists of non-current assets and net current assets. The long-term financing of these assets are therefore not considered. This is in line with the Stern-Steward model (Stewart, 1990).
Instead of using net book value of assets as per the financial statements, the market value should rather be used for EVAâ„¢ purposes. Some of the adjustments required could include the revaluation of fixed property and other non-current assets. Operating leases are often capitalised as well to present a better picture of the operating asset base used to generate income.
Non-operating assets, for example housing provided to staff, are excluded from the EVAâ„¢ calculation. Intellectual property is in practice a very difficult item to account for in EVAâ„¢ calculations. Valuing intellectual capital is not always practical, and this is one of the reasons why it is often difficult to apply EVAâ„¢ in human capital-based companies.
Determining the weighted average cost of capital (WACC)
It was evident from the discussion that calculating EVAâ„¢ does not necessarily involve the calculation of the WACC as well. In all the cases, a previously determined WACC was provided to the individual preparing the EVAâ„¢ calculation. It appears that a number of companies have at some stage prepared a WACC calculation, and that this is subsequently used without too much questioning.
The participants agreed that WACC should be determined by comparing the company reviewed to similar listed entities and any other benchmark peer company available. It would be more appropriate to use target debt-equity ratios instead of actual debt-equity ratios. Typical WACC for larger listed companies could be estimated around 12%-13%, and a premium of at least 5% to 6% would be added for unlisted medium sized companies. A further country-specific risk premium could also be added if deemed necessary.
Theme 3: Understanding the nature of business
The nature of the business not only refers to the industry in which the organisation is operating, but also to the stage or season of the life cycle the organisation is currently in and the organisation's risk profile as well as the way it operates. One should also take into account that the business and the different business units are not necessarily in the same stage of the life cycle.
An in depth understanding of the business is required to select the most appropriate performance metric and to perform the most accurate calculation.
Before attempting to measure performance, time should be invested into the client to understand who and what is being managed by the business. The main purpose of performance measurement is first to increase shareholder wealth and secondly to improve people's performance. A number of metrics might be required to accurately measure whether the above-mentioned goals have been met.
The economic sector, in which the organisation is functioning, plays a significant role in deciding on the most appropriate performance metric. The focus group indicated that there is a significant correlation between turnover, capital expenditure and inventory levels in the capital intensive organisations like mining, inventory, trade and electricity, while the correlation is less significant in other sectors like business services, which will influence the choice of performance metric.
The focus group agreed that a capital intensive organisation is more suitable for the EVAâ„¢ calculation than an intellectual capital based organisation.
The stage or season of the life cycle the organisation is currently in significantly influences the performance metric to be used. The fact that different units in the business might be on different stages in the life cycle might require different metrics. Using the same metric throughout the business might result in an inaccurate calculation of performance, which might have a significant effect on decision making. However, understanding the stage of the different units and selecting the metric accordingly will result in the calculation of a more accurate performance indicator.
Engaging with the client to gain an understanding of the business is of utmost importance to determine what adjustments need to be made in the EVAâ„¢ calculation and to accurately calculate the WACC.
Theme 4: Performance metrics and the human factor
During the focus group discussions it became evident that performance metrics are either positively or negatively influenced by the human factor.
Metrics are subject to manipulation: "Any metrics can be manipulated" and the manipulation may be based on the intentions of the people running the metrics.
Negative impacts associated with some internal metrics for instance performance bonuses: EVAâ„¢ promotes the creation of a bonus bank (when results are EVAâ„¢-positive) whereby an employee may earn a bonus of 10% and only a third is paid to the employee and the rest is banked to incentivise the employee to think long term. The bonus is paid at a certain point in time based on past results and may therefore not invoke a forward looking strategy. The following example was raised during the discussion: If an employee knows he will not be with the company for longer than three years, he may try to maximise his bonus by manipulating the performance measurement through reducing capital charges, balance sheet items and adjustments to the detriment of the company. His successor will need to face the challenge of recovering the lack of capital investment and restoring long term value.
Reasons why many general managers are not using EVAâ„¢: General managers may not be willing to be part of a certain performance metric unless it is included in their key performance indicators (KPI) and they have control over the allocation and utilisation of assets. Hence it is important for a company to make sure that the managers' KPI's are aligned with the specific performance metrics in place and managers are consulted for input.
Span of analysis of company financials. EVAâ„¢ could give rise to short-termism: EVAâ„¢ favours short term projects although long term projects are usually more profitable. The longer you keep the asset in operation the more the profitable the project will be - this came about when ABC-costing was applied to measure unit costs.
Staff buy-in into metrics is very important: A performance metric will only be effective when you have the necessary employee buy in into the metric applied by the company.
Theme 5: Challenges with implementing EVAâ„¢
EVAâ„¢ suggests a possibility of hundred and sixty adjustments. Therefore it is important to understand the business and strategy to implement the important adjustments. Normally this can be limited to ten adjustments. Adjustments for different countries in which the business operates should also be considered.
It is important understand that a lot work should be done behind the curtains - that data should be correct (valid/reliable) and the systems in place to calculate EVAâ„¢ with the other metrics. Companies should remember to understand the costs within the concept of the company, sector and the cycle of the business. Before EVAâ„¢ can be calculated, the business and its strategy need to be understood therefore buy-in from all important stakeholders are important.
Companies are already struggling to calculate net profit correctly and EVAâ„¢ made it even more difficult. EVAâ„¢ is a long-term process, and should be calculated consistently over time. Sometimes EVAâ„¢ is incorrectly used by managers as a short-term tool to enhance their own performance normally associated with bonuses, without considering the long-term effect on and value of the company.
A good performance metric is top-down and bottom-up. EVAâ„¢ can be calculated for each division (only if the financial information is available per division) or for the company as a whole.
The EVAâ„¢ theory is subjective and can be manipulated and is mostly dependant on the ethics of top management. Adjustments should be implemented consistently and objectively chosen and can't be included and excluded on whim, this will ensure that the measure is bullet proof. Sometimes adjustments will be included or excluded to understand the effect of the adjustment. This is also important to smooth out the difference between internal and external reporting. It is normally used as a performance measurement and therefore an incentive for people in controlling positions to manipulate the calculation.
Businesses need to be educated in terms of the EVAâ„¢ method and understanding the EVAâ„¢ concept. Sufficient investment of time and resources to help managers understand what EVAâ„¢ is and how it should be used in managing their business.
EVAâ„¢ can add value but is complex and not clear cut. It is important to automate the EVAâ„¢ calculations so that it becomes part of the monthly reporting to ensure optimal utilisation of the business decision tool.
It became evident during the focus group discussion that there are a number of different metrics to measure the financial performance of a company. A number of hybrids were also suggested by the participants in the focus group. The metric used is dependent on what the company wants to measure.
The EVAâ„¢ calculation is categorised into three steps, namely: calculating the profit; determining the asset base and determining the WACC. It was agreed that the calculation includes a number of adjustments which are not always followed. These adjustments are often agreed with the organisation's management and seldom agree with the adjustments suggested by Stern and Stewart. It was agreed that the market value rather than the book value should be used for the calculation of the asset base. It is also very difficult to put a value on intellectual capital and therefore EVAâ„¢ may not be a suitable measure for human capital intensive companies. It became evident that the calculation of WACC is not always calculated concurrent with EVAâ„¢, however a predetermined WACC is often used for the EVAâ„¢ calculation.
To understand a company entails the sector in which it operates as well as the seasonal trends of the business. The concept of understanding your business is very important when making an informed decision on which metric to use to measure financial performance. Engaging with the client to gain an understanding of the business is of utmost importance to determine what adjustments need to be made in the EVAâ„¢ calculation and to accurately calculate the WACC.
There are a number of challenges with the implementation of EVAâ„¢. It became apparent that any metric can be subject to manipulation. The human factor may also lead to selfish decisions being made by managers especially when they know they are not going to be with a company much longer. It is of utmost importance that the staff buy into the metric that is going to be used especially in companies with large capital outlays. If managers do not have a say about the use and allocation of the assets, they may not want to implement EVAâ„¢.
Companies struggle with the calculation of net profit and even more with the calculation of EVAâ„¢. The EVAâ„¢ theory is subjective and may be manipulated and may be mostly dependant on the ethics of top management. It was established that EVAâ„¢ is used by companies but that the metric used is industry specific and influenced by the nature of the company. To conclude: a good performance metric is a top-down and bottom-up metric.
Based on the preliminary findings of this research project it became clear that different metrics are used for financial performance. More focus groups with participants from listed companies are planned and based on information gathered from these focus groups a better understanding of EVAâ„¢ and other metrics may be gained.