EVA - we can work it out

Annie Gurton sings the praises of this clever calculation.

Theories of corporate performance come and go, but most managers still talk of P/E ratios, revenue, profit and growth.

In the US, and therefore about to enter the lingua franca over here, they have a new phrase called EVA or Economic Value Added, a most appropriate term for Vars.

The principle is very simple: a measurement between the return on capital and its cost, thereby creating a figure which gives a price on how much value has been created by a business over a 12-month period. In other words, investors can see a return on their money. One attraction of EVA, which is based on the academic theory of a capital asset pricing model, is that it can be applied to businesses and departments within a business, not just to the business as a whole. Consequently it can be used to set targets for individual bonuses, which in turn can be extended to all staffers.

Those who have tried EVA say that it drives continuous performance improvement, and it rewards people for rapid achievement. One said: "It's all about changing the culture of the business and aligning the objectives of managers and shareholders." Such a system obviously has an appeal not only for Var business managers but for their customers too.

The theory is actually not new: it has been widely used in some sectors for over 30 years, and it has several different approaches and models practised varyingly by consultants and accountants. The main benefit of EVA is that it circumvents normal accounting presentations of the health of a business and all the inherent flaws and distortions perpetuated by the more traditional methods of presenting a business health snapshot.

The main problem with traditional accounting is that it presents the business in terms of its liquidation value, that is from the viewpoint of its creditors and debtors rather than owners or investors. Yet from their point of view the most important issue is the company's cash and cash-generating assets rather than its long-term liabilities.

EVA also sees R&D expenditure as investment is an asset rather than a cost, which is an important difference for many IT-related companies.

The main effect of accounts seen through EVA is that it tends to inflate the profit figure and possibly the balance sheet as a whole. It also deals ruthlessly with restructuring charges and other acquisition costs, because it deducts cash charges from profits.

EVA is most dramatic in calculating the cost of equity. In many traditional firms equity is still seen as a cheap form of capital measured in terms of the cost of servicing it, but what matters most to owners and investors is the cost of having money tied up and not used. The table here, provided by Nat West Securities as an example, shows how EVA can be calculated for a fictitious UK conglomerate called Williams. Even though Williams is a highly profitable company in conventional terms, its EVA works out as a negative figure because it is destroying value for its shareholders.

EVA analysts claim that many companies are destroying value while more conventional presentations show them to be delivering profit. It is not an alternative to showing how a business operates in terms of profit and loss, but takes a broader snapshot which includes the cost of capital.

EVA can be used effectively to work out incentives for staff, right down to the shop floor. If an EVA target for a year has been set at u10m and a manager meets it exactly a bonus is paid, but if the EVA is doubled so is the bonus. But the bonus should not all be paid at once - half should be paid now and half retained, because if the EVA target is not met the next year a corresponding amount of money will be forfeited. This is a safeguard against managers massaging the first year's figures - perhaps by running down inventories - in ways which will show up in a year or two.

It means that bonuses can be paid on profits rather than sales, as happens in most businesses today. It helps managers realise the real value of capital, and helps staff take responsibility for projects after they have been finished, not just before and during them. IT makes managers live with the consequences of their spending decisions, since they have to carry them forward as part of their capital.

EVA critics say that the cost of capital can be extremely hard to pin down, and the market value of assets can vary according to replacement costs. But generally speaking, EVA is being widely acclaimed as a more realistic, helpful interpretation of a company's health than any other theory.

Understanding EVA and its benefits over alternative, more traditional financial performance schemes can be beneficial for two reasons: to help you understand better your suppliers' and customers' positions so you can pitch your business requests and solutions more appropriately, and to help you run your own business more positively and equably. The Var that takes the EVA route will have more satisfied, committed staff, with all the benefits that that brings.

Annie Gurton is consultant editor of Var World and can be contacted on [email protected].