Introduction
EVA is a concept that was known in Latin America in the 1990s, despite the fact that economic and financial theories developed approximate elements for a little over a century.
Alfred Marshall was the first to express a notion of EVA, in 1980, in his landmark work The Principles of Economics: "When a man is engaged in a business, his earnings for the year are the excess income he received from the business during a year on your business outlays. The difference between the value of the plant, inventories, etc., at the end and at the beginning of the year, is taken as part of its income or as part of its disbursements, according to whether there has been an increase or a decrease in the value. What remains of your earnings after deducting interest on principal at the current rate is generally called your profit for undertaking to manage.
The idea of residual profit appeared in the accounting theory literature in the first decades of this century; it was defined as the product of the difference between operating profit and cost of capital. The General Electric company has been using it since the 1920s. Subsequently, in the 1970s, some Finnish academics were using it and, among them, Virtanen defines it as a complement to return on investment (ROI) for decision-making.
Peter Drucker in an article for Harvard Business Review approaches the concept of value creation when he states the following: “ As long as a business performs less than its cost of capital, it will operate at a loss. It doesn't matter that you pay a tax like you have a real profit. The company still leaves a lesser economic benefit to the resources it devours… while this happens it does not create wealth, it destroys it ».
Given this background, why the appearance of EVA only in recent years? Simply because the American consulting company Stern Stewart & Co. has developed a methodology on the subject and patented that product called EVA as a registered trademark, but which is a general concept based on the financial and economic theory of many years.
EVA summarizes the initials in English of the words Economic Value Added or Economic Value Added in Spanish.
EVA is also called EP (Economic Profit), a term used by another consulting firm, Mc Kinsey & Co.. Other terms derived from Residual Income are approximate to EVA, although they do not have the characteristics of the trademark registered by Stern Stewart. Simply, each consultancy has developed its own concept, although all refer to similar aspects.
The EVA methodology assumes that business success is directly related to the generation of economic value, which is calculated by subtracting from operating profits the financial cost of owning the assets that were used in the generation of said profits.
The EVA model
Every company has different objectives of an economic - financial nature. The most important are listed below:
1. Increase the value of the company and, therefore, the wealth of the owners. This objective includes the following goals:
- Obtain the maximum profit with the minimum investment of the shareholders. Achieve the minimum cost of capital.
2. Work with minimal risk. To achieve this, the following goals must be achieved:
- Balanced ratio between the indebtedness and the investment of the owners. Balanced ratio between short-term and long-term financial obligations. Coverage of different risks: foreign exchange, credit interests and stock values.
3. Have optimal levels of liquidity. To do this, they have the following goals:
- Adequate financing of current assets. Balance between collection and payments.
Explanation of the concept:
The economic added value or economic profit is the product obtained by the difference between the profitability of its assets and the cost of financing or capital required to own said assets.
EVA is more than an action measure, it is part of a culture: that of Value Management, which is a way for all those who make decisions in a company to put themselves in a position that allows delineating strategies and objectives aimed fundamentally at value creation.
If all operating income is deducted from all operating expenses, the value of taxes and the opportunity cost of capital, the EVA is obtained. Therefore, in this measure the productivity of all the factors used to develop the business activity is considered. In other words, the EVA is the result obtained once all expenses have been covered and a minimum expected return has been satisfied by the shareholders.
In other words, the added economic value or economic profit is based on the fact that the resources used by a company or strategic business unit (UEN) must produce a profitability higher than its cost, otherwise it is better to transfer the used goods to another exercise.
This requires a deeper analysis than that developed by traditional growth indicators in income, profits and assets as performance evaluation factors. This, in addition, forces a clearer presentation of the balance sheets to establish the different resources, assets and rights used by each strategic business unit in its process of generating profits and cash flow.
Decision making can be influenced by the type of indicators selected to measure performance.
Companies targeting the use of parameters such as net profit, different profit margins, or sales growth may develop a myopic point of view and ignore other elements of analysis such as the rationalization of working capital or the productivity derived from the use of installed capacity.
The evaluation of such opportunities can only be based on the use of indicators focused on the concept of value.
Factors that influence the value of the company
The single profits are not sufficient for the results of a company, it is also necessary that when compared with the assets used to generate them, they show an attractive profitability.
It is also necessary that both profits and profitability are accompanied by high free cash flows (FCL) if the company does not immobilize resources in working capital or investments in non-performing fixed assets.
The three elements, profits, profitability and free cash flow guarantee business permanence and growth, all of which allow creating value.
Chart: value creation process
>>>>>> ………………………….Permanence
Profits …….. Profitability ……..Value generation flow
……………………… >>>>>>>> Growth
Among the factors that influence the value creation process are:
- Dividend policy. If large profits are made and few dividends are paid out, homeowners looking for immediate returns will be discouraged by their investment by not having attractive results. Types of company activity. Business operations are related to risk, therefore higher risk should be expected to achieve greater results to achieve adequate profitability. Future business prospects. Economic, political, socio-cultural, technological and environmental aspects must be considered.
Cash flow
In the previous point, it was described how profits, profitability and free cash flow immediately allow the company to remain.
In the long term, the combination of the three elements allows the organization to achieve its growth objectives.
Taking into account that the first two elements, profits and profitability, are sufficiently known by the reader, the term Free Cash Flow (FCL) is analyzed below, using a simple example.
Pedro Rodríguez, head of the family, is a traditional owner of a retail store of groceries and household toiletries. Every night, when he closes his store, he carries out his routine "financial exercise" by separating the product of his sales into three amounts. The three amounts of money have the following destinations:
- to. The first sum is intended for the resupply of the store the next day with cash payment to the different suppliers. The second amount of money is used to accumulate and complete the monthly installments of your acquired obligations to improve your business. C. The third amount is used to cover her personal expenses and those of her family.
Pedro, with the passing of time, has noticed that he has been able to meet these three liquid resource requirements daily, which is why he considers the warehouse a good business and every year he would be willing to sell it for a higher value.
If you compare Pedro with a company, you can see the need to achieve the same "financial year". In the case of the duly organized company, the three objectives satisfied by Pedro will express them in a technical way:
The company manages to cover a first condition to satisfy its fundamental financial objective if it generates a cash flow that allows it to:
- to. Replenish your working capital (KT) and fixed asset investments (AF).b. Cover the debt service (principal and interest) c. To distribute profits according to the expectations of minimum profitability for the partners.
These are, in short, the only three ways to use cash flow for the business. How does this influence her?
Suppose two companies that operate in the same economic activity. Company A is a dealer of the ABC car brand and Company B sells OPQ cars. Therefore, both have a similar risk when operating in the same sector. On the other hand, their size and resources are the same and therefore their earnings results and performance and debt indicators are identical; Finally, both generate the same amount of cash flow.
|
Cash flow |
KT and AF replacement |
Debt service |
Available to distribute profits |
|
|
TO |
500 |
250 |
100 |
150 |
|
B |
500 |
200 |
100 |
200 |
Cash flow. Companies A and B.
The situation of A and B is shown in the table above. Company A must allocate a greater amount of money to meet its requirements for replacement of working capital (KT) and investment in fixed assets (AF). Taking into account that both use the same amount to service the debt (principal and interest), it is concluded that B has more money to satisfy the owners' expectations regarding profit sharing. Therefore B is more interesting to them than A, and potential investors would be willing to pay more for B than for A. In short, B has generated more value than A.
However, this conclusion may be a bit hasty. The exposed situation can be conjunctural. If A has made an investment plan in Fixed Assets (AF), it will initially demand more liquid resources, but in the medium term it will possibly generate a higher cash flow than B and reverse the initial disadvantage with the achievement of competitive advantages derived from its investment.
On the other hand, if we analyze B's initial advantage, it depends on the decisions made by the partners with those available. If they distribute too much, in the long term it will affect the value of B. There is an intimate relationship in itself between the value of a company and future cash flows.
Fixed asset replacement projects must be carried out with the company's own cash flow.
Free cash flow
Free Cash Flow (FCL) is the amount that is available to meet commitments with the company's capital providers: financial creditors and owners or partners. Financial creditors are serviced with the debt (capital and interest) and the owners with the remaining amount and on which the partners make decisions about its use, one of them refers to the amount they decide to distribute as profits or dividends.
| Gross Cash Flow |
KT and AF replacement |
Free cash flow |
Debt service |
Available for profit sharing |
|
|
TO |
500 |
250 |
250 |
100 |
150 |
|
B |
500 |
200 |
300 |
100 |
200 |
Free cash flow. Companies A and B.
It is noted, then, that the Free Cash Flow (FCL) is the result of subtracting from the cash flow the amounts destined to replace working capital (KT) and fixed assets (AF).
On the other hand, we know that the value of the indebtedness is the product of the decisions that the partners make about it. Businesses do not necessarily require debt to operate; since the shareholders or partners could finance it exclusively with their contributions and not distribution of the generated profits, in such a way that the free cash flow (FCL) would be totally available to the owners, since there would be no debt service.
This allows us to affirm that the greater the free cash flow (FCL) that a company can produce, the greater its perceived value, that is, that there is an intimate relationship between the value of the company and its FCL and therefore the A company's value would equal the present value of its FCL.
Therefore, management efforts should focus on the permanent increase of the FCL.
The information in the financial statements allows us to determine the value of the FCL, as follows:
Where, FCL = free cash flow
KTNO = net operating working capital
AF = fixed assets
Working capital
Working capital can be understood as the resources that a company uses to carry out its operational activities.
The resources available to management are available, accounts receivable and inventories, that is, in accounting terms, correspond to current assets. Under the same accounting perspective, these resources are reduced by all kinds of short-term obligations that commit them, that is, by current liabilities.
The difference between current assets and current liabilities is what, in accounting terms, is called working capital.
Where, KT = working capital
AC = current assets
PC = current liabilities
In summary, there are two perspectives of working capital. The accounting or difference between AC and PC that can be called net accounting working capital and managerial in which working capital (KT) is the resources that a company requires to run its operations smoothly.
However, the KT forgets that cash is a momentary quantity, that it is not a direct product of the company's operations. Furthermore, within optimal financial management, the available, as such, should tend to zero. Therefore, from now on, its value is not included in the KT in this text.
By contrast, accounts receivable and inventories do have a direct relationship with operations. To the extent that the operating volume necessarily increases, the company will require a greater investment in these items. So there is a cause and effect flow between the amount of operating income and inventories and accounts receivable.
This allows us to affirm that from an operational point of view, the KT is the sum of inventory and accounts receivable.
On the other hand, inventories are directly related to supplier accounts and accounts payable, therefore operations affect the volume of these liabilities, which means that the calculation of the KT must take into account the part of the suppliers of goods and services.
Taking into account the above, if the KT is called operating working capital (KTO) and the amount of the accounts payable to the suppliers of goods and services is reduced, the net operating working capital (KTNO) is obtained. or amount of cash flow that the company appropriates in order to replenish working capital.
So:
Where, KTO = operating working capital
INV = Inventories
CxC = accounts receivable
and
where, KTNO = net working capital of operation
CxP = accounts payable to providers of goods and services.
EVA: Factors for its calculation and evaluation
This chapter seeks to analyze the measures to calculate the EVA, the elements or factors that determine it and, therefore, affect it.
EVA calculation
At the beginning of the previous chapter, it was established that the economic added value or residual profit represents the wealth generated for the owners and is calculated by subtracting from the operating profit the tax expenses and the financial cost produced by having assets.
Thus:
The cost for the use of the assets is equal to the value of the net operating assets multiplied by their cost of capital (CK).
So:
From where: UODI = Operating income after taxes
CK = Cost of capital
EVA is based on the following principle: the resources used by a company or strategic business unit must produce a profitability higher than its cost.
Assets used in the calculation of eva
The clarity of the financial information presented in the balance sheet and the income statement is necessary for an adequate calculation of the EVA.
A first problem that arises for the determination of value is presented in the definition of the assets that must be taken into account.
The resources that are used in the value creation process will be called net operating assets and are those that directly participate in the generation of operating profit. For this reason, in addition to the assets and rights presented in the balance sheet within the group of other assets, the following should be excluded: temporary and long-term investments and any current or fixed assets that do not have a direct causal relationship with operating profits.
In addition, there is talk of net operating assets because the total of the operating assets is deducted from the accounts payable to the suppliers of goods and services.
On the other hand, if current operating assets have been defined as the sum of accounts receivable and inventories, then by subtracting from this sum the accounts payable to suppliers of goods and services, what is obtained is the capital of net operational work (KTNO), explained in the previous chapter.
Therefore, the net operating assets would be equal to the KTNO plus the market value of the fixed operating assets.
Other types of adjustments to the assets shown in the balance sheet to improve the calculation of the EVA have to do, for example, with the inventory valuation system (LIFO, FIFO, average); the leasing contracts registered in the assets with the capitalized portion, in the liabilities with the present value of the owed and the respective adjustment in the statement of results for the interests implicit in the rental fees; research and development expenses; and, good-will amortizations.
Asset profitability
The profitability is the measure of the productivity of the funds committed in a strategic business unit (UEN) or company and from the long-term point of view, where what prevails is the permanence and growth and, consequently, the increase of its value, is the most important factor to consider.
The importance of profitability lies in the fact that performance problems are structural in nature and are solved with strategic decisions that result in the long term.
On the other hand, the risk element should not be forgotten when a concept is issued or a decision is to be made based on profitability-related indicators. The principle must be kept in mind: the higher the risk, the higher the profitability.
The operational profitability of the asset (ROA) expressed as a percentage as the ratio between operating profit and operating assets.
|
ROA = |
UAII |
X 100% |
(8) |
||
|
ASSETS |
Where: ROA = Operational profitability of the asset
UAII = profit before taxes and interest
ROA calculation involves the use of operational assets; that is, those that are not used in the main activity of the business and that normally appear as other assets are excluded. In addition, the calculation of the indicator must consider the market value of the assets at the beginning of the period, since that amount is the investment required to generate operating profits.
Using the UAII or operational profit to calculate the ROA, provides an idea of the efficiency with which the resources are being used to generate a volume of profits that is sufficient to cover the cost of the liabilities and leave a remnant to the partners that is attractive.
If the operating profit produced by the company is compared with the interest produced by a financial investment, then it can be affirmed that said profit represents the interest produced by the investment in goods and rights or assets that take the form of a company.
When relating the operating profit with the assets that produce it, we have a rate that is, therefore, the interest that the company's assets produce or the interest rate that the company earns, and that as a financial indicator is the operational of the active.
Return on equity
If the interest is deducted from the Operating Income (UAII), the profit is obtained before taxes or value available to the members and if we relate it to the equity we obtain another rate that is the interest that the owners earn and is equivalent to the indicator called profitability of assets before taxes.
The following chart shows the balance-related interest rates.
|
ASSETS UAII ASSETS |
=%….. | LIABILITIES =% | Þ | Interest Rate Earned by Creditors of Capital AVERAGE COST OF DEBT |
| PATRIMONYUAIPATRIMONY | =% | Þ…. | Interest rate earned by owners PROPERTY PROFIT BEFORE TAX | |
| ß Interest rate produced by the assets Operational profitability of the asset |
Implicit interest rates on the balance sheet
How are these interest rates related to each other?
When comparing the one that the creditors earn with that of the owners, it is necessarily concluded that the rate of the latter must necessarily be higher than that of the former, because the owners assume more risk and if not, it would be preferable for them to liquidate your investment and become creditors of the company. For that reason:
| UAI |
|
|
| HERITAGE |
Now, if the return on the asset is compared with what the creditors earn or the cost of debt, the return on the asset must necessarily be higher, otherwise the company would be hiring capital resources at a cost higher than the return produced by investments in assets made with those monies, which is not logical; the liabilities are assumed with the purpose of putting them to generate an interest rate higher than their cost. Therefore, the ideal situation would be:
| UAII |
|
|
| ASSETS |
Finally, when comparing the returns on assets and equity, the interest rate of the owners must necessarily be higher than that produced by the assets. So:
| UAI | UAII |
| HERITAGE | ASSETS |
If the assets produce a rate higher than the cost of the debt, a surplus is generated on the value of the debt that corresponds to the premium that the owners earn for assuming the risk of getting into debt. Likewise, the greater the debt, the greater the remainder and therefore the greater profitability for the owners.
However, the above does not mean that if the return on assets (ROA) is higher than the cost of debt (i%), the greatest possible indebtedness should be sought. A high level of debt may not be viable due to limitations in the ability to pay, thus implying high profitability for the owners.
If the assets yield at a rate below the cost of the debt, the owners work for the creditors.
- Example:
To unify all these statements, the examples of the company Valorizable SA are shown.
When verifying each of the statements set out above with Valorizable SA, it can be concluded that the only situation that favors the partners is the one that meets the following inequality.
| UAI | > | UAII | > | i% | (9) | |||
| HERITAGE | ASSETS |
-
| TABLE 2.1. | ||||
| EMPRESA VALORIZABLE SA | ||||
| SITUATION 0 | SITUATION 1 | SITUATION 2 | SITUATION 3 | |
| 1. Operating profit | $ 400 | $ 400 | $ 400 | $ 400 |
| 2. Debt cost | 24% | 24% | 40% | Four. Five% |
| 3. Debt | $ 600 | $ 700 | $ 600 | $ 600 |
| 4. Heritage | $ 400 | $ 300 | $ 400 | $ 400 |
| 5. Total Assets | $ 1,000 | $ 1,000 | $ 1,000 | $ 1,000 |
| 6. Equity Return | 64% | 77.3% | 40% | 32.5% |
| 7. Active profitability | 40% | 40% | 40% | 40% |
| 8. Debt cost value | 144 | 168 | 240 | 270 |
-
| Situation 0: | UAI | > | UAII | > | i% | ||
| HERITAGE | ASSETS |
- Situation 1: Debt increases Situation 2: The cost of debt equal to the ROA of situation 1
| Situation 3: | The i%> | UAII |
| ASSETS |
Business Essence
The inequality expressed at the end of the previous point does not take into account the minimum required rate of return (TMRR) expected to be received due to the risk assumed in the investments of the partners.
Therefore, the inequality noted will be to the extent that it expresses that demand from the owners. So,
| TMRR < | UAI | > | UAII | > | i% | (10) |
| HERITAGE | ASSETS |
This inequality called the essence of business, summarizes the ideal situation of a company in terms of profitability.
The cost of capital
It is the cost that the company implies owning assets and is calculated as the weighted average cost of the different sources of long-term financing that it uses to finance its assets.
The cost of capital (CK) is also defined as what the company costs each peso it has invested in assets; This statement assumes two things: a) all assets have the same cost, and b) all assets are financed with the same ratio of liabilities and equity.
The cost of financing with the suppliers' credit is the opportunity cost that implies not having the discounts for prompt payment that they offer.
Heritage is the most expensive source for the company. Said cost is implicit and is represented by the opportunity cost of the owner.
In calculating the cost of capital (CK) current liabilities are not considered. It is calculated based on the long-term structure or capital structure.
CK is generally calculated as an effective cost after tax.
Return on assets and cost of capital
The cost of capital (CK) is the other rate that must be taken into account in the inequality of the essence of business.
If a company generates a return on its assets higher than its CK, the owners obtain a return on their equity higher than expected and therefore they are generating added value with which the value of the company (perceived by them) is increases, thereby meeting the fundamental financial objective.
The operational profitability of the asset (ROA) is the measure to compare against the cost of capital (CK), in such a way that the essence of business could also be determined by analyzing a relationship such as the following:
| UAII |
|
|
| ASSETS |
If we take the example of the company Valorizable SA, suppose that the TMRR of the partners is 45%. The company's cost of capital would be:
| SOURCE | AMOUNT | % PARTICIPATION | ANNUAL COST | WEIGHTED COST |
| Debt | $ 600 | 60% | 24% | 0.144 |
| Heritage | $ 400 | 40% | Four. Five% | 0.18 |
| TOTAL ASSETS $ 1000 | CK = 32.4% |
Capital cost. Business. Valorizable SA
The CK obtained is 32.42, lower than the operational profitability of the asset of 40% and therefore fulfills the inequality just expressed.
If you look closely, this occurs because a lower TMRR was assumed than what was actually achieved (64%, situation 0).
Now suppose that the TMRR is 66%, a rate higher than the ROA (40%), the CK would be 40.8% and higher than the operational profitability of the asset. In this case, although the owner's profitability is higher than the cost of the debt (66%> 24%), it does not meet the TMRR (66%), it does not meet the TMRR (66%) because the ROA does not exceed the CK (40% <40.8%), which means that if a company does not achieve a profitability higher than CK, although higher than the cost of debt (i%), the owners do not obtain their TMRR: Therefore, the inequality that Explains the essence of business based on the comparison of the profitability of the asset and the cost of the debt. It also supposes that the debt must be greater than this, the owner in any case achieves a rate higher than the minimum expected.
In conclusion, the two inequalities proposed to analyze the profitability of the asset refer to the same thing and therefore can be used independently to explain the attractiveness of a company. So:
| TMRR < | UAI | > | UAII | > i% | |||
| HERITAGE | ACTIVE | ||||||
| UAII | > CK | ||||||
| ASSETS | |||||||
| BUSINESS ESSENCE |
Business Essence
The following arguments allow us to study why both inequalities explain the essence of business.
- If equity is always more costly than debt and CK is a weighted average of the cost from both sources, CK will always be greater than the cost of debt and less than the cost of equity. If a company achieves an asset return greater than the CK, that is, it fulfills the second inequality, it is because said profitability is necessarily greater than the cost of debt (i%) with which the right portion of the first inequality is fulfilled.If a company achieves a profitability of Asset greater than the CK the owner obtains a return on his patrimony above his expected TMRR, as just explained. This supposes the fulfillment of the left portion of the first inequality.
Return on equity
The profitability of equity has already been defined as the UAI / EQUITY ratio, the amount in the denominator is expressed at market values to determine the opportunity cost of the money invested in the activity and is determined as follows:
To analyze the return on investment of the partners, let us return to the case of Valorizable SA and suppose that the shareholders decide not to have debt, this means that the owners would only be assuming operational risks, since the financial risks arise from the existence of the debt.. In other words, the maximum return of 40% that they would obtain if they did not take financial obligations is the prize they obtain for assuming operational risks in their company.
Since in reality they obtain a higher return than the asset (64%> 40%) just for contracting debt at 24% lower than the ROA, it means that the difference of 24% (64% - 40%) corresponds, within their equity profitability, to the premium for assuming debt, that is, the financial risk premium. This leads us to express the return on equity as the combination of the operational return on the asset and the remainder generated by the debt or financial contribution. Then we have:
Return on equity = roa + financial contribution
Heritage
Where: ROA = operational profitability of the asset
i% = cost of debt
Returning to the example of Valorizable SA
Financial Contribution =
= (0.4 - 0.24) x 1.5 = 24%
In this way, in Valorizable SA
= 0.40 + 0.24 = 0.64
In conclusion, the owners' profitability expectation (TMRR) is broken down into two elements: the expected compensation for financial risk and the expected compensation for operational risk, in such a way that the higher the participation of the debt in the financial structure, the higher the expected TMRR must be.
This allows to avoid the error that is made when evaluating projects under the perspective of the cash flow of investors, where the same TMRR is taken regardless of the level of debt.
Profitability trees:
The decomposition of profitability in the margin and turnover indices by means of the tree method makes it possible to clearly establish the relationships of the different factors that contribute to affecting profitability, which, according to everything explained in this chapter, constitutes free cash flow. the two great promoters of value of the company and therefore the managerial efforts should be directed towards its permanent improvement.
