What is economic value added?

Rishikesh Gaikwad
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What is economic value added?

Economic value added is a measure of profitability that goes a step ahead of accounting profit reported by the company in its financial statements. For example, let us suppose that there are two companies A and B. Company A has a part debt financing, whereas, company B is only equity financing. Even though both companies may be having the same operating profit, company A will report lower net profit because it has to deduct debt cost in the way of interest before arriving at profit figure, whereas, company B has no interest cost. So on the face of it, Company B might look more profitable while comparing the profit numbers. However, this happened only because of the difference in the funding method of the two companies.
 
It should be noted that even equity financing has a cost that should be considered while arriving at the profit figure. This is taken care of by EVA, which considers the cost of equity as well.
 
Formula for EVA, EVA = NOPAT - $WACC,
Where NOPAT = net operating profit after tax,
 $WACC= is the cost of capital in amount (debt and equity both considered).
 
EVA is gained after the cost of capital provided by lenders and shareholders is deducted from net operating profit after tax. While it is not mandatory to report EVA in annual reports, few companies in India, such as Hindustan Unilever, Pidilite, Hero MotoCorp, and Infosys, do report this number.
 
EVA is a better measure of profitability than PAT because it considers the cost of equity financing as well. One must remember that the company should not only earn profits but the profits should be enough to justify equity investing. So, the next time you see a company reporting EVA, consider it a positive sign because it means its profits are enough to cover the cost of equity too.

 



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