By Yuriy Smirnov Ph.D.

Economic value added (EVA) ^{[1]} is a concept used in corporate finance to designate an excess or lack in value created over the cost of invested capital. In other words, it is the difference between net operating profit after taxes (NOPAT) and cost of invested or operating capital. The positive value of this performance indicator means that a company managed to cover the cost of capital and create additional value. Conversely, negative economic value added indicates that the value of invested capital is being destroyed.

The basic formula to calculate economic value added is as follows:

EVA = NOPAT - Invested Capital × WACC

where NOPAT is net operating profit after taxes and WACC is weighted average cost of capital.

In turn, NOPAT can be calculated as follows:

NOPAT = EBIT × (1 - Tax Rate)

where EBIT is earnings before interest and taxes (can also be referred as operating income).

In terms of return on invested capital (ROIC), the formula of EVA can be written as follows:

EVA = Invested Capital × (ROIC - WACC)

The formula to calculate ROIC is

ROIC = | NOPAT |

Invested Capital |

Calculating NOPAT is one of the essential steps in finding economic value added, but this process isn’t as simple as it may seem. The problem is that there are different accounting standards (e.g., GAAP and IFRS), so not all companies disclose EBIT in their income statement. Even so, if the EBIT is disclosed, some adjustment must be applied to convert it from an accrual-based to a cash-based number.

After the net operating profit is appraised, taxes must be deducted. For a rough appraisal, the reported taxes can be used, but if a precise number is needed, some adjustment has to be made because reported taxes may be different from taxes actually paid.

Thus, the rough appraisal of NOPAT can be made using the formula given above. If a more precise appraisal is needed, please follow these guidelines.

There are many ways to calculate the amount of invested capital using balance sheets and other financial statements. Here we consider the key steps and adjustments that need to be made to get the correct number.

For the first step, we get the book value of investment capital from the balance sheet. The common approach is as follows:

Invested Capital = Total Assets - Noninterest-Bearing Current Liabilities

The most common examples of noninterest-bearing liabilities are accounts payable, accruals, and customer advances. Fulfilling this step is enough for a rough appraisal of EVA, but extra adjustments need to be made for a more precise appraisal.

For the second step, accrual-based items of the balance sheet must be converted to cash-based items. For example, the increase in item “Allowance for doubtful accounts” doesn’t mean that the company will receive less cash, so that amount should be added back to get the true amount of invested capital.

Finally, the third step is adjustment for off-balance sheet financing.

To examine the detailed calculations example of invested capital, follow the link.

Weighted average cost of capital is the third component needed to calculate economic value added. To find the WACC, follow these recommendations.

XYZ Company had the following results in the last financial year:

Balance sheet, US $ in thousands

Statement of income, US $ in thousands

The weighted average cost of capital is 14.35%.

To get a rough estimate of economic value added, we need to first find NOPAT. XYZ Company disclosed an operating income of $9,060,000 and provision for taxes of $2,100,000.

NOPAT = $9,060,000 - $2,100,000 = $6,960,000

The amount of invested capital is equal to total assets of $46,950,000 less noninterest-bearing liabilities: accounts payable of $5,680,000 and accruals of $1,890,000.

Invested capital = $46,950,000 - $5,680,000 - $1,890,000 = $39,380,000

Thus, the economic value added of XYZ Company is

EVA = $6,960,000 - $39,380,000 × 14.35% = $1,308,970

So, the economic profit generated by XYZ Company covers the cost of capital provided by investors.

© 2018 FinancialManagementPro.com. All rights reserved.