Economic Value Added

Raditya Pratama (008201200136)

Economic Value Added refers to the financial gain after deducting the cost of capital. However, this
term is used with different meanings across multiple industries and it is significant particularly in
finance. Generally, investors are using the most common method of valuing stocks through PriceEarnings-Ratio or PER. Trying several valuation methods can help in identifying different fair
values.
In recent times, the Economic value Added has gained worldwide attention as a method that offers
intuitive measurement of profitability that shareholders are looking for. This method helps in
calculating the actual amount of dollar either created or destroyed. It considers the opportunity cost
or the considerable amount allowed investing in a risky asset just like government bonds.
This method of determining value is categorized as positive and negative value. In case of positive
EVA, a value is created and added to the companys intrinsic value. On the contrary, a negative EVA
indicates that the value eroded in such a way that the company has lesser worth as compared to the
initial capital.
Uses of Economic Value Added
The Economic Value Added is a valuable tool that is used by most businesses and investors. It is
because this method determines potential future earnings as compared to other methods that only
provide snapshot of past financial expectations.
Likewise, this method becomes more effective if the company uses considerable amount of capital.
It will help in determining not only the positive cash flow of a business but also its profitability. In
this sense, this method is useful in comparing the return on investments with the profitability that
you can obtain from other investments.
In addition, Economic Value Added is also useful in determining the financial impact of the R&D
investments and marketing of a company. This method is the best option of translating the R&D and
marketing into tangible value. Likewise, this method is also valuable if a company is planning to
sell the business or look for outside investment.
Keep in mind that a potential buyer or investor will only be interested if a business has higher value.
This method can provide measurement of the companys value that is important in loan review
documentation. Indeed, EVA will help in managing the business in becoming a valuable investment.
How to Improve EVA?
Although the economic value added is positive, there is still a possibility of declining EVA that may
deteriorate over time if the negative trends continue and it may affect the financial performance.
Remember that a negative economic value added implies that the business is not gaining profit
more than its capital. In this sense, it is important to apply corrective actions to prevent deterioration
of financial performance.
The first thing to do in preventing negative EVA is to improve the operating performance such as
the asset turnover ratios and the operating profit margins. In this way it will be possible to produce
more revenue without utilizing additional capital. Likewise, by selling assets that are not utilized
can reduce the capital investment and at the same time improve the operating performance.

Using the capital invested to activities and projects that show higher operating performance can also
help in improving the economic value added. On the other hand, if the business does not show
leverage the best thing to do is modify the capital structure by using higher cost equity instead of
lower cost debt.
Advantages of Economic Value Added
Utilizing the economic value added in determining the profitability of a business offers several
advantages. This method facilitates firms and managers toward efficiency in gaining more profits
with little capital investment. Likewise, if the manager is implementing EVA in meeting the yearly
budgets, most likely it will make a way of achieving greater incentives for excellent performance.
Another advantage of EVA is its applicability for virtual operation. Its application only requires
using of financial statements that include income statement and balance sheet. Additionally, the
principles involve in economic value added are easy to comprehend in such a way that it can be
easily understand even by employees.
Disadvantages of Economic Value Added
The universal suitability of economic value added is one of the disadvantages of this business tool.
Some experts believed that EVA is not suited for companies that are sensitive to capital availability.
On the other hand, other investors have brought up another disadvantage that is the limitations of
measuring the efficiency. Another potential disadvantage of EVA is the inaccuracy of figuring out
the EVA results since the calculation is dependable on the financial statements.
In addition, it is believed that EVA only considers shortsighted approach that requires managers in
making positive changes particularly for the present time and benefits without considering projects
that may provide good returns in the future. Despite of the shortfalls that this method shows, still
many investors and business owners are using this approach as compared to other financial
measures. It is because the advantages stand out as compared to other financial measures.
To sum it up EVA is a straightforward and intuitive approach that measures the value and at the
same time calculates the business performance. It recognizes end results as well as the input of
funds. In this way, managers are motivated to become efficient in managing funds.
However, when using economic value added approach it is necessary to have oversight in order to
prevent acting unethically in reaching a goal.
Since this method uses fairly universal data, it can be expected that it offers consistent measurement
of value. It also emphasizes the need for efficient and wise management in producing wealth in
such a way that managers can easily determine the right way of improving the financial aspects not
only for the current period but also in the future.
Therefore, if you are a manager who is concern about improving the profits as well as the
performance of the company, the best thing to do is employ economic value added method. In this
way, all the factors that cause deterioration of value can be eliminated if not improved.