Economic Value Added models

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What is Economic Value Added?

Economic Value Added is a means of calculating the financial performance of a company by subtracting the cost of capital from operating profits with adjustments made based on taxes. The Economic Value Added is also often referred to as economic profit, as its key aim is to establish the real economic profit. It goes beyond a simple net income calculation, and enables you to make sure that your company is operating profitably.

The benefits and negatives of Economic Value Added

The key idea behind Economic Value Added is that a business is only profitable when it is creating gross profits for its shareholders and thus, when it is performing at a financial level higher than its cost of capital. Calculating the Economic Value Added can be very beneficial to business as it is an effective means of tracking your company’s performance. The EVA acts as a helpful indicator of a company’s overall performance and also highlights where exactly a company is creating its wealth.

The EVA can also be seen as a reflection of management performance, not only the overall financial performance of a company.

However, the EVA only works best for businesses that are rich in assets and more established.

The different components of Economic Value Added

The basic equation used when calculating a business’ EVA shows that there are three major components to consider:

  • NOPAT (Net Operating Profit after Tax)
  • Capital Invested (Total Assets – Current Liabilities)
  • WACC (Weighted Average Cost of Capital)

Thus, the EVA gives you an overview of the business’ overall economic profits.

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