Economic Value Added (EVA) – Part 3

Check out this explanation on how risk impacts economic activity…

VIDEO SUMMARY

This video is going to continue to discuss EVA (Economic Value Added) and we’re going to dive deeper into the equation.  Bear with me. EVA is complicated and I’m covering a lot of ideas. First talked about productivity. Then talked about profit and assets and how they are used in the equation. Now we are talking about risk. What I am doing is going around all the topics and showing how they fit together. There’s going to be a couple more videos, putting the pieces together and then we will hit the main concept like a bullseye. So please keep watching these videos. This video is going to talk about risk and explain how risk gets incorporated into EVA.

There is an important element of financial statements you need to understand and that has to do with time. The balance sheet is a snapshot of one point in time. The income statement depicts performance over a period of time. Two very different things. So on the balance sheet, you usually find the assets at the beginning of the period and assets at the end of the period. The income statement shows what profit was created between those dates. So when we’re calculating EVA, what we’re doing is taking the assets from the beginning period, and the profit that was created during the period.

So because time is a factor, risk comes into play, and becomes very important. Because what happened? You were given capital, with the understanding that you would turn it into profit. But there is some risk because we don’t know for sure whether you are going to create a profit or not. This risk is central to understanding your EVA. For a moment, let’s assume we are calculating EVA at the end of a period. We know the profit. We know the starting assets. But it would be silly to calculate economic value added without taking into the account the risk the investor took on at the start of the period. It’s the risk we need to understand.

Let’s go back to the EVA equation. We discussed capital charge previously. Capital charge is more than just assets. It’s calculated using assets and risk.

EVA = NOPAT – capital charge

We discussed that NOPAT already deals with profit, so let’s focus on capital charge. Capital charge is not just assets. It is calculated using both assets and risk. Here is the deal. Two companies could have the exact same profit, and the exact same assets. But one is very low risk and the other is very high risk. And here’s an investor, sitting at the beginning of the period looking at these two options. Whether the investor gives the capital to one or the other is two very different things to the investor. So it is all about risk. Understanding risk, and calculating out the risk.

EVA is determined from three things:

• Profit
• Assets
• Risk

We’re going to get into actually calculating this out in the next video. But I really want to start by getting you to get this concept. Every day you are faced with a string of financial decisions. If you just pick up one piece of data you might not get the best analysis. If you just look at income, you might make your decision on incomplete data. EVA helps you look deeper into solving those decisions, whether you are an investor or a business owner. Economic value comes down to profit, assets, and risk. Those three things, and if you can frame your decisions in that context, you will get better outcomes.

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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.