EVA as the best financial performance measure: the theory of reality

CONTENT

I. Introduction

II. The main functions of the financial performance management

III. From ROI to Value-based management

IV. EVA as the best management performance measure

V. Conclusion

VI. References

I. Introduction

Traditionally, companies and analysts focus on the use of performance measures because they play critical role not only in evaluating the current performance of a firm but also in achieving high performance and growth in the future. Investors measure overall company performance in order to be able to make right investment decisions. The financial performance measures have a variety of users but especially they assumed to be of primary interest of shareholders^[1] as they entrust their money to companies’ managers which are responsible for the application of capital but may have no incentives to increase shareholders’ value. For example, agency theory^[2] argues that unless managers are monitored constantly they act in self-interest, which might be at variance with interests of shareholders. But this variance can be reduced through the added costs of monitoring or designing appropriate incentive structures. In order to achieve goal congruence, managers’ compensation is often linked with the performance of the responsibility centers and also with overall company performance. Up to this point everything looks great but when it comes closer to the question what are the appropriate financial performance measures the researches opinions do not gee.

Most of the traditional financial performance measures directly relate to the current net income of a business entity with equity, total assets, net sales, like return on equity (ROE) and operating profit margin. But nowadays became very popular and common Economic Value Added (EVA) as the best financial performance measure. The proponents of EVA are presenting it as the wonder drug of the millennium in overcoming all corporate ills at one stroke and ultimately help in increasing the wealth of the shareholder, which is synonymous with the maximization of the firm value.^[3] But the academic world has come up with different opinions towards EVA and the claims of its proponents.

So still for today one of the most tough and controversial task is to build performance management system which will assure that managers will make decisions that will increase shareholders’ wealth.

In this paper these issues will be discussed:

- the main purpose and functions of the financial performance management and how it is related to the problem of shareholders value creation, company growth and managers decision making process and management motivation;
- the appropriate measures of management performance from the shareholders point of view;
- contradictions or goal incongruence between shareholders, management and company long-term growth.

II. The main functions of the financial performance management

Many researchers have identified three main functions of financial performance management: as a primary objective of a business organization, as a tool of financial management and as a means of motivation and control.^[4]

The financial objectives of a for profit business are closely related to the needs of the external suppliers of company’s capital - shareholders. The main interest of shareholders are the rate of return on their capital which includes dividends and capital gains on the market value of their shares for a period divided by the share value at the start of a period. As earnings determine what can be paid out as dividends in the long run, shareholders and their agents (such as investment analysts) are primarily concerned with financial measures like earnings, earnings per share (EPS), dividend yield, dividend cover and ROI.^[5] That is why the shareholders of the company seek to hold their managers accountable for the performance of the assets entrusted to them. External financial reports are intended to meet these needs.

Also financial performance management provides financial management with valuable information for planning, controlling, capital investment decisions, budgeting and ratio analysis.^[6]

The third major function of financial performance measurement lies in its internal use as a means of motivating and controlling the activities of managers so that they concentrate on increasing the overall value of the business or, at least, the value attributable to the shareholders. Between different scholars in the history of financial performance measurement there have been continuing debates over the rival merits of return on investment and value-based measures as financial performance measures.^[7] Most researches are now agreed that value-based measures, under which a cost of capital charge is deducted from operating profit, is conceptually superior to ROI as it explicitly allows for risk. It is stated that positive economic value added (EVA) is the accounting equivalent of a positive net present value that increase shareholders’ wealth.^[8]

The essence of the problem with financial performance measures is that although numerous shareholders own a public corporation, control over its operations is in the hands of professional managers, who typically hold relatively few shares and whose interests often diverge from those of the silent majority of shareholders.^[9] Moreover, there is an asymmetry of information among owners and managers which possess detailed information about the company. This cause the problem of management control which can be overcome by the right system of incentives. Ideally, managers’ performance measures have to be developed in such a way that they will influence managers’ internal decision making process through management compensations in the best interest of the company and shareholders (Figure 1). Further, it is assumed that shareholders are interested in the long-term company performance and their value depends on the company’s long-term performance. Thus shareholders may send right signals to managers through performance measures and the latter will make their decision in the best interest of the company as a whole organization and in the best interest of the shareholders.

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III. From ROI to Value-based management

The traditional performance management tool is ROI (Return on Investment). It was developed by the DuPont Powder Company in the early 1900s to help manage the vertically integrated enterprise.^[10] The purpose of this measure is to evaluate the performance of the company or its department by comparing its accounting measure of income to its accounting measure of investment. The formula to measure ROI is:

ROI = Income/Investment.

ROI is the apex of the DuPond “pyramid of ratios” as an overall measure of profitability. It can be broken down into two ratios the profit margin on sales and the capital turnover:

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^[1] Brignall, T. J. Stan. 2007. "A FINANCIAL PERSPECTIVE ON PERFORMANCE MANAGEMENT."Irish Accounting Review 14, no. 1, p. 16.

^[2] Ibid, p. 16.

^[3] Bhattacharya, Ashish, B.V.Phani. 2000. “Economic Value Added: In search of Relevance.” Decision. Vol.27, no.2.: p.25-55

^[4] Brignall, T. J. Stan. 2007. "A FINANCIAL PERSPECTIVE ON PERFORMANCE MANAGEMENT."Irish Accounting Review 14, no. 1, p. 17-20.

^[5] Ibid, p.18.

^[6] Ibid, p.18.

^[7] Ibid, p.19.

^[8] Ibid, p.19.

^[9] Stern, Joel M., John S. Shiely and Irvin Ross. 2001. “'The EVA Challenge: Implementing Value-Added Change in an Organization.” Wiley Finance Series. New York John Wiley & Sons, Inc. (US), p. 2.

^[10] Brewer, Peter C., Gyan Chandra and Claiton A.Hock. 1999. "Economic Value Added (EVA): Its Uses and Limitations."SAM Advanced Management Journal (07497075) 64, no. 2, p. 5.