Two Financial Frameworks: Part 2 - EVA

EVA—Economic Value Added

In its simplest terms, EVA is a measurement of enterprise performance.  The model was created in 1993 by the consulting company Stern Stewart Management Services.  EVA is defined as, “a measure of a company's financial performance based on the residual wealth calculated by deducting cost of capital from its operating profit (adjusted for taxes on a cash basis).” ¹ EVA is also sometimes referred to as Economic Profit (EP). 

The EVA model is helpful in light of supply chain contribution as it comprehensively captures the causal drivers for financial performance and the interrelationship between these drivers.  Many of the operational tradeoffs in operating profit and invested capital become complex very quickly.  The EVA Model is a good tool to build a common framework and language for both financial and operational leaders in an organization.  

There are certain components that are important to the model but less applicable to our purposes related to supply chain.  The tax rate and WACC portions of the model are components excluded for our supply chain specific analysis. 

Here is a visual overview of the EVA Model:

There are distinctions between the EVA and ROA model that are important to highlight as they relate to operational performance and integration.  We will look at the differences between the models and why they are important in our next entry.

(1) http://www.investopedia.com/terms/e/eva.asp

Two Financial Frameworks: Part 1 - ROA

In an earlier entry we discussed the importance of A Supply Chain Finance Lingua Franca—a common language leading toward an integration of operational metrics and financial corporate performance.   This is possible through the linking of tools like SCOR, DuPont Model, and EVA in defining the ability for supply chain to be the strategic enabler of financial performance.  

Before we dive into the details of each of The Seven Prime Supply Chain Performance Metrics, it is important to have a working understanding of the broader context of financial performance models.   The intent is not to be cost accounting experts.  However, a fundamental understanding of basic business math is needed.  The good news is it is primarily simple addition and subtraction.  It gets a bit complicated with some division but no calculus required!  

Two models will be reviewed.

1. Return on Assets (ROA)
2. Economic Value Added (EVA)

ROA—Return on Assets

Return on Assets (ROA) looks at an organization’s profitability relative to its total asset base.  Also known as the DuPont Analysis Model, the ROA ratio was developed by F. Donaldson Brown, a financial executive at DuPont and General Motors.  The ROA model was originally designed to coordinate financial controls across the organization. ¹ ROA measures the combined effects of profit margins and asset turnover. ²

The ROA calculation looks like this:

Here is a visual depiction of the model and the related operational levers:

There is some debate over the finer points of this model as it relates to inclusions and relationships.  Some of these points are related to items like Return-on-Equity (ROE) and Return-on-Investment (ROI). As an example, is ROA the same as ROI?  That depends on various schools of thought.  It is good to be aware that there is not a uniform glossary of terms across financial models.  For our specific to supply chain purposes, we will leave those nuanced definitions out for now and focus on the model as it relates to building a common language for finance and operations professionals.  

Next, we will look at the Economic Value Added (EVA) model.  

(1) http://history.gmheritagecenter.com/wiki/index.php/Brown,_Donaldson

(2) Groppelli, Angelico A.; Ehsan Nikbakht (2000). Finance, 4th ed. Barron's