FREE online courses on Financial Management and Creating Value - Chapter 3 -
EVA Adjustments
When we calculate EVA, we need to calculate the cash
equivalent of income (NOPAT) and the cash equivalent equity that has been
invested in the business (adjusted capital). This requires that we remove many
of the accounting distortions that have blurred cash flow. In his book Quest for
Value, Bennett refers to these adjustments as "equity equivalents" so that we
can restate book values to economic values. When the market value of an
organization exceeds the economic value of the organization, this is Market
Value Added (MVA).
In order to calculate NOPAT, we will add back to income
current year's equity equivalents that have distorted cash flows. Cumulative
equity equivalents will be added back in arriving at adjusted capital. In Quest
for Value, Bennett describes the ollowing equity equivalent adjustments:
- Deferred Taxes: The Income Statement reflects tax
expenses which may or may not be paid. The difference between what has been
expensed and what has paid is called deferred taxes. By adding deferred taxes
back to capital, we reverse out the distortion for taxes not paid. An increase
to deferred taxes in the current year would be added back to income in arriving
at NOPAT (Net Operating Profits After Taxes).
- LIFO Reserve: LIFO (Last In First Out) is used to
price inventories on the Balance Sheet. Under LIFO, investments in inventory
are subject to understatement. A LIFO Reserve Account captures the difference
between LIFO and FIFO (First In First Out). This amount is added back to
capital since we want to reflect the total amount of capital invested. An
increase to the LIFO Reserve in the current year would be added back in
arriving at NOPAT.
- Amortization of Goodwill: Non-cash expenditures
such as goodwill will distort capital deployed. We are trying to measure the
cash return on all cash invested into the business. Therefore, we would add
back the total amount amortized for goodwill in arriving at capital and we
would add back the current year's amortization in arriving at NOPAT.
- Capitalized Intangibles: Intangibles such as
Research & Development expenditures provide a long-term economic benefit. These
transactions are capitalized under EVA as opposed to expensing the entire
amount within traditional accounting. The original R & D expense is reversed
out and replaced with a Net Capitalized Intangible (NCI). The total amount for
R & D less the amount amortized is the NCI and this represents an adjustment to
capital. The amount amortized in the current year would be adjusted to earnings
in arriving at NOPAT.
- Other Reserves and Allowances: Besides the LIFO
Reserve, we may have material amounts related to other types of reserves and
allowances. Examples include Reserve for Inventory Obsolescence and Allowance
for Doubtful Accounts. These accounting transactions would be treated similarly
to the LIFO Reserve.
In summary, we are trying to arrive at earnings that are
close to cash and compare this return to a capital base that is expressed in
cash equivalent terms. This means that we recognize economic values, such as
expenditures that provide long-term benefits and reverse out non-cash entries as
well as reserve account balances. Also, we must express the asset base (capital)
in terms of replacement capital. This requires removing distortions like
goodwill write offs, asset write offs, and highly depreciable fixed assets that
have a carrying (book) value substantially different than market or replacement
values. In Quest for Value, Bennett summarizes the following adjustments:
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Adjustments Required to Calculate NOPAT:
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Adjustments Required to Calculate Capital:
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+ Increase to Deferred Taxes
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+ Deferred Taxes
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+ Increase to LIFO Reserve
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+ LIFO Reserve
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+ Goodwill Amortized in Current
Year
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+ Total Goodwill Amortized to
Date
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+ Increase to Net Capitalized
Intangibles
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+ Net Capitalized Intangibles
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+/- Unusual Loss or (Gains) net
of tax
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+/- Cumulative Loss or (Gain) net
of tax
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+ Increase to Other Reserves &
Allowances
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+ Other Reserves & Allowances
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A complete example of how to calculate EVA is included as an
Appendix to this Chapter. You may want to review the Appendix before proceeding
to the next section in this course.
