Economic Value Added (EVA) is a financial performance method, which measures the true economic profit of a company (Makelainen, 1998). True economic profit is the wealth, which remains to a company, after deduction of all expenses from the operating profit including the cost of capital. EVA measures a company’s performance in relation to shareholders’ or lenders’ rate of return, because it determines the amount at which a company’s earnings have exceeded or fallen short in relation to the required rate of return (Makelainen, 1998). EVA is determined by subtracting the cost of capital from a company’s net operating profit (earnings after tax). The formula of calculating EVA is as follows: Net operating profit – (Capital x Cost of capital) = EVA (economic profit). If a company has more than one source of capital, the weighted average cost of capital (WACC) is used to determine EVA (Makelainen, 1998).
There are numerous ways, concerned with increasing revenue, which company can use to increase EVA. It can be done through increasing the volume of sales, in order to increase the gross profit, and hence the net operating profit. A company can also increase its EVA by minimizing the operating expenses used to generate revenue. This would result an increase of net operating profit. In addition, a company can avoid utilizing a lot of capital in its operations that would cause the reduction of the cost of capital, hence allowing more EVA to be earned (How to Increase EVA, 2007).
The relationship between EVA and ratio analysis lies in measuring the company’s financial performance. Shareholders use EVA to determine if a company is profitable enough and whether it worth their investments. Lenders also use EVA to determine company’s ability to earn enough profit for covering its operating expenses as well as the cost of capital. Similarly, shareholders and lenders use financial analysis ratios to determine the profitability and credit worthiness of a company. These ratios include return on assets, return of sales, debt-to-equity, and current ratios among others. (Makelainen, 1998).