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Engineering Economics
Professor António Quintino & Cândido Peres
Created Based on Prof. Isabel Pedro’s Materials
Engineering Economics
3. Planning and Financial Analysis
3. Planning and Financial Analysis
4
3.1 Working with Financial Statements
3.2 Ratio analysis
5
DR(NATUREZA)-IncomeStatementbyNatureVendas e serviços prestados Sales and services
Outros rendimentos e ganhos operacionais Other operating income
Variação nos inventários de produtos acabados e em curso Variation in inventories of finished goods and in progress
Outros rendimentos e ganhos financeiros Other income and financial gains
Total de rendimentos e ganhos (A) Total income and gains (A)
Custo das merc. vendidas e mat. consumidas Cost of goods sold and materials consumed
Fornecimentos e serviços externos Supplies and services
Gastos com o pessoal wages costs
Gastos de depreciação e de amortização Depreciation and amortization costs
Provisões e perdas por imparidade e suas reversões (em
ativos fixos, inventários, clientes)Provisions and impairment losses and their reversals (in
fixed assets, inventories, customers)
Outros gastos e perdas operacionais Other operating costs and losses
Juros e outros gastos e perdas financeiros Interest and other financial costs and losses
Total de gastos e perdas (B) Total costs and losses (B)
Resultado antes de impostos (A) - (B) Earnings before tax (A) - (B)
Imposto sobre o rendimento Tax
Resultado líquido do período Earnings after tax (net profit)
3.1 Working with Financial Statements
6
3.1 Working with Financial Statements
Balanço - Balance SheetACTIVO – ASSETS CAPITAL PRÓPRIO - SHAREHOLDERS’ EQUITY
Activo não corrente – Non current Assets Capital– Capital
Investimentos Financeiros - Financial Investments Reservas legais - Legal reserves
Activos fixos tangíveis –Tangible Fixed Assets Resultados transitados – Retained Earnings
Activos fixos intangíveis – Intangible Fixed Assets Resultado líquido do período – Net profit
Activo corrente – Current Assets PASSIVO – LIABILITIES
Inventários - Inventory Passivo não corrente – Non current Liabilities
Clientes – Accounts Receivable Provisões – Long term Provisions
Estado e outros entes públicos – State and other public bodies Financiamentos obtidos – Long-term debt (bank loans and bonds)
Outras contas a receber - Other current assets Outras contas a pagar – Other non current liabilities
Diferimentos - Deferrals Passivo corrente – Current Liabilities
Caixa e depósitos bancários – Cash and Bank Deposits Fornecedores - Suppliers
Estado e outros entes públicos – State and other public bodies
Financiamentos obtidos – Short-term debt (bank loans and bonds)
Outras contas a pagar – Other current liabilities
Diferimentos - Deferrals
• As a relationship between two quantities, they provide more adequate information than
indicators in absolute value / Monetary units (eg EBITDA or EBIT);
• They are essentially ways of summarizing financial data and comparing companies'
performance;
• They help to ask the right questions but by themselves they don't provide the answers;
• Similar Ratios can translate into different situations: 2 companies with 40 equal Ratios will
hardly be equal.
• May lead to false comparability (different accounting practices / policies);
Some preliminary questions about financial ratios
7
3.1 Working with Financial Statements
1st Step
Conversion of Financial Statements
In a first phase, the Income Statement by Nature, originating from the Financial Accounting,
must be reconverted into a simplified one, identifying variable and fixed expenses, payable and
non-payable.
8
3.1 Working with Financial Statements
Sales
Variable expenses
Gross Margin (Contribution Margin)
Disbursable Fixed Expenses
EBITDA
Non-Disbursable Fixed Expenses
Operating Income (EBIT)
Financing Financial Expenses
Earnings Before Taxes (EBT)
Income tax
Net Income (Net Income)
9
3.1 Working with Financial Statements
2nd Step
Identification of types of results and their impacts
The indicators to be analyzed must be selected depending on the
variable to be tested.
10
3.1 Working with Financial Statements
3rd Step
Selection of the means used to build the indicators
You have to choose between accounting and non-accounting
information.
11
3.1 Working with Financial Statements
Engineering Economics
3.2 Ratio analysis
13
3.2 Ratio analysis
•Ratio analysis compares line-item data from a company's financial
statements to reveal insights regarding profitability, liquidity,
operational efficiency, and solvency.
•Ratio analysis can mark how a company is performing over time, while
comparing a company to another within the same industry or sector.
•While ratios offer useful insight into a company, they should be paired
with other metrics, to obtain a broader picture of a company's financial
health.
Types of Ratios
• Financial Ratios - appreciate the balance of the balance sheet assets
Exp.: Financial Autonomy = Equity / Assets
• Economic Ratios - assess the company's profitability through the relationship betweenelements of the Income Statement
Exp.: Net return on sales = Net Profit / Sales
• Economic-Financial Ratios – analyze economic-financial relationships, integrating thevalues of the Income Statement and the balance sheet
Exp.: Return on Equity = ROE = Net Profit / Equity
• Technical Ratios - depict aspects related to the company's production and general activity
Exp.: Productivity per worker = Quantity produced/No. of workers
14
3.2 Ratio analysis
Types of Ratios
(According to Brealey and Myers – Chapter 27 – Corporate Finance)
Indebtedness ratios – essentially medium / long term perspective;
Liquidity ratios – essentially short-term ratios, seek to assess the repayment capacity of
short-term liabilities;
Profitability or efficiency ratios – assessment of the level of efficiency in the management
of resources used;
Market value ratios – incorporate external elements (eg PER, EPS, Dividend Yield)
15
3.2 Ratio analysis
It relates two magnitudes, one economic or financial
and the other patrimonial, associated with the
concepts of return and evaluation of efficiency or
performance.
It uses, as basic elements, the income statements
combined with other accounting and extra-accounting
elements
Since it is a ratio, it should be interpreted not in
isolation but by comparison with theoretical standards,
between periods and companies, in relation to the
sector, against the expectations of investors, etc...
Results obtained
Means Used
16
3.2 Ratio analysis
17
3.2 Ratio analysis
1.Price/Earnings or PE Ratio = Price per share / Earnings per share (EPS)
2.Earnings per Share (EPS) = Net Profit (Earnings) / total number of shares outstanding in the market
3.Cash Earnings per Share (CEPS) = Net Profit + Non-cash items / outstanding shares in the market.
4.Book Value per Share = (Shareholder’s Equity – Preference stock) / Outstanding numbers of shares.
5.Market Value per Share = Market Capitalization / Outstanding shares in the market.
6.Dividend Yield= Total dividend paid in a year / Number of shares outstanding.
7.Market to Book ratio = Price of one share / Book value of one share
8.Market Value Added = Market Capitalization – Equity Value of the Company
Market Value ratios – only for public companies
Profitability - Economic Vs Financial
Economic profitability
Indifferent to the capital structure and its costs - it does not separate equity from others,
remunerated from unremunerated, etc...
E.g.: ROA, NP%, EBIT%, etc...
Financial profitability
Directly influenced by the structure and costs of capital – there is a clear separation of capital as a
function of its origin and the calculation is influenced by the financial costs of financing.
E.g.: ROE, ROCE, etc...
18
3.2 Ratio analysis
3.2 Ratio analysis
19
Net profit margin =Net profit
Net sales
Return on assets (ROA) =Net Income
Total assets
Operating profit margin or Return on Sales =Operating Income
Net Sales
Return on equity (ROE) =Net income
Average Shareholders Equity
Profitability Ratios
Return on Capital Employed (ROCE) =EBIT
Total assets
3.2 Ratio analysis
20
Vendas e Prestação de serviços – Sales and services rendered 14,367,563
Custo das vendas e prestação de serviços – Cost of sales and
services provided
- 6,667,327
RESULTADOS BRUTOS – GROSS INCOME 7,700,236
Out. Rendimentos Operacionais – Other operating income and gains 31,993
Gastos de distribuição – Distribution Costs -3,267,384
Gastos administrativos – Administrative Expenses -3,285,128
Out. Gastos Operacionais – Other operating costs and losses -771,205
RESULTADOS OPERACIONAIS – OPERATING INCOME – EBIT –
EARNINGS BEFORE INTEREST AND TAXES 408,512
Juros e rendimentos similares obtidos - Interest revenues 50,000
Juros e gastos similares pagos – Interest paid -108,249
RES. ANTES DE IMPOSTOS – EBT – EARNINGS BEFORE TAXES 350,263
Imposto sobre o rend. do período - Taxes -120,754
RESULTADO LÍQ. DO PERÍODO – NET PROFIT/LOSS 229,510
Rendibilidade operacional vendas (Return on Sales)= EBIT / Sales and services rendered= 408,512/14,367,563 = 2.8%
Rendibilidade líquida vendas (Net profit margin)= Net Profit / Sales and servicesrendered= 229,510/14,367,563 = 1.6%
3.2 Ratio analysis
21
Sales and services rendered 14,367,563
Cost of sales and services provided - 6,667,327
GROSS INCOME 7,700,236
Other operating income and gains 31,993
Distribution Costs -3,267,384
Administrative Expenses -3,285,128
Other operating costs and losses -771,205
OPERATING INCOME – EBIT – EARNINGS BEFORE
INTEREST AND TAXES
408,512
Juros e rendimentos similares obtidos - Interest revenues 50,000
Juros e gastos similares pagos – Interest paid -108,249
EBT – EARNINGS BEFORE TAXES 350,263
Taxes -120,754
NET PROFIT/LOSS 229,510
ASSETS SHAREHOLDERS’ EQUITY
NON CURRENT ASSETS Capital 650,000
Financial investments 998 Legal reserves 13,145
Tangible Fixed assets 1,752,356 Other reserves 1,206,578
Intangible fixed assets 113,445 Retained earnings -72,980
CURRENT ASSETS Net profit 229,510
Inventory 1,747,280 TOTAL EQUITY 2,026,253
Accounts Receivable 3,575,620 LIABILITIES
Marketable securities 102,815 NONCURRENT LIABILITIES
Deferrals 60,279 Long term Provisions 0
Cash and bank deposits 720,444 Debt
MLT 1,739,790
CURRENT LIABILITIES
ST – Suppliers 2,055,897
ST – Other current liabilities 1,702,536
Deferrals 548,761
TOTAL LIABILITIES 6,046,984
TOTAL ASSETS 8,073,237 TOTAL LIABILITIES + EQUITY 8,073,237
%3.11Próprios Capitais
Líquidos ResultadosPróprios Capitais dos adeRentabilid ==
Return on equity (ROE) =Net profit
Equity=11.3%
3.2 Ratio analysis
22
Liquidity Ratios
Quick ratio =cash + marketable securities+ receivables
current liabilities
Cash ratio =cash + marketable securities
current liabilities
Current ratio =current assets
current liabilities
Net working capital = Current assets - Current liabilities
Current Ratio
Assesses the ability to meet short-term commitments
Advantage over working capital given that it is a relative and not an absolute value
Limitations - it is a "static" indicator, it must be completed with others (e.g. average terms - that
assess the degree of liquidity and enforceability)
Minimum financial balance rule
CR ≥ 1
2 companies with the same CR will be quite different depending on the composition of their short-term assets and liabilities
23
Current ratio =current assets
current liabilities
3.2 Ratio analysis
3.2 Ratio analysis
24
Inventário/Inventory 1,747,280
Clientes/Receivables 3,575,620
Caixa/Cash 823,259
Activo Corrente/Current assets 6,146,159
Fornecedores/Short-term debt 2,055,897
Out. Dívidas CP/Other current liabilities 1,702,536
Passivo Corrente/Current liabilities 3,758,433
Fundo de Maneio/Net working capital 2,387,726
ASSETS SHAREHOLDERS’ EQUITY
NON CURRENT ASSETS Capital 650,000
Financial investments 998 Legal reserves 13,145
Tangible Fixed assets 1,752,356 Other reserves 1,206,578
Intangible fixed assets 113,445 Retained earnings -72,980
CURRENT ASSETS Net profit 229,510
Inventory 1,747,280 TOTAL EQUITY 2,026,253
Accounts Receivable 3,575,620 LIABILITIES
Marketable securities 102,815 NONCURRENT LIABILITIES
Deferrals 60,279 Long term Provisions 0
Cash and bank deposits 720,444 Debt
MLT 1,739,790
CURRENT LIABILITIES
ST – Suppliers 2,055,897
ST – Other current liabilities 1,702,536
Deferrals 548,761
TOTAL LIABILITIES 6,046,984
TOTAL ASSETS 8,073,237 TOTAL LIABILITIES + EQUITY 8,073,237
3.2 Ratio analysis
25
ASSETS SHAREHOLDERS’ EQUITY
NON CURRENT ASSETS Capital 650,000
Financial investments 998 Legal reserves 13,145
Tangible Fixed assets 1,752,356 Other reserves 1,206,578
Intangible fixed assets 113,445 Retained earnings -72,980
CURRENT ASSETS Net profit 229,510
Inventory 1,747,280 TOTAL EQUITY 2,026,253
Accounts Receivable 3,575,620 LIABILITIES
Marketable securities 102,815 NONCURRENT LIABILITIES
Deferrals 60,279 Long term Provisions 0
Cash and bank deposits 720,444 Debt
MLT 1,739,790
CURRENT LIABILITIES
ST – Suppliers 2,055,897
ST – Other current liabilities 1,702,536
Deferrals 548,761
TOTAL LIABILITIES 6,046,984
TOTAL ASSETS 8,073,237 TOTAL LIABILITIES + EQUITY 8,073,237
Activo corrente
(Current Assets)6,146,159
Passivo corrente
(Current liabilities)3,758,433
Liquidez Geral (Current ratio) 1.6
Activo corrente – Inventário
(Current Assets – Inventory)4,398,879
Passivo corrente 3,758,433
Liquidez Reduzida (Acid test) 1.2
Activo corrente – Inventário –
Clientes (Current Assets –
Inventory – Receivables)
823,259
Passivo corrente (Current
Liabilities)3,758,433
Liquidez Imediata (Cash ratio) 0.2
Financial autonomy =
Solvency =
Equity
Total Assets
Equity
Debt
Financial Balance (Medium and Long Term):
Identifies the level of commitment of the partners in the organization
Observe the relationship between the partners' capital and the level of indebtedness
26
3.2 Ratio analysis
100% Equity
▪ Exposure to operational risks only;
▪ Maximum flexibility;
▪ Stability;
Debt
▪ Reduction of the tax burden;
▪ Fixed costs, then financial risk (default and possible
bankruptcy);
▪ Potentially, more profitability for shareholders (if
contracted at rates lower than the return on invested
capital – financial leverage);
It is not enough to have growth opportunities:
It is also necessary for growth to create value…
… and that is financed in a way that creates (at least, not destroys) value;
27
3.2 Ratio analysis
3.2 Ratio analysis
28
Leverage Ratios
Total debt ratio =Total Liabilities
Total Assets
Long- term debt ratio =Long - term Debt
Total Assets
Debt to equity =Liabilities or (Long term debt + Values of Leases)
Average Shareholders Equity
Times interest earned ratio =EBIT
Anual Interest Expense
3.2 Ratio analysis
29
ASSETS SHAREHOLDERS’ EQUITY
NON CURRENT ASSETS Capital 650,000
Financial investments 998 Legal reserves 13,145
Tangible Fixed assets 1,752,356 Other reserves 1,206,578
Intangible fixed assets 113,445 Retained earnings -72,980
CURRENT ASSETS Net profit 229,510
Inventory 1,747,280 TOTAL EQUITY 2,026,253
Accounts Receivable 3,575,620 LIABILITIES
Marketable securities 102,815 NONCURRENT LIABILITIES
Deferrals 60,279 Long term Provisions 0
Cash and bank deposits 720,444 Debt
MLT 1,739,790
CURRENT LIABILITIES
ST – Suppliers 2,055,897
ST – Other current liabilities 1,702,536
Deferrals 548,761
TOTAL LIABILITIES 6,046,984
TOTAL ASSETS 8,073,237 TOTAL LIABILITIES + EQUITY 8,073,237
Rácio de endividamento (total debt ratio)
= Total Liabilities / Total Assets
= 6,046,984 / 8,073,237 =75%
Debt to equity ratio
= Total Liabilities / Equity
= 6,046,984 / 2,026,253
= 2.98
3.2 Ratio analysis
30
Efficiency Ratios
Asset turnover ratio =Net Sales
Total assetsProductivity =
Gross Added Value
Number of workers
Inventory turnover ratio =Cost of goods sold
Average Inventory
Average Collection Period =Receivables
Net Sales*12
Average Payment Period =Accounts Payable
Purchases*12
3.2 Ratio analysis
31
Sales and services rendered 14,367,563
Cost of sales and services provided - 6,667,327
GROSS INCOME 7,700,236
Other operating income and gains 31,993
Distribution Costs -3,267,384
Administrative Expenses -3,285,128
Other operating costs and losses -771,205
OPERATING INCOME – EBIT – EARNINGS BEFORE
INTEREST AND TAXES
408,512
Juros e rendimentos similares obtidos - Interest revenues 50,000
Juros e gastos similares pagos – Interest paid -108,249
EBT – EARNINGS BEFORE TAXES 350,263
Taxes -120,754
NET PROFIT/LOSS 229,510
ASSETS SHAREHOLDERS’ EQUITY
NON CURRENT ASSETS Capital 650,000
Financial investments 998 Legal reserves 13,145
Tangible Fixed assets 1,752,356 Other reserves 1,206,578
Intangible fixed assets 113,445 Retained earnings -72,980
CURRENT ASSETS Net profit 229,510
Inventory 1,747,280 TOTAL EQUITY 2,026,253
Accounts Receivable 3,575,620 LIABILITIES
Marketable securities 102,815 NONCURRENT LIABILITIES
Deferrals 60,279 Long term Provisions 0
Cash and bank deposits 720,444 Debt
MLT 1,739,790
CURRENT LIABILITIES
ST – Suppliers 2,055,897
ST – Other current liabilities 1,702,536
Deferrals 548,761
TOTAL LIABILITIES 6,046,984
TOTAL ASSETS 8,073,237 TOTAL LIABILITIES + EQUITY 8,073,237
Clientes/Receivables 3,575,620
Vendas/Sales 14,367,563
Prazo Médio de Recebimento (em dias)
Average Collection Period (number of days)90.8
Custos de vendas/Cost of goods sold 6,667,327
Inventário/Inventory 1,747,280
Rotação de Stocks/ Inventory turnover ratio 3.8
∆ média ∆ médiaACTIVO
Activo não corrente -27% 51% -7% 34%
Activo corrente -29% 49% -20% 66%
Total do activo -28% 100% -15% 100%
CAPITAL PRÓPRIO E PASSIVO
Total do capital próprio -59% 25% -2% 31%
Passivo
Passivo não corrente 27% 25% -12% 18%
Passivo corrente -31% 50% -24% 52%
Total do Passivo -14% 75% -21% 69%
Total do capital próprio e do passivo -28% 100% -15% 100%
SectorEmpresa
32
3.2 Ratio analysis
Company Sector
AssetsNon Current AssetsCurrent Assets
Total Assets
EquityTotal Equity
DebtNon Current DebtCurrent Debt
Total DebtTotal Equity and Debt
33
3.2 Ratio analysis
Accounts Payable Weight
Cash and Equivalents WeightCompany
Company
Traditional Ratio Analysis
Aceitavel Ideal
Autonomia Financeira ≥ 25% ≥ 33%
Solvabilidade ≥ 33% ≥ 50%
Liquidez Geral ≥ 1,3 ≥ 2
Empresa
Autonomia Financeira 25%
Solvabilidade 51%
Liquidez Geral 0,98
Sector
31%
59%
1,2834
3.2 Ratio analysis
Financial AutonomySolvencyCurrent Ratio
Financial AutonomySolvencyCurrent Ratio
Aceptable Ideal
Company
Multivariate Discriminant Analysis
Carvalho das Neves (2012) Model
Score= -0,950+2,518X1+1,076X2+5,566X3-0,00254X4+0,156X5
Ponto de Corte: Score≥0,3735
3.2 Ratio analysis
X1 = Retain Results / Total Assets
X2 = Current Assets / Total Assets
X3 = Cashflow / Total Assets
X4 = State and Other Public Bodies Liquid / Sales * 365
X5 = Financial Debt / Current Assets
Separation point
Previsão de Falência Empresarial
– O Modelo de Carvalho das Neves (2012)
2010 2011 2012 2013 média
Sector NF NF NF NF NF
Empresa F F F F F
36
3.2 Ratio analysis
Multivariate Discriminant Analysis
Altman (2002) Model
37
3.2 Ratio analysis
X1 = Working Capital / Total Assets
X2 = Retain Results / Total Assets
X3 = Earnings Before Tax / Total Assets
X4 = Equity / Total Debt
Separation point: Score = 0
Z’’ = 3,25 + 6,56X1+ 3,26X2 + 6,72X3 + 1,05X4
38
3.2 Ratio analysis
Combining the ratios into a single score can separate the creditworthy firms from thestruggling firms, in terms of default probability.
For example, William Beaver, Maureen McNichols, and Jung-Wu Rhie, concluded thatthe chance of failing their financial compromises (i.e., defaulting) during the next yearrelative to the chance of not failing was reasonably good estimated by the followingequation:
Log (L, relative chance of failure)
= −6.445 − 1.192 ROA + 2.307 Liabilities/Assets − 0.346 EBITDA/Liabilities
Relative chance of failure = 𝑒L
39
3.2 Ratio analysisScore
(Z'')
Rating
(S&P)
Rating
(Moodys)
Rating
(Finch)
8,15 AAA Aaa AAA Prime
7,60 AA+ Aa1 AA+
High Grade7,30 AA Aa2 AA
7,00 AA- Aa3 AA-
6,85 A+ A1 A+Upper Medium
Grade6,65 A A2 A
6,40 A- A3 A-
6,25 BBB+ Baa1 BBB+Lower Medium
Grade5,85 BBB Baa2 BBB
5,65 BBB- Baa3 BBB-
5,25 BB+ Ba1 BB+Non-Investment
Grade speculative4,95 BB Ba2 BB
4,75 BB- Ba3 BB-
4,50 B+ B1 B+
High speculative4,15 B B2 B
3,75 B- B3 B-
3,20 CCC+ Caa1 CCC Substantial Risk
2,50CCC Caa2
Extremely
Speculative
1,75
CCC- Caa3 Default Iminente
with little prospect
of recoveryCC
CaCC
C C
0,00 D C D in Default
For each of these scoring grades, each rating company associates a proprietary default probability.
Source: Brealey & Myers 40
Shareholder value also depends on good financing decisions. Again, there are obvious questions: Is theavailable financing sufficient? The firm cannot grow unless financing is available. Is the financing strategyprudent? The financial manager should not put the firm’s assets and operations at risk by operating at adangerously high debt ratio. Does the firm have sufficient liquidity?
3.3 Economic Value Added (EVA)
EVA→ is concerned in measuring shareholder value.
As EVA is a composite and plural indicator, it is at the top of the pyramid of economic-financial
analysis logic.
Registered trademark of Stern Stewart & Co., for many, is nothing more than the rename of an
old concept – The Residual Result.
One of the first references is due to Alfred Marshall in 1890 who defined it as “what is left of the
profits after deducting the interest on its capital at the rate in force...”.
41
3.3 Economic Value Added (EVA)
When accountants draw up an income statement, they start with revenues and thendeduct operating and other costs. But one important cost is not included: the cost ofthe capital that the company has raised from investors.
Therefore, to see whether the firm has truly created value, we need to measurewhether it has earned a profit after deducting all costs, including its cost of capital.
The cost of capital is the minimum acceptable rate of return on capital investment. It isan opportunity cost of capital, because it equals the expected rate of return-on-investment opportunities open to investors in financial markets.
The firm creates value for investors only if it can earn more than its cost of capital, thatis, more than its investors can earn by investing on their own.
The profit after deducting all costs, including the cost of capital, is called the company’seconomic value added or EVA.
42
3.3 Economic Value Added (EVA)
Source: Brealey & Myers
To compute EVA, adjustments must be made; accounting standards distort the concept of true
economic and financial performance.
Stern Stewart & Co. has identified more than 160 fixes. Several authors, who consider that most of
them aren’t relevant or only have a marginal effect.
Typically 10 to 15 adjustments are made.
The most common concern:
• Goodwill
• Adjustments (provisions)
• Operating leasing transactions Meaningless with IFRS 16
• Deferred taxes
• Research and development expenses
• Valuation criteria (LIFO) Meaningless with the SNC
43
3.3 Economic Value Added (EVA)
EVA = NOPAT – Capital Charge = EBIT * (1-t) – Capital Charge
• NOPAT = Net Operating Profit After Taxes = EBIT*(1-t) = NOP + Interest*(1-t)
• EBIT= Earnings Before Interest and Taxes
• Capital Charge = Invested Capital * k = (Equity + Long Term debt) * k
• k – Funding rate of the Invested Capital (WACC); t = corporate tax rate
→ Different rates according to the nature of the invested capital and its risk
→ Differentiated rates according to the operational risk of the business units
→Is there a debt or not? And if so how much?
Usually, k=WACC, Weighted average cost of capital (to be explained later)
EVA measures how many dollars a business is earning after deducting the
cost of capital.44
3.3 Economic Value Added (EVA)
EVA = EBIT*(1-t) – Capital Charge
Another way to write EVA is:
The return on capital (or ROC) is equal to the total profits that the company has
earned (NOPAT) divided by the amount of money that they have contributed (Equity
+ Long Term Debt). If the company earns a higher return on its capital than
investors require, EVA is positive.
Other things equal, the more assets the manager has to work with, the greater the
opportunity to generate a large EVA.45
3.3 Economic Value Added (EVA)
Source: Brealey & Myers
= EBIT*(1-t)
• The company has had an excellent operational performance. In relation to absolute values;
Positive EVA variationbetween two periods
• Indicates that although value creation is taking place, the investorshould pay attention to the actions carried out by the investee andverify the causes that led to a decrease in performance;
Positive EVA but withnegative evolution
• there is a destruction of value and indicates that there was an effortby the company to recover and create wealth;
Negative EVA but withpositive evolution
• indicates that a destruction of wealth has occurred. The investor must analyze what strategies and actions are being adopted by thecompany to reverse the situation.
Negative EVA withnegative evolution
46
3.3 Economic Value Added (EVA)
47
3.3 Economic Value Added (EVA)
Accounting measures of company performance, June 2013 (dollar values in millions). Companies are ranked by economic value added (EVA)
Source: Brealey & Myers
If the company earns a lower return on its capital(ROC) than investors require (WACC), EVA is negative.
48
3.3 Economic Value Added (EVA)
Source: Brealey & Myers
Limitations of Rate of Return and Economic Value Added (EVA):
• Rate of return and economic value are based on book (balance sheet) values for
assets. Debt and equity are also book values, so often they not reflect the market
value of the company.
• Investment over the years is not shown on the balance sheet and cannot be
measured exactly.
• Balance sheet does not show the current market values of the firm’s assets. Older
assets may be grossly undervalued in today’s market conditions and prices.
• A high return on assets indicates that the business has performed well by making
profitable investments in the past, but it does not necessarily mean that you could
buy the same assets today at their reported book values.
• Conversely a low return suggests some poor decisions in the past, but it does not
always mean that today the assets could be employed better elsewhere.
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