EVA – Economic Value Added
The financial management system refers to financial measures, policies, methods, and procedures that guide the strategy and operations of a firm. It subsumes such things as setting financial goals, developing long term strategic plans and short term profit plans, making capital investment and disinvestment decisions, measuring operating performance, determining incentive compensation, and communicating with investors. Companies often do not do these things in a unified, systematic, and cohesive manner. Corporate financial goals are defined in terms of earnings per share and return on net worth; individuals lines of business are assessed in terms of return on assets; capital investment is analyzed in terms of discounted cash flow; acquisitions are judged on the basis of contribution to earnings growth; department are evaluated with reference to budgeted cost or profit figures; incentive compensation schemes are based on arbitrarily determined targets; and investor communication is primarily in terms of earnings per share and divided policy.
It appears that a typical financial management system is hardly a system. Rather it’s a hodgepodge of rules, guidelines, and procedures that employs an array of frequently contradictory measures and objectives, that fosters confusion and conflict within an organization that focuses on performance variables that bear little ration to the value of a business and often leads smart managers to do dumb things. In many companies an obsolete financial management system confounds the search for value. These deficiencies call for an entirely different approach financial management and the EVA financial management system seems to be the answer.
The EVA financial management system is based on the premise that EVA provides a single, unified, and accurate measure of performance. It thinks well forward looking valuation and capital budgeting analysis with actual performance measurement. For these reasons and more EVA may be used for goal setting and business planning, performance evaluation, bonus determination, investor communication, capital budgeting ands valuation.
EVA is an excellent bed rock on which an integrated financial management system can be constructed as it has the following features or characteristics:
1. It is a performance measure that ties directly, theoretically as well as empirically, to shareholders wealth creation.
2. It converts accounting information into economic reality that is readily grasped by non-financial managers. It is a simple yet effective way of teaching business literacy to everyone.
3. It serves as a guide to every decision from strategic planning to capital budgeting acquisitions to operating decisions.
4. As the basis for inventive compensation, it truly aligns the interest of managers with that of shareholders and makes management think and act like owners.
5. It is an effective tool for investor communication.
6. It serves as an anchor for an internal system of corporate governance that motivates everyone to work co-operatively and enthusiastically to achieve the best attainable performance.
EVA and incentive compensation:
The purpose of an incentive compensation plan (bonus plan) is to motivate employees to work harder and smarter so that the organizational performance is maximized. Unfortunately, the incentive compensation plans used by most companies fail to accomplish these objectives. These plans induce managers to be more conservative than the shareholders; they diminish incentive and motivation by paying too little for outstanding performance or too much for inferior performance they encourage managers to negotiate easily achievable targets, by gaming the system finally they give managers an additional incentive to lower performance when there are signs that the actual performance may turn out to be significantly higher than the un-ambitious targets.
The centerpiece of the EVA financial management system is a unique bonus plan that overcomes these limitations and aligns the interest of managers with shareholders. The key elements of the EVA bonus plan are:
1. Bonus is linked to increase in EVA
2. There is no floor or ceiling on the bonus
3. The target bonus is generous
4. A bonus bank is established