Here are two additional ways you can assess an organization’s financial health:
- Economic value added (EVA)
- Productivity measures
Economic value added (EVA)
Economic value added (EVA) was introduced as a way to induce employees to think like shareholders and owners. It’s the profit left over after the company has met the cost of capital—that is, after it pays wages to employees, interest to lenders, and a return to shareholders. A positive EVA amount shows that the company is in fact producing an economic profit.
Economic value added (EVA) is also a measure of a company’s financial performance based on the residual wealth calculated by deducting its cost of capital from its operating profit, adjusted for taxes on a cash basis. EVA can also be referred to as economic profit, as it attempts to capture the true economic profit of a company. This measure was devised by management consulting firm Stern Value Management, originally incorporated as Stern Stewart and Co.
The goal of EVA is to quantify the charge, or cost, of investing capital into a certain project or firm and to then assess whether it generates enough cash to be considered a good investment. The charge represents the minimum return that investors require to make their investment worthwhile. A positive EVA shows a project is generating returns in excess of the required minimum return.
Productivity measures include sales per employee and net income per employee. These measures link revenue and profit generation information to workforce data. In so doing, they help you assess employees’ effectiveness in producing sales and income. Some analysts classify these measures as operating ratios.
The operating ratio shows the efficiency of a company’s management by comparing operating expense to net sales. The smaller the ratio, the greater the organization’s ability to generate profit if revenues decrease. When using this ratio, however, investors should be aware that it doesn’t take debt repayment or expansion into account.
Operating Ratio Calculation
The operating ratio is calculated by dividing operating expenses by net sales. Operating expenses are essentially all expenses except taxes and interest payments. Occasionally, a company has non-operating expenses as well, which are also deducted. All of these line items are listed on the income statement. Companies must clearly state which expenses are operational and which are designated for other uses.
Points of Consideration
It is important to compare the operating ratio with other firms in the same industry. If a company has a higher operating ratio than its peer average, it may indicate inefficiency, and vice versa. That said, some companies have taken on a great deal of debt, meaning they are committed to paying large interest payments which are not included in the operating expenses figure of the operating ratio. Two companies can have the same operating ratio with vastly different debt levels, so it is important to compare debt ratios before coming to any conclusions. Finally, as with all ratios, it should be used as part of a full ratio analysis, rather than in isolation.
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