Economic Value Added - Formal Application to Business Finance
"Economic Value Added" is a term used to explainthe true economic profit generated by a company. Coined by Bennett Stewart, Economic Value Added (EVA®) statesthat "Net Operating Profit After Taxes" (NOPAT) doesn't tell the full story of true economic profit. NOPAT must also be adjusted for the opportunity cost of all capital invested in the company. Although somewhat complicated, EVA® accounts for factors such as cost of capital, amortization of goodwill, capitalization of brand identity, etc. to determinea true characterization of economic profit.
Economic Value Added - Important Concept in Personal Financial Plans
If we think this conceptthrough, Economic Value Added also applies to our personal financial statements. Simply calculating an annual, after-tax returnon our investments doesn't tell the whole story of our true financial position. There are certain costs of investment and other eroding factors that must be identified to obtaina true picture of our financial success.
Companies sometimes package annual figures in ways thatmake things look better than they really are. They use Generally Accepted Accounting Principles (GAAP) to report profit in the best light possible. Similar to reporting companies, we sometimes do the same thing with our personal finances. We analyze our return on investment in one place (ex., a qualified retirement plan), but we fail to account for the costs of capital in other areas of our financial lives (ex., interest paid on our cars).
Who are we hiding reality from - ourselves?
Regardless of the perception of investment success, the concept of "Economic Value Added" has an important impact on the true success of our overall financial plan. Cost erosion elements on the expense-side of the financial plan, including taxes, inflation, interest, transaction fees, insurance, and other lost opportunity costs, always impact the real return on your investments. Although we can package the numbers and percentages any way we want, not telling the truth to ourselves in our own financial planning makes absolutely no sense.
As Jesus said nearly 2,000 years ago... "The Truth will set you free!"