Value Added – Concept, Definition and Uses

Meaning and Definitions of Value Added

The traditional basic financial statements are balance sheet and Profit & Loss account. These statements generate and provide data related to financial performance only. They do not provide any information which shows the extent of the value or the wealth created by the company for a particular period. Hence, there arose a need to modify the existing accounting and financial reporting system so that the business unit is able to give importance to judge its performance by indicating the value or wealth created by it. To this direction inclusion of Value Added statement in financial reporting system is useful. The Value Added concept is now a recognized part of the accountant’s repertoire.

However, the concept of Value Added (VA) is not new. Value Added is a basic and broad measure of performance of an  enterprise. It is a basic measure because it indicates the net output produced or wealth created by an enterprise. The Value Added of an enterprise may be described as the difference between the revenues received from the sale of its output, and the costs which are incurred in producing the output after making necessary stock adjustments.

Some definitions of Value Added are following;

  • E.S.Hendriksen has defined Value-added as: “The market price of the output of an enterprise less the price of the goods and services acquired by transfer from other firms.”
  • Morely has defined Value-added as:”The value, which the entity has added in a period that equals its sales less bought-in-goods and services.” i.e.
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Market Value Added (MVA)

Economic Value Added (EVA) is aimed to be a measure of the wealth of shareholders. According to this theory, earning a return greater than the cost of capital increase value of company while earning less than the cost of capital decreases the value. For listed companies, Stewart defined another measure that assesses if the company has created shareholder value or not. If the total market value of a company is more than the amount of capital invested in it, the company has managed to create shareholder value. However, if market value is less than capital invested, the company has destroyed shareholder value. The difference between the company’s market value and book value is called Market Valued Added or MVA.

From an investor’s point of view, Market Value Added (MVA) is the best final measure of a Company’s performance. Stewart states that MVA is a cumulative measure of corporate performance and that it represents the stock market’s assessment from a particular time onwards of the net present value of all a Company’s past and projected capital projects. MVA is calculated at a given moment, but in order to assess performance over time, the difference or change in MVA from one date to the next can be determined to see whether value has been created or destroyed.

The Market Value Added (MVA) measure is based on the assumption that the total market value of a firm is the sum of the market value of its equity and the market value of its debt.… Read the rest

Economic Value Added (EVA) and Shareholders Value Maximization

Almost in all books on financial management, the very first chapter introduces the fact that the goal of financial decisions is to maximize shareholder’s value. But why only shareholder’s value and what about others stakeholders like employees, customers, creditors? If one focuses on the shareholder value creation other stakeholder’s interests will automatically become the sub-goals and achieving these sub goals becomes crucial to the achievement of the overall goal i.e. shareholder value maximization. For example, the firm’s profit depends a lot on how the employees perform and to motivate them the firm needs to satisfy their needs and constantly upgrade their knowledge and skills by proper training. Similarly the firm would be required to pay its creditors on time so that they keep providing them credit whenever needed in the future and the credit availability does not hamper the operations of the firm. So a firm’s goal to maximize wealth of the shareholders can be taken to be a reasonable overall goal.

In general, the shareholder value is the present value of the anticipated future stream of cash inflows from the business plus the terminal value of the company. The positive shareholder value is created when these cash inflows are greater than the investors’ risky investment over the same time frame. Shareholder’s value is measured by the returns they receive on their investments. A return are in two parts, first is in the form of dividends and second in the form of capital appreciation reflected in the market value of shares, of which market value is the dominant part.… Read the rest

Economic Value Added (EVA) – Definition, Calculation and Implementation

Economic Value Added (EVA) is a value based financial performance measure, an investment decision tool and it is also a performance measure reflecting the absolute amount of shareholder value created. It is computed as the product of the “excess return” made on an investment or investments and the capital invested in that investment or investments.

“Economic Value Added (EVA) is the net operating profit minus an appropriate charge for the opportunity cost of all capital invested in an enterprise or project. It is an estimate of true economic profit, or amount by which earnings exceed or fall short of the required minimum rate of return investors could get by investing in other securities of comparable risk.”

Economic Value Added (EVA) is a variation of residual income with adjustments to how one calculates income and capital. Stern Stewart & Co., a consulting firm based in New York, introduced the concept on EVA as a measurement tool in 1989, and trade marked it. The EVA concept is often called Economic Profit (EP) to avoid problems caused by the trade marking.

Economic Value Added is the financial performance measure that comes closer than any other to capture the true economic profit of an enterprise; Economic Profit = Total revenues from capital – Cost of capital. The basic idea of this criterion is to find, in microeconomics, where it is said that the main goal of a company is maximization of profit. However it does not mean book profit (the difference between revenues and costs) but economical profit.… Read the rest

Concept of Economic Value Added (EVA)

The onset of liberalization and globalization of the Indian economy over the ten years has resulted in shift of the corporate goals from socio-economic focus to an increasing shareholders value. Therefore, the present day need is to choose the right metrics that would help to measure organizational progress in meeting the above mentioned strategic goal. Although there are few traditional performance metrics like balance sheet measures (namely, rate of return, shareholders’ profit, earning per share) and market driven measures (namely, market capitalization, price earning ratio), these are subject to certain deficiencies. Balance Sheet based measures are veiled in accounting anomalies that generally measure notional profit, not real ones and market driven measures are prone to volatility of the bourses. The need is for a mix and match measure that factor in a market’s assessment of a company’s value. At the same time, it should be a real measure of its financial performance extracted from its financial statements.

Thus, corporate world’s need for a tool to measure value creation has been filled with the emergence of a new concept namely, Economic Value Added (EVA). It has been redefined and popularized by US based Stem Stewart & Company. It is an attempt to resolve the need for a performance measure that is highly correlated to the shareholders wealth and responsive to the actions of the company’s managers. Shareholder value is considered as an essential measure of the corporate performance. It is an accurate reflection of the quantum of incremental value a company generates for shareholders after accounting for its cost of operations, which include the cost of capital.… Read the rest

Credit Policy in Receivable Management

Concept of Credit Policy

The discharge of the credit function in a company embraces a number of activities for which the policies have to be clearly laid down. Such a step will ensure consistency in credit decisions and actions. A credit policy thus, establishes guidelines that govern grant or reject credit to a customer, what should be the level of credit granted to a customer etc. A credit policy can be said to have a direct effect on the volume of investment a company desires to make in receivables.

A company falls prey of many factors pertaining to its credit policy. In addition to specific industrial attributes like the trend of industry, pattern of demand, pace of technology changes, factors like financial strength of a company, marketing organization, growth of its product etc. also influence the credit policy of an enterprise. Certain considerations demand greater attention while formulating the credit policy like a product of lower price should be sold to customer bearing greater credit risk. Credit of smaller amounts results, in greater turnover of credit collection. New customers should be least favored for large credit sales. The profit margin of a company has direct relationship with the degree or risk. They are said to be inter-woven. Since, every increase in profit margin would be counterbalanced by increase in the element of risk.

Credit policy of every company is at large influenced by two conflicting objectives irrespective of the native and type of company. They are liquidity and profitability. Liquidity can be directly linked to book debts.… Read the rest