Would you rather have a 20% return on a $100,000 base of invested capital or 10% on $20 billion?
CFOs are capital allocators at heart. Their decisions are measured on multiple scoreboards: as a percentage, as a real dollar amount, and as pure cash flow.
This guide draws on my podcast with Tony Boor, CFO of Blackbaud, a software company that powers nonprofits, charities, and educational institutions. Blackbaud generated over $1.1 billion in revenue last year and is one of the most valuable vertical software companies in the world.
Tony explained that he relies on three metrics to measure the company’s capital efficiency at scale:
Return on Invested Capital (ROIC)
Economic Value Added (EVA)
Residual Cash Earnings
Today, we'll explore all three metrics and compare their outputs using a real scenario.
For anyone looking to move beyond managing budgets to making strategic capital allocation decisions, this guide will help you get there.
Return on Invested Capital (ROIC)
“The percentage scoreboard”
ROIC measures how effectively a company uses its invested capital to generate profit. For example, if you invest $1 million and earn $200,000 in profit, your ROIC is 20%. This metric is useful for comparing investment efficiency across different companies or industries.
However, ROIC doesn’t provide insight into the absolute value created, which limits its meaning when considering investments of different scales.
Economic Value Added (EVA)
“The P&L scoreboard”
EVA measures the absolute dollar value created over the cost of capital. For instance, if a company generates $150,000 in profit but the cost of capital is $100,000, the EVA is $50,000. It shows whether the company is adding real economic value or destroying it, in absolute terms.
While EVA provides a clear picture of value creation, it’s influenced by the scale of operations, which makes it less comparable across different companies.
Residual Cash Earnings
“The cash flow scoreboard”
Residual Cash Earnings focuses on the cash generated by the business after accounting for the cost of capital. This metric shows how much cash is available to reinvest, pay off debt, or distribute to shareholders. It reflects the actual cash earnings after covering all capital costs, making it practical for managing working capital and prioritizing resource allocation.
This metric is particularly helpful in understanding liquidity, though it might not capture the full economic profit like EVA, especially when non-cash expenses like depreciation are involved.
Using All Three Metrics
None of these metrics is inherently "better" than the others; each has its strengths, depending on the context. In practice, using all three offers a comprehensive view of a company’s capital efficiency and overall value creation:
ROIC is useful for comparing investment efficiency across opportunities or benchmarking against peers.
EVA helps determine if the overall business or a specific project is generating value over its cost.
Residual Cash Earnings help prioritize capital allocation, especially in periods of growth or investment.
Tony uses all three metrics to get different perspectives on efficiency, suggesting that there isn’t a single best metric but rather a right one depending on the situation.
All Three in Action
Let's create a theoretical example to illustrate how to calculate ROIC, EVA, and Residual Cash Earnings using the same set of inputs.
Assumptions:
Capital Invested: $12,000,000
Operating Profit (EBIT): $5,000,000
Tax Rate: 25%
Weighted Average Cost of Capital (WACC): 8%
Depreciation Expense: $1,000,000
Step 1: Calculate Net Operating Profit After Tax (NOPAT)
Operating Profit (EBIT): $5,000,000
Tax Rate: 25%
Step 2: Calculate Capital Charge
Capital Invested: $12,000,000
WACC: 8%
Step 3: Calculate Depreciation Impact
JK, I won’t make you do that.
Take my word for it… the Depreciation Expense is $1,000,000
Calculations
1. ROIC (Return on Invested Capital)
ROIC measures the percentage return generated on the invested capital.
2. EVA (Economic Value Added)
EVA measures the profit after accounting for the cost of capital, focusing on whether the company generates value above the required return. Since EVA is based on NOPAT, which is after depreciation:
3. Residual Cash Earnings
Residual Cash Earnings focus more on the cash available after covering the cost of capital. Since depreciation is a non-cash expense, it is added back when calculating cash earnings:
Summary
ROIC measures the percentage return on invested capital. Here, the ROIC is 31.25%, indicating that the company generates a return significantly higher than the cost of capital (8%).
EVA measures the profit after accounting for the cost of capital, considering depreciation. In this case, EVA is $2,790,000, meaning the business generates value beyond its capital charge.
Residual Cash Earnings add back the non-cash depreciation expense to reflect actual cash generated. Here, Residual Cash Earnings are $3,790,000.
So, Who Cares About What?
Different stakeholders may prioritize different metrics:
1. Growth vs. Efficiency Focus
CFO (Growth Focus): A CFO focusing on growth may prioritize Residual Cash Earnings, as it shows available cash for reinvestment.
Investor (Efficiency Focus): An investor might prioritize ROIC for insight into capital efficiency as it relates to their portfolio’s performance.
2. Internal Management vs. Shareholder Value Creation
CFO (Internal Management): For strategic decisions, a CFO may prioritize EVA to evaluate if investments add economic value.
Investor (Shareholder Value): Investors also care about EVA, as it indicates whether the company consistently creates value over time.
3. Operational vs. Financial Engineering Focus
CFO (Operational Focus): A CFO focused on operational health may find Residual Cash Earnings useful for managing cash flow in the day to day of the business.
Investor (Financial Engineering): An investor interested in optimizing returns might prioritize ROIC and EVA to assess capital efficiency and economic profit.
Now you can use all three appropriately as various scenarios arise in your business. Just keep in mind the purpose and the stakeholder when you pick your metrics.
