What are the financial measures ROS, ROA, and EVA?

There are several measures that are useful in measuring the health of a company. These measures are also useful in measuring the health of a project. The trend in project management is to have the project manager take on more and more responsibility for the projects she is managing. Project managers in the future will be more concerned with their projects from the standpoint of managing them as small businesses. It is therefore useful for them to have some financial knowledge. Return on sales (ROS), return on assets (ROA), and economic value added (EVA) are three simple measures that a project manager can use to help determine the financial health of a project that is in progress or one that is being contemplated.

The return on sales is the ratio of net operating profit after taxes (NOPAT) compared to gross sales. The higher the ROS, the more favorable the project.

The return on assets is the ratio of net operating profit after taxes (NOPAT) compared to the gross assets needed by the project. The higher the ROA, the more favorable the project.

The economic value added is a measure of the amount of increase in the company's assets after subtracting the cost of the capital used on the project.

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The return on sales is a relatively easy calculation to make. It is simply the net operating profit after taxes divided by the gross sales. The gross sales is the total amount of revenue that the project generates. That is the total amount of money flowing into the company as a result of doing this project. The gross sales minus all of the cost and expenses associated with the project gives us the net operating profit before taxes. Net operating profit before taxes minus the taxes paid relative to the project gives us the net operating profit after taxes (see Figure 4-8). For example,

Figure 4-8: INCOME STATEMENT

In this example, a company does a project for a client. The client pays the company $3,000,000 to do the project. This is the gross sales of the project. The company has $2,500,000 of cost and expense associated with the project, and the company's tax rate is 50 percent.

The return on sales is a measure of the amount of profit that a dollar of sales generates. Projects that return higher profits per sales dollar are generally more favorable to the company than projects that have a lower profit per dollar of sales. The return on sales ratio tells us that some projects are relatively more profitable than others. If it is our wish to generate more profits, we should look for those projects that have higher ROS's.

ROS is not the only financial measurement we should be interested in. Some projects use more of our assets than others. Projects that generate profits and use relatively lesser amounts of our assets than others are generally more favorable than those that have relatively lesser returns and use more of our assets. Projects that use large amounts of our assets make those assets unavailable for other projects and the profits those projects can generate.

The return on assets is the ratio of the net operating profit after taxes to the assets that are used by the project. The net operating profit after taxes is calculated just as it was in the ROS calculation. The assets that are used by the project are represented by the share of the company's assets that are needed by the project. Much of the assets used by a project is the cash the company must use while completing the project. The share of the assets the company uses is included in this calculation of the assets used as well. In the above example, let us say that the assets this project uses are equal to $4,000,000.

The economic value added calculation compares the cost of maintaining the assets with the net operating profit after taxes. The rationale behind this calculation is that the profit generated by doing a project should be greater that the cost of the assets the project uses. Capital or assets cost money to own. Whether we owe the money to some lending institution or whether our stockholders have generated the investment money that paid for them, they still cost money.

If the money necessary to acquire assets was generated by borrowing the money from a lending institution or some other lending person or agency, we must pay for the use of the money lent. This is called interest. If the money came from people investing in our business, they expect to have some return on their investment. This is usually in the form of dividends to the stockholder. Most companies obtain assets by a combination of these means.

The first thing we need to do is estimate the percentage of the company assets that are acquired by loans. These are the shortand longterm liabilities. The difference between the total assets of the company and the total longand short-term liabilities of the company is equal to the amount of the company assets financed by our investors and stockholders. Let us say that in our continuing example the percentage of the company's assets that is financed through loans is 30 percent. The amount financed through investment and stockholders is therefore 70 percent. We can also find the average annual interest rate on our loans. Let us say that this is 9 percent. We can also calculate the money that we have to return to our investors each year. Let us say that this figure is 14 percent. The length of time that the project uses these assets is six months.

We can now calculate the weighted average cost of our assets in Table 4-2.

Table 4-2

	Percentage of total capital assets	Annual percentage cost	Total
Loans	30%	9%	.0270
Stock	70%	14%	.0980
		Average cost of assets	.1250 or 12.5%

The economic value added calculation compares the cost of the assets for the time they are used by the project to the NOPAT generated by the project.

Of course, the higher the EVA, the more favorable the project will be. All companies will be happier if they are getting the most profit out of their investment. There is a problem with managing to this ratio, however. If projects are being measured according to their EVA, one way the project manager can have a good EVA is by reducing the amount of capital the project uses. This may mean using less equipment than is necessary for an efficient operation, which might, in turn, increase cost and expenses rather than decreasing them. You can always tell when a project manager is taking this calculation too seriously: He has a project team that is using out-of-date computers and is working on old desks and is always borrowing equipment from other projects.