Abstract
Inflation can have a pronounced effect on the financial performance of a firm. This study makes inflation adjustments to a firm’s cost of sales, depreciation, level of gearing and assets in line with International Accounting Standard 15 (IAS15) in order to calculate an inflation-adjusted version of the economic value added (EVA) measure. The study was conducted using data from South African industrial firms during a period characterised by highly variable inflation levels (1991-2005). The results indicate that during this period there were significant differences between the nominal and real values of the firms’ EVAs
Highlights
Value-based financial performance measures have been proposed as an improvement over traditional financial measures because valuebased measures appear to overcome some of the limitations of traditional measures
Production Price Index (PPI) values were used for the inflation adjustments rather than the changes in the general GDP deflator applied by Warr (2005:126), because the PPI values reflect changes in the prices of the items used in the production processes of the industrial firms investigated in this study
While proponents of the measure Economic Value Added (EVA) argue that changes in the measure are not influenced by inflation rate fluctuations, a number of studies have cautioned against the possible distorting effects that inflation could have on the value of the measure
Summary
Value-based financial performance measures have been proposed as an improvement over traditional financial measures because valuebased measures appear to overcome some of the limitations of traditional measures. Warr (2005:119) proposed inflation adjustments to depreciation, nominal debt, the book values of a firm’s assets and its weighted average cost of capital (WACC) when EVA is being calculated. This study was conducted for South African industrial firms during a period in which decreasing, increasing, and low levels of inflation were experienced, namely the period from 1991 to 2005 These changing levels of inflation provided this study with the ideal background against which to extend the study conducted by Warr and to investigate the possible influence of such inflation changes on EVA. The results of the current study indicate that, during periods of low, decreasing inflation (when inflation levels dropped below four percent), the median nominal EVA values exceed the median real values. When analysts apply EVA as a financial performance measure in such circumstances, analysts should be aware that the changes in the EVA values are the result of the inflation changes, rather than of a change in the firm’s performance
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