Financial and Non Financial Measures of an Organisation - Research Paper Example

Financial and Non Financial Measures I. Introduction When trying to estimate the value and the performance of an organisation the most preferable method is to examine its current strengths and weaknesses comparing to the ones of past periods. However, the above task cannot be completed without the use of a series of specific measures (both financial and nonfinancial) which are going to formulate the basis for the relevant evaluation. Regarding this issue, numerous theories have been stated trying to present a standard method for measuring the firm’s performance. In practice, the most applicable method for the evaluation of a firm’s performance seems to be the balanced scorecard system which is cooperating with the economic value added (EVA) measure in order to achieve the desired result. The above two financial measures can be used in a variety of organizational forms. One of the areas of their application is the banking sector. Specifically in this area the balanced scorecard can be combined with the EVA and produce a complex method of measurement like the stakeholder scorecard which is the proposed tool for the measurement of a bank’s financial performance. II. Measuring business performance – literature review The description of the nature and the role of financial and nonfinancial measures has been mainly based to their use for the estimation of the business value and its performance in specific period of times and under certain circumstances. According to the study of Moore (2001, 572) financial measures are ‘outcome measures based on historical results; in contrast, nonfinancial measures, categorized as lead indicators, tend to focus attention on actions that drive future results, creating value for the long-term from such intangible assets as human capital, customer relations, innovation in products, and highly efficient operating systems’. In this context, the balanced scorecard has been found as combining measures in such a way that management has access to key financial and nonfinancial information, while not being inundated with an abundance of information’. However, in order for the above measures to produce their results, there should be a specific system of financial control which could use these measures in order to lead to secure results regarding the firm’s performance. The performance measures that have been accepted by the market as valuable to the estimation of a firm’s value can be summarized (Neely, 2002, 17) in the following: a) ‘short – term profitability, b) market share, c) productivity, d) product leadership, e) personnel development, f) employee attitudes, g) public responsibility, h) balance between short-range objectives and long-range goals’. On the other hand, it has been stated (Neely, 2002, 295) that ‘the key benefit in the process of deciding what to measure appears to lie in the fact that the process forces management teams to be explicit about their priorities; without precise definitions and targets it is impossible to establish appropriate measures for customer satisfaction; hence the act of deciding what to measure, forces management teams to clarify their language and make explicit what they mean when they say “we want to increase customer satisfaction’. In a research made by Neely et al. (2002, 301) the role of the non financial measures to the firm’s performance tried to be located through a postal survey of ‘1802 large service firms (employing over 250 people and with reported turnovers in excess of £10 million)’. The main findings of this survey can be summarized to the following ones: a. ‘Ninety-two percent of mass services, 84 percent of professional services, and 81 percent of service shops claimed to measure customer satisfaction. b. Seventy percent of mass services, 66 percent of professional services, and 64 percent of service shops claimed to measure employee satisfaction. c. Thirty-six percent of mass services, 36 percent of professional services, and 47 percent of service shops claimed to try and explore the links between employee and customer satisfaction, although the extent to which they do this on the basis of statistical analysis is less clear’. On the other hand academic research (Bartov et al., 2002, 359) suggests that ‘nonfinancial performance measures are relevant for predicting future financial performance and valuing corporate equity; additionally, there is some evidence that nonfinancial performance measures can enhance the value of financial measures due to interactive effects between the two’. Furthermore, regarding the findings of the academic research ‘nonfinancial performance measures possess at least some degree of reliability, and that having such information audited should increase investors’ perceived reliability of those measures whereas noncomparability among types and formats likely hampers investors’ ability to use nonfinancial measures’ The operation of the financial measures in practice can face a series of difficulties. According to the study of Schuster (2000, 92-93) ‘in the process of defining value drivers and outcome measures there undoubtedly is a high potential for mistakes; particularly in the field of ‘softfact measures’ like employee motivation or organizational learning there is a risk of creating false rationalities; another problem could be the data modelling of the whole scorecard system; there is probably a lot of training and communication needed in order to avoid the impression of a ‘staff control system’ that finally leads to completely transparent employees’ III. Financial measures in the banking sector IIIa. The Balanced Scorecard One of the most important financial measures for the evaluation of a firm’s performance (Neely, 2002, 17) is the balanced scorecard which ‘has a number of features which make it a good vehicle for structuring an array of performance measures; first, it makes an explicit link between the espoused strategies of an organization and the performance measures it uses to monitor and control strategy implementation; second, the four major areas in which performance measures are to be devised (financial, customer, business process, and innovation and learning) closely match the main stakeholders of the organization (especially as the employees tend to be discussed in the fourth, innovation and learning, area); it would not be difficult to extend the balanced scorecard approach into a more fully developed stakeholder model’. As to its nature the balanced scorecard has been considered (Schuster, 2000, 84-5) as a ‘set of financial and non financial measures relating to a company’s critical success factors; furthermore, although the relevant perspectives and their relative importance can be expected to vary among companies and industries there is some agreement that the framework for a balanced scorecard will include at least four major perspectives: financial, customer, learning and growth, and internal business perspective; within each of these dimensions, a company should select performance measures that enable the business to achieve its strategies and become more competitive. Introducing a balanced scorecard means introducing a sustainable change in the company. In order to structure this management process, according to Kaplan and Norton (2001a), four phases can be distinguished: a) translating the vision into strategies, b) linking strategies with objectives and measures, c) planning targets and initiatives and d) feedback and learning Regarding especially the banking sector, Kaplan and Norton (2001a) give the example of ‘US-based Metro Bank where a strategic review revealed a changing environment in retail banking. Metro embarked upon a two-pronged strategy to deal with the expected problems: a) Revenue growth strategy: reduce the volatility of earnings by broadening the sources of revenue with additional products for current customers and b) Producitivity strategy: improve operating efficiency by shifting non profitable customers to more cost-effective channels of distribution’. Furthermore, in the process of implementing a balanced scorecard at the bank, ‘these two strategies were translated into strategic objectives in the four perspectives whereas the financial perspective serves as a focal point’ (Schuster, 2000, 86) . Regarding the role of the balanced scorecard, it has been found that ‘the balanced scorecard uses measures of financial performance to ensure that the requirements of financiers are addressed; this closely matches the financial management use of accounting information, and may also incorporate some concept of an overall objective’. In this context, EVA ‘could quite appropriately be used as one of the financial measures in a balanced scorecard formulation (Neely, 2002, 18) IIIb. Economic value added (EVA) EVA is ‘a financial performance measure based on operating income after taxes, the investment in assets required to generate that income, and the cost of the investment in assets (or, weighted average cost of capital)’. Moreover, the three elements used in calculating EVA are ‘operating income after tax, investment in assets, and the cost of capital; the formula to measure EVA is: EVA = After tax operating income —(investment in assets x weighted average cost of capital)’. It should be noticed that EVA is a dollar amount. This means that’ if the dollar amount is positive, the company has earned more after-tax operating income than the cost of the assets employed to generate that income; in other words, the company has created wealth; if the EVA dollar amount is negative, the company is consuming capital, rather than generating wealth’. In this context, it has been stated that ‘a company’s goal is to have positive and increasing EVA’ (Brewer, 1999, 4) According to Ray (2001, 71) ‘EVA can be a powerful tool; when properly applied, it allows a firm to ascertain where it’s creating value, and where it’s not; more specifically, it allows a firm to identify where the return on its capital is outstripping the cost of that capital while for those areas of the firm where the former is indeed greater than the latter, EVA analysis allows the firm to concentrate on the firm’s productivity in order to maximize the value created by the firm’. The above views however mainly refer to the role of EVA as a method to estimate the return of a firm’s capital and avoid mentioning its crucial role as a tool of measuring a firm’s financial performance in general (Cates, 1996). On the other hand, Fletcher et al. (2004, 1) stated that ‘from an EVA perspective, the ultimate success of a firm is not measured only by its capacity to grow its sales, produce profits, or generate cash from its operations, but whether the firm’s activities are creating value for its owners’. The above view is based on the economic theory, according to which ‘a firm is creating value if the net present value of all its investments is positive’. For the above reason, EVA could only be considered as a measure that ‘enables managers to see whether they are earning an appropriate return on the capital under their control; moreover it is the one measure that properly accounts for all the complex trade-offs, often between the income statement and balance sheet, in creating value’. Regarding the above presented, EVA is characterized as ‘the 8entrepiece of a strategy development and implementation process’. IIIc. Implementation of Balanced Scorecard – EVA – Interaction When creating a balanced scorecard (Brewer, 2002, 9), one of the most important issues is to ‘gain consensus regarding the firm’s strategic goals and to examine if the firm is creating its competitive advantage in terms of cost leadership, differentiation (in the form of quality, time, or flexibility), or some combination of the two’. In this context, it is noticed that ‘the strategic objectives of a company are what determine the specific measures it will include in its scorecard; once a clear understanding of the firm’s strategy exists, the process of formulating a balanced scorecard begins by selecting appropriate measures for each of the four perspectives; for example, the process may begin with the customer perspective by selecting measures that define success from the customer’s point of view, such as customer retention rates, on-time delivery percentage, or surveys of customer satisfaction; next, the internal business process perspective focuses on nonfinancial measures that reflect how well a firm is translating inputs into outputs that are valued by customers; cycle time, yield percentage, and quality defect rate are examples of internal business process measures that may be used’. While implementing the balanced scorecard we should take into account that ‘the innovation and learning perspective measures are leading indicators that reflect the likelihood a firm will continue to be world-class competitive in the long run; these measures are often research- and development-intensive, such as the number of new products developed in the last three years, the lead time for new product development, and the number of new process technology patents’. The balanced scorecard is related with EVA to the point that the former contains a financial perspective. IV. Non financial measures — banks Iva. Customer satisfaction as a measure of performance The role of customer satisfaction as a nonfinancial measure of company’s performance has been examined by Hall (2002, 10). Specifically, according to their study ‘the importance of satisfied customers is emphasized by the European Business Excellence Model, developed by the European Foundation for Quality Management (EFQM); this model underpins the European and many national quality awards and includes nine criteria on which companies are evaluated’. According to the above model, ‘the criterion customer satisfaction is the weightiest criterion and accounts for 20 percent of the total points in the scoring system when companies assess and measure their own excellence; this means, that understanding the customers, and measuring customers’ satisfaction is an important element in companies’ continuous quality improvement, which leads to improved business performance, including economic performance’. Moreover, it has been found that ‘many companies are using some form of customer satisfaction measurement, but most companies find it difficult to demonstrate the link from customer satisfaction to economic performance; the primary reason for the difficulties is the traditional customer satisfaction measures’ poor reliability, predictive validity, and the lack of explicit quantitative links to the desired economic results’. Regarding the above assumptions, it has been found that ‘a customer satisfaction strategy must be connected to actions that get results in terms of products and or services for customers; performance measures provide feedback on the success of strategies by serving as a progress reporting system’. In this context, ‘measurements in an organization need to be balanced between leading and lagging, as well as between hard and soft indicators while measures need to represent a variety of areas such as finance, customer satisfaction, stakeholder, internal operations, and employee learning’ (Hall, 2002, 10) Ivb. Employees Inside an organization, employees are considered as the most crucial factor for the firm’s performance. In fact, employees are the ones on which the operation of the whole business is based and for this reason they should be rewarded in accordance with the volume and the quality of their work, not just in accordance with a pre-set standard of payment. Employees as part of stakeholders, participate in the evaluation of the company’s performance through the stakeholder scorecard (which is a type of balanced scorecard) and can influence its administration through the decisions on the firm’s strategic management team. However, it should be noticed that this influence has to be in a specific framework and any particular aspect (company’s financial situation, existence of other stakeholders) should be taken into account before proceeding to any decision. V. Interaction between financial and non-financial measures The use of balanced scorecard by many organizations (Kaplan et al., 2001, 5) has been based to the fact that these organizations use ‘a mixture of financial and nonfinancial measures; such measurement systems are certainly more “balanced” than ones that use financial measures alone; yet, the assumptions and philosophies underlying these scorecards are quite different from those underlying the strategy scorecards and maps described above’. In this context, it has been found that within a specific organization the financial measures could cooperate with the nonfinancial ones through the use of a specific balanced scorecard system, the stakeholder scorecards. The specific scorecards can be formulated in order to refer on the whole stakeholders or just a part of them. Customers and employees as presented above could participate in the balanced scorecard system (which also interacts with EVA as described previously) and in this way a direct link between the company’s financial and nonfinancial measures is built. Regarding specifically the stakeholder scorecard, this ‘identifies the major constituents of the organization- shareholders, customers, and employees—and frequently other constituents such as suppliers and the community while at a next level it defines the organization’s goals for these different constituents, or stakeholders, and develops an appropriate scorecard of measures and targets for them’ Regarding the cooperation of financial and non financial measures it has been stated that the scorecard ‘combines both financial and nonfinancial performance measures along four perspectives: a. Customer Perspective—Focuses on the external environment to understand, discover, and emphasize customer needs. Common measures: customer satisfaction, customer loyalty, and customer retention. B. Internal Business Processes Perspective—Focuses internally along a value chain comprising innovation, operations, and post-sale service processes. Common measures: research and development expenditures, sales from new products, productivity, cycle time, and throughput efficiency. C. Learning and Growth Perspective—Provides the foundation, or infrastructure, needed to meet the objectives from the other two operational perspectives. Common measures: employee satisfaction, dollars spent on training, and voluntary turnover. D. Financial Perspective—Focuses on shareholders. Every measure in the balanced scorecard should be part of a causal link that ends in financial measures; common measures: economic value-added (EVA [R]), return on investment, and net income’. (Moore et al., 2001, 573) VI. Conclusion The above presented issues show that the implementation and control of a performance-measurement system inside an organization is a rather complex task. Moreover, there are a lot of issues that should be previously considered before formulating any assumption. On the other hand, the changes and turbulences that may occur in the internal and external organizational environment can operate as factors of instability for the specific organization. However, the careful examination of all the variables in advance can help to avoid any possible negative influence regarding the firm’s performance in its market. In any case, the design and the implementation of the specific financial measurement tool have to be in accordance with the firm’s needs but also the rights of its stakeholders. References Bartov, E., Fairfield, P. M., Hirst, D. E., Iannaconi, T. E., Maines, L. A., Mallett, R., Schrand, C., M., Skinner, D. J., Vincent, L. (2002). 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Cambridge University Press, Cambridge Ray, R. (2001). Economic Value Added: Theory, Evidence, A Missing Link. Review of Business, 22(1): 66-71 Schuster, L. (2000). Shareholder Value Management in Banks. St. Martins Press, New York Read More