The Use of Financial Instruments in Evaluating a Firm - Essay Example

This paper discusses the use of financial instruments in evaluating a firm and compares them to nonfinancial measures.

This paper in effect compares the effectiveness and reliability of using financial measures as opposed to nonfinancial measures.

Analysis

         Financial measures are the traditional ones for evaluating operating performance, benchmarking competitors, and comparing industry results. To determine whether a company is profitable, profitability ratios like return on equity, return on assets and net profit margin may be used. Other companies or competitors normally use the same ratios also so that comparison and benchmarking are possible among companies (Meigs, Meigs & Meigs, 1995).  However, it does not mean that non-financial measures are not useful since normally they are the underlying explanations of the difference in performance measures.  To illustrate in the case of two similar companies in the industry, one may have more revenues or higher profitability than the other. What could explain the difference between the two companies may be the more loyal and active sales force of one company over the other. Upon investigation, it can be found that the personal objectives of the workforce or people of the more profitable company are tied to the corporate financial objectives. The human resource contribution, which is non-financial, is normally not emphasized in the financial statements but it could constitute the competitive advantage of one company over the other company. After knowing that a company has a more loyal and hard-working sales force, the same company could sustain profitability or further, the advantage and that makes the non-financial measure very useful. Of course, they are other non-financial measures such as better customer service, better attendance of employees in meetings, zero absences in important activities, and timely submissions of reports by concerned employees or departments (Streetdirectory, 2010).

      The advantage and disadvantages of each measure can be drawn from the example given. Financial measures are readily measurable and are closer to measuring the attainment of measurable financial objectives. It is easier to assess the performance of managers as well using those ratios.  The disadvantage of financial ratios is that limiting the use of the same may not completely see the bigger picture since they just measure data in a more meaningful and readily verifiable information way like revenues, expenses, assets, liabilities, and equity. Without the underlying explanations like the more loyal and responsive workforce, financial ratios become less meaningful. In the given example, it could amount to disregarding the human resource in organizations, which is one the best source of competitive advantage, and even the most important resource in the organization. 

       On the other hand, the advantage of non-financial measures is the reverse or opposite of those of financial measures. Thus, they could give the underlying reasons or explanations why a company is more or less profitable and better or less superior than competitors. They complement the limitation of the financial measures. Their disadvantage is that they cannot stand apart from financial measures. In other words, one cannot talk of a more loyal and responsive workforce if the results are not translated to better financial performance of the organization.
As far as effectiveness however concerned, it can be asserted that the financial information should be given more weight since they should be there to bring out the non-financial measures as an explanation for the variance. As to better reliability, the same may be given to financial measures since the same is verifiable across more companies easily. Since non-financial measures complement the financial, their effectiveness and reliability could not be underestimated for purposes of decision-making.