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Is financial performance enough to know if your business is doing well?

It is common knowledge that if you want to understand how a business is doing, you need to look at its financial statements. This is the go-to place for any investor or stakeholder interested in finding out how the business is performing. But does it tell the full picture? Are financial metrics enough, or do we need something more?
What you will find in this post

To understand the need for more than financial measurements, we will explore why these measures are insufficient and how nonfinancial measurements are the answer to ensure a much more balanced approach.

 

Short Termism

Too many times, we have seen bonuses paid on hitting financial targets. This spurs not only incongruent nature between shareholders and managers but also short-termism. A manager promised to get a bonus on hitting a certain amount of profit will do whatever he can to make sure profits for a particular period are looking as healthy as possible. Any future outcomes will be blindsided, as this is not what the manager is concerned about.

This sort of behavior is seen when rewards are linked solely to financial performance, and therefore tempt managers to improve short-term financial performance, however, with a negative long-term outcome.

Manipulation of financial results

Regardless of the huge amounts of financial regulations, there are always crafty ways to manipulate financial results, all under the legal realms, of course. However, performed to manipulate results to show a better outcome today, with a negative one tomorrow.

There are many ways financial results can be manipulated; however, we will point out a few common ones.

  • Provisions – Reductions in provisions will lead to an increase in profits.
  • Cut off Decisions – Invoices for a previous period may get recorded in the future period to show an increase in profits.
  • Misclassification of revenue and capital items – Any repairs that are done to a business must be expensed; however, these can wrongly be classified as capital items and therefore avoid being expensed to the profit and loss account, making the profit figures exaggerated.

 

You can learn more about the relation between profits and cash in our earlier article.

Historic Records

As financial records provide information for all the transactions in the past, it is not wise to make all future decisions based on historical records. For example, you wouldn’t want to drive your car looking at the rearview mirror only.

 

Nonfinancial Performance Measures

Relying on just financial measures to ensure the smooth running of a business is not the best method. Therefore the need for nonfinancial measures is paramount to balance things out.

To tackle this, Kaplan, in 1992, wrote an article outlining how his new ‘balanced scorecard’ method has helped numerous businesses. After his article was published, nonfinancial methods became the norm and are used across all businesses today.

In an extract from his article ‘The Balanced Scorecard—Measures That Drive Performance’, he explains in plain English how the balanced scorecard is a necessity:

“During a year-long research project with 12 companies at the leading edge of performance measurement, we devised a “balanced scorecard”—a set of measures that gives top managers a fast but comprehensive view of the business. The balanced scorecard includes financial measures that tell the results of actions already taken. And it complements the financial measures with operational measures on customer satisfaction, internal processes, and the organization’s innovation and improvement activities—operational measures that are the drivers of future financial performance.

 

Think of the balanced scorecard as the dials and indicators in an airplane cockpit. For the complex task of navigating and flying an airplane, pilots need detailed information about many aspects of the flight. They need information on fuel, airspeed, altitude, bearing, destination, and other indicators that summarize the current and predicted environment. Reliance on one instrument can be fatal. Similarly, the complexity of managing an organization today requires that managers be able to view performance in several areas simultaneously.”

balanced scorecard

Why are Nonfinancial Models better?

As illustrated by the balancing scorecard, financial and nonfinancial metrics, when placed together, gives a much better-balanced approach to ensure goal congruency between shareholders and managers.

After Kaplan’s balancing score care card was introduced, other models were adopted by many businesses worldwide, two of which are building block and the performance pyramid.

These models took a very tailored approach to the type of industry they wanted to target. For example, building block was established only for the service industry and the performance pyramid for manufacturing.

Having such brilliant models made it possible to provide a framework to create key performance indicators, which helped identify what would drive the performance rather than just provide results.

Furthermore, these models included an element of subjectivity where diverse opinions can be considered and based on which decisions can be made.

This can be in the form of customer satisfaction surveys where they could be asked to rate the service provided between 1 & 10.

Are there any negatives associated with non-financial models?

Like anything, there are always pros and cons to an equation, and non-financial models are no exception.

Implementing a non-financial model will require a great amount of data to be analysed. This data will have to be processed via various systems, which can prove to be extremely costly. Therefore, businesses looking into implementing a non-financial model must scale the risks involved in such an investment.

Once these systems are introduced, there will be resistance from staff. As essentially, the power is being taken away from them and relied solely on hard facts through these non-financial models. Moreover, having to re-train staff and introduce systems is often difficult, as change is usually seen as discomforting.

The number of measures needed will also become somewhat of a moot point. Introducing far too many measures may result in data overload, so striking a balance would be difficult to achieve.

Moreover, all measures will have to be crystal clear to ensure the greatest outcome. You don’t want to spend a lot of money and time in introducing these measures and not be able to gain anything from them.

 

Conclusion

Even though there can be many obstacles in implementing such measures in a business, it is quite clear that the benefits outweigh the negatives. Having both financial and non-financial metrics will make decision-making that much easier and will allow your business to propel.

Lastly, we will leave you with a quote from Kaplan’s article and wish you all the best in implementing your non-financial measures.

“This understanding can help managers transcend traditional notions about functional barriers and ultimately lead to improved decision making and problem-solving. The balanced scorecard keeps companies looking—and moving—forward instead of backward. By combining the financial, customer, internal process and innovation, and organizational learning perspectives, the balanced scorecard helps managers understand, at least implicitly, many interrelationships.

About the Author

Bilal Khalid

CEO, Accountant

Bilal Khalid EvoTax accountant

Successfully running my own small business for years has taught me a great deal about the complexities of taxation and I understand all the pain points that every entrepreneur has to go through. I often found myself paralysed with fear of making a mistake and getting fined and eventually decided to take up accounting and finances myself. Today, I help other small businesses suffering through similar mistakes and I am happy to share my knowledge, jargon free!

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