Connect with us

Business

Financial and non-financial performance are now inseparable

Financial and non-financial performance are now inseparable 5

The financial value of non-financial performance is debatable, but in the long term, one cannot exist without the other, explain Franck Bancel and Henri Philippe.

Over the past two decades, the pressure on companies in terms of non-financial performance (or ESG performance) has increased significantly. Several reasons explain this major development. One is the regulatory framework, which has imposed new rules on companies in terms of non-financial reporting and has reinforced transparency obligations. Another is the financial community, especially large institutional investors, which considers that respecting the environment (E), taking on social responsibilities (S) and setting up effective governance mechanisms (G) are all essential to a company’s long-term development. Institutional investors are now sensitive to ESG criteria and analyse non-financial performance carefully before deciding to invest in a company.  

However, although ESG performance may be a source of competitive advantage, it also generates additional costs for companies. These costs may be significant and may have a negative impact on company cash flows. This is why understanding the relationship and interactions between ESG performance and financial performance is critical. For example, do investments that improve ESG performance necessarily translate into higher profitability and/or higher stock market performance? How can we define the level of investment required to reach a “good” level of ESG performance? What does a good level of ESG performance mean? Investors also have to face similar issues. Does investing in companies that perform well on non-financial criteria necessarily create value for investors? Will this value be integrated in stock prices in the short term, or do investors have to wait a certain period to benefit from that value creation? Should we consider that companies with poor non-financial performance destroy financial value and that the only option for investors is to sell their shares in such companies?

Researchers have tried to answer these questions and there is now a wealth of academic literature focusing on the relationship between financial and non-financial performance. However, the answers are not always so clear-cut. Although the majority of academic studies show that companies that perform well in terms of non-financial criteria are more profitable, incremental profitability appears limited. In the same way, the majority of academic studies conclude that companies that perform well on non-financial criteria are valued more highly, but again, the results are not particularly significant. It also seems that companies with a better ESG rating are structurally less risky and have a lower cost of financing, but even this difference is narrow. In other words, the academic literature does not clearly conclude on the financial value of non-financial performance. Researchers consider that additional work must be carried out to try to answer these questions. The fact is that researchers are struggling to resolve two major issues: the direction of causality and the measure of what non-financial performance is. It is not clear whether ESG performance improves financial performance or vice versa. The most profitable companies can more easily invest in ESG; perhaps, therefore, the direction of the relationship is reversed. The other difficulty is defining what constitutes a “good” company according to non-financial criteria. For example, non-financial rating agencies can attribute different ESG ratings to the same company because these agencies use different methodologies (they do not evaluate the same aspects of ESG performance). Beyond that, measuring the externalities that condition a company’s non-financial performance is a particularly complex exercise. 

In light of all this, what would we say to a company that is hesitant to invest in order to improve its non-financial performance? Paradoxically, we do not think that our advice would relate directly to financial arguments. We would explain to this company that by not managing its non-financial performance, it risks being increasingly ostracised by financial investors, more broadly by its customers and even by the future employees that it hopes to recruit. Furthermore, regulatory frameworks are set to be strengthened; it would be better to prepare for such a development, or even to help build it, rather than to suffer as a result of it. This means that non-financial performance will affect access to financing, for example, as well as the quality of recruitment and ultimately the company’s ability to be competitive. In this sense, financial and non-financial performance are intrinsically linked, and one will not exist without the other in the long term. This is a real paradigm shift for investors and companies alike.

In this context, the question for companies is no longer whether they should invest in ESG; the answer is positive. However, the question now is how to make progress in managing non-financial performance. This will require a better understanding of the level of investment and the organisational changes necessary to achieve this new objective. 

Financial and non-financial performance are now inseparable 6

 

 

Franck Bancel is a Professor of Corporate Finance at ESCP Business School, where he was Associate Dean for Research and Director of the doctoral programme. 

 

Financial and non-financial performance are now inseparable 7

 

 

Henri Philippe is a partner at Accuracy, a corporate finance consulting firm.

Editorial & Advertiser disclosure
Our website provides you with information, news, press releases, Opinion and advertorials on various financial products and services. This is not to be considered as financial advice and should be considered only for information purposes. We cannot guarantee the accuracy or applicability of any information provided with respect to your individual or personal circumstances. Please seek Professional advice from a qualified professional before making any financial decisions. We link to various third party websites, affiliate sales networks, and may link to our advertising partners websites. Though we are tied up with various advertising and affiliate networks, this does not affect our analysis or opinion. When you view or click on certain links available on our articles, our partners may compensate us for displaying the content to you, or make a purchase or fill a form. This will not incur any additional charges to you. To make things simpler for you to identity or distinguish sponsored articles or links, you may consider all articles or links hosted on our site as a partner endorsed link.
Global Banking and Finance Review Awards Nominations 2022
2022 Awards now open. Click Here to Nominate

Advertisement

Newsletters with Secrets & Analysis. Subscribe Now