How is corporate governance related to corporate performance?

Introduction

The concept of corporate governance and performance became the area of interest in India, primarily after the Satyam scam. Corporate governance refers to “the system by which companies are directed and controlled.”[1]It facilitates a company’s regulatory mechanism and defines roles and responsibilities among management, the board, shareholders, and others.

Corporate governance and performance are measured by the tool return on assets (ROA). Corporate governance is mainly concerned with four issues: effectiveness and efficiency of the company’s operations, compliance with laws and regulations, reliability of financial reporting, and safeguarding of assets. The central idea is to improve the corporation’s decision-making process and strategic guidance to achieve more remarkable performance, productivity, profitability, and competitiveness. Governance ultimately enhances the economic value of the corporation and increases ROA.

Concept of Corporate Governance

Corporate governance is referred to a set of relationships between a company’s management, its board of directors, shareholders, and other stakeholders. Corporate governance tends to provide a refined structure to a company through which its objectives are set and act to attain those objectives by effectively monitoring the company’s performance. It holds management accountable to the board and board of directors responsible to the shareholders and other significant stakeholders.

Every corporate entity aims to achieve sound corporate governance and performance values and incorporate them into the company rules to gain proper growth. Corporate governance deals in the same sense in which suppliers of finance corporations guarantee getting a good return on their investment. It facilitates a company’s ability to define and achieve its purposes and promotes corporate fairness, transparency, and accountability.

Parameters of good corporate governance

Good Corporate Governance should establish a way for shareholders, stakeholders, management, and the board to interact and determine the direction and performance assessment of corporations. It should also provide proper incentives for the management and board to pursue desired objectives in the company’s best interests and shareholders.

Good Corporate Governance facilitates effective monitoring of the company’s performance and encouraging other firms to use resources more efficiently.[2] The most critical parameter of good corporate governance in a company is that the firm believes in the sustainable allocation of corporate resources to achieve better performance. Suppliers, employees, and even investors seek to get associated primarily only with such firms and maintain a long-lasting relationship with a view of their fair and transparent system.

There are five critical variables of corporate governance: board independence and board diversity, audit committee, audit quality, and corporate governance principles at a place. It is undisputed that a company’s board functions effectively if it comprises the ‘right people’ and has the ‘right chairman’ and is supported by the ‘right attitude and approach’ from the management and external auditors.  Let’s see a brief overview of these variables and their relation with corporate performance:

Board independence and corporate performance

Board independence represents the number of outside directors in comparison to the number of inside direction. Board independence is the proportion of inside directors to outside directors. Now, outside directors are those people who are not members of top management, their associates, family, employees of the firm, or members of the past management. While inside directors control the firm’s daily working activities, outside directors keep a check on those activities and ensure that shareholder’s interests are protected.

Outside directors are independent directors in a company having no affiliation with the board are viewed as people who bring transparency, proper management and control to the firm.[3] Their presence is vital on the board of directors because the insider dominated directors can’t provide appropriate board monitoring and control against themselves.

Board diversity and corporate performance

Board diversity represents a well-balanced board of directors that comprises individuals from different professional fields. It includes various determining factors such as gender, age, education, and experience. Based on empirical evidence, the relationship between female directors’ proportion on board and corporate performance is quite controversial. While some studies found a positive relationship between women on board and corporate performance, others found a negative or not any connection thereof.[4] As Board diversity consists of varied factors, it positively correlates with improvement in corporate governance and performance.

Audit committee and corporate performance

The audit committee plays a crucial role as a committee in ensuring effective monitoring of the company’s accounting process to provide reliable and relevant information to the stakeholders. The existence of an audit committee’s independence within a sizeable limit can deliver credible accounting information and yield dividends by conducting frequent committee meetings. Hence audit committee independence is expected to facilitate the improvement in corporate performance.

Audit quality and corporate performance

A firm comprising large auditors reflects the company’s excellent quality than having small auditors. As a means of monitoring corporate governance from the outside of management, audit quality can improve corporate performance. Further, the audit quality significantly has a positive effect on profitability to the firm.

Corporate governance principles and corporate performance

The key principles of corporate governance comprises of transparency, fairness, accountability, independence, and responsibility. Incorporation of these fundamental principles in the company’s management is expected to improve the company’s performance.[5]

Evaluation of corporate performance

For evaluating a corporate entity’s performance, there are four main criteria: Financial viability, Effectiveness, Corporate Growth, Efficiency, and Risk Reduction with the effect of internal corporate governance structures and mechanisms on them.[6] Let’s study each of them one by one:

1. Financial viability: Financial viability is inclusive of the following elements:
2. Profitability includes net profit margins, return on equity, return on total assets and earnings per share.
3. Activity includes inventory and total assets turnover.
4. Liquidity includes networking capital and current ratio.
5. Debt comprises of debt to assets and debt to equity.
6. Investment value includes net present value, return on equity, return on investment, and internal rate of return.
7. Effectiveness in the corporate performance is evaluated in terms of achieved goals and objectives, the quality of products, demand for services or products, number of clients served, service access and usage product, and knowledge generation and utilization in the entity.
8. The corporate Growth of the company is determined through the following indicators: profit growth, funds growth, and annual revenue, amount of resources, new market accessibility, new products, new customers, and relative market share growth.
9. The performance’s efficiency weighs in terms of the output per staff in the company, cost per product or service provided by the company, cost per client served, timeliness of delivery of services, the overhead cost of full service or production cost, and frequency of system breakdowns.
10. Risk Reduction in corporation functioning can be achieved by a proper risk management framework, environmental controls and monitoring, having disaster recovery systems in place, regulatory compliance, evidence of monitoring systems, and much more.

Good Corporate Governance improves Corporate performance

Good corporate governance improves corporate performance by facilitating the company’s capacity to define and achieve its desired goal, reduce the waste or malfeasances, and effectively monitor its performance to generate more profits at a lower cost. It does so by providing a detailed guideline for the firm to enhance its value and stand beneficial for its shareholders.

According to theory, good corporate governance refers to a combination of structures and mechanisms that align all the parties involved and governance, which ensures the voice of the company’s stakeholders is heard, and relevant information is distributed fairly. The mentioned structures and mechanisms must commit all parties involved to work together towards a common goal.

Ways in which good corporate governance improves corporate performance

Multiple elements of corporate governance interact with each other and influence the corporation’s performance. There are substantially six effective drivers of good corporate governance that corporate entities should apply:

1. Independent board of directors- The board of directors comprises many people who should work independently to improve the board’s objectivity and its capacity to represent multiple viewpoints. It is better if the board size is not too large because that might slow down the decision-making process.[7]
2. Diversity of board of directors- Demographic diversity on the board of directors has a positive impact on the company’s performance except when it is enforced by statutory regulation.
3. Remuneration- An institutional remuneration arrangement contributes to corporate performance by aligning senior management and the shareholders’ best interests. However, although stock options for management may be helpful during times of good performance, they have no effect when the corporation’s performance is stagnating.
4. CEO characteristics- The CEO is appreciated to have leadership characteristics when it comes to risky decision making. A sensible and powerful CEO has a positive effect on corporate performance.
5. Active Oversight- An active oversight is much appreciated in collective decision-making process. The board of directors and owners are recommended to have an active oversight role in decision-making, especially in international joint ventures. A more attentive decision-maker is all required, and it will positively affect the company’s performance.
6. Ownership structure- A well-structured institutional ownership helps improve the board’s quality of strategic decisions via active engagement with the directors and adding an external relevant perspective.

Each of those mentioned above good corporate governance variables perfectly balances the structure and regulatory mechanisms, supports decision-making, and eventually enhances corporate performance. The governance variables have a scientifically proven correlation with corporate performance because it helps the board and directors decide on the right structures and mechanisms.

Conclusion

Corporate governance and performance are intertwined with each other. Corporate governance guides the performance of various participants who make up the corporation. It is considered in general to be a significant factor influencing the growth prospects of a firm because adoption of best governance practices reduces the risk for investors, improves financial performance, and attracts investors. Improvement in governance has led to a considerable increase in investment by foreign investors and companies’ profitability. Those particular companies appear to have a better risk-return trade-off for investors. So, examining the relationship between corporate governance and performance has shown that both are closely related to each other regarding the company’s overall growth. Therefore, sound corporate governance principles should be taught in the company’s regulatory mechanism for its effective management.

References:

[1] Cadbury Committee Report, (London: London Stock Exchange, 1992)

[2] OECD Principles of Corporate Governance, 1999.

[3] Rhoades, D.L., Rechner, P.L., & Sundaramurthy, C. (2000). Board composition and financial performance: A meta-analysis of the influence of outside directors, Journal of Managerial Issues, XII,pp.76-91.

[4] Rose, C.: 2007, ‘Does female board representation influence firm performance? The Danish evidence.’ Corporate Governance, 15 (2), 404–413.

[5] The Indonesian Institute for Corporate Governance, Laporan Program Riset dan Pemeringkatan Corporate Governance Perception Index 2014. (The Indonesian Institute for Corporate Governance, 2015).

[6] Jerab, Daoud Abdellatef, The Effect of Internal Corporate Governance Mechanisms on Corporate Performance 2011 last assessed Jan 8th 2021, at SSRN: https://ssrn.com/abstract=1846628 or http://dx.doi.org/10.2139/ssrn.1846628.

[7] Kajola, Sunday O, “Corporate Governance and Firm Performance” 2008.