Sep 18, 2010

Sustainability and Financial Analysis. An Integrated Framework for the Analysis of the Firm Value Creation Oriented to Sustainability.



It is essential to support the application of the language, knowledge and tools of the financial theory to the orientation of the decision making processes of the diverse economic agents when incorporating these sustainability objectives. Once the market has incorporated sustainability into its strategies a “sustainability circle” will have been closed:
 


Most appropriate question: What does sustainability performance tell us that we do  not  know  about  financial  performance  yet?  (Feldman,  Soyka  and  Ameer,1996).
In this sense, it is specially significant the absence of fundamental approaches to the  incorporation  of  sustainable  development  considerations  into  the  traditional financial  analysis  of  the  firm.  This  is  not  only  a  tool  to  assess  a  firm’s  past financial  performance,  but  also  its  strengths  and  weaknesses  for  the  future.  The information that such analysis provides is critical for all the firm’s stakeholders in order  to  develop  their  decision  making  processes,  and  what  it  tells  us  about  the financial  performance  of  a  firm  can  be  completed  and  best  understood  with information about its sustainability performance.
The ratio, mathematical relation between two quantities, is of major importance in financial analysis because it injects a qualitative measurement, it demonstrates in a precise manner the adequacy of one key financial statement item relative to another and it facilitates comparisons between companies in the same industry as well as year-to-year comparisons within a single company.
In this sense, it is generally assumed that the financial ratio  analysis can be developed under two perspectives:
·         Diachronic perspective: where it is necessary to collect information on the  evolution in time of the essential variables of the diagnostic.
·         Synchronic perspective: where the value of the firm’s ratios is compared with the same figures for the sector it belongs to in order to draw conclusions on each individual ratio and determine if the firm’s situation is good, standard or bad.
Unfortunately, earlier attempts to relate important elements of  the financial statements through key financial ratios have suffered from a lack of systematic application because of unawareness of the fundamental principle of cause and effect.
The cause-effect ratio analysis is derived from the following assumptions:
·         The different ratios do not have the same importance for the analysis. Some key ratios are primary, driving changes in the rest of relevant measures.
·         The analysis acts in an inductive manner: the immediately visible situation is the effect; the cause or causes must be searched.
·         The ratio analysis potential and its strategic value for financial analysis are based on two fundamental methodological principles: the breakdown of each ratio in its main components and the definition of relationships between the different ratios.
Our aim is to provide companies with a methodology that allows them to focus on the sustainability activities that generate significant financial and/or non-financial benefits and to integrate financial considerations into every major sustainable development decision, as well as to provide the financial community with the appropriate decision making tools and rules as to be able of evaluating a company’s sustainable management system and support its sustainability as well as its financial objectives.
So our proposal is based on the belief that it is necessary to adapt existing tools and models of financial analysis in two directions:
·         To incorporate the impact of sustainability issues on economic and financial performance.
·         To implement the cause and effect rationale.
The main sources of knowledge from which we pick the background for our Model of Financial Analysis of Sustainability are:
1.      General Financial/Environmental Knowledge.
2.      The DuPontratios Pyramid.
3.      The Balanced Scorecard/The Sustainability Balanced Scorecard.
4.      The Shareholder Value/Environmental Shareholder Value Concepts.


 
The main sources of knowledge from which we pick the background for our Model of Financial Analysis of Sustainability are:
1.      General Financial/Environmental Knowledge.
2.      The DuPontratios Pyramid.
3.      The Balanced Scorecard/The Sustainability Balanced Scorecard.
4.      The Shareholder Value/Environmental Shareholder Value Concepts.
The Balanced Scorecard (Kaplan and Norton, 1997) is based on the establishment of cause-effect relationships between key indicators across four perspectives of a firm’s management. Application of the Balanced Scorecard approach to sustainability: Elkington 1997; Johnson 1998; Hahn and Wagner 2001; Figge et al. 2002; Schaltegger and Dyllick 2002.
There is not a systematic procedure for the construction of the leading and lagging indicators defined across categories. Here is where the financial analysis through cause and effect ratios, as we have defined it above, provides the most valuable contribution to the management and assessment of the impact of sustainability issues on shareholder value.
The main sources of knowledge from which we pick the background for our Model
of Financial Analysis of Sustainability are:
1.      General Financial/Environmental Knowledge.
2.      The DuPontratios Pyramid.
3.      The Balanced Scorecard/The Sustainability Balanced Scorecard.
4.      The Shareholder Value/Environmental Shareholder Value Concepts.
The shareholder value concept, coined by A. Rappaport (1986), was applied for the first time to the environmental area by Schaltegger and Figge (1998), who consider what forms of corporate environmental management can help to improve  shareholder value or can destroy it.
Sustainability (2001) has identified six financial drivers of the sustainable value creation: Customer Attraction, Brand Value & Reputation, Licence to Operate, Human & Intellectual Capital, Innovation and Risk Profile. We can integrate these six value drivers in Rappaport’s Shareholder Value Added Model in an effort to make more evident the link between firm’s environmental management and its value creation capacity.



 
Our model, called Model of Financial Analysis at the service of Sustainability (although here we are mainly focused on the environmental side), suggests a number of conceptual relationships between some significant ratios reflecting the financial as well as the environmental performances of a firm, linked by means of mathematical expressions, so that the relations defined are far from subjective.
Obviously, the list of ratios that could be created is almost infinite. It is necessary to identify in each particular case which are the more relevant, what will depend on variables such as sector/subsectormembership, firm size, etc. The result of the identification of the relevant ratios and the  definition of relationships between them can be modeled with the form of a pyramid similar to that of the DuPont methodology, where at the base can be found the main causes that deliver the results shown on the top, being the final effect ratio the price per share, as directly dependent of the ROE, the cost of equity capital and the rate of future growth .





in the firm’s site and the likely reduction of the financial leverage of the firm’s capital structure (owing to the improved ROA, which would lead to a higher profit that would allow the reduction of total liabilities).








But let’s suppose that the firm’s management is delaying the adoption of a new cleaner technology, and that this is the reason why the value of the Sales/Fixed Assets ratio is so high. We all agree that this is not good from an environmental perspective. Although the financial result is good, it is not accompanied by a good environmental performance. But how can we detect this situation if we only follow the path we have just described and show onto the figure? It is necessary to broaden the analysis, taking into account other areas of the firm management and deepening in the cause-effect chain to find other signals of the real environmental (and
financial?) situation of the firm. Pure logic: What can be the expected result of not updating or removing the dirty technology? More emissions (both in kg and euros)? More waste (idem)? More fines? 
The analysis of ratios such us Sales/Waste, Cost of emissions/Sales, Environmental  Fines/Sales, etc can add valuable information to the financial ratio analysis. Although a high Sales/Fixed Assets ratio may be signaling an improved ROA and ROE, there can be other ratios signaling the opposite: a high  Cost of Emissions/Salesand/or a high Environmental Fines/Saleswill be limiting the profit generation and a low Sales/Waste will mean a reduction of the Sales/Current Assetsratio that can compensate the high value initially found for the Sales/Fixed Assetsratio.
At the end the firm manager could have to explain to the firm shareholders that the increment in the Sales/Fixed Assetsratio has been compensated by the reduction of the Sales/Current Assets ratio, in such a way that the ratio Sales/Total Assets remain unchanged and do not affect the ROA, while the profit margin has suffered a decrease so that the final impact is a reduction of the ROA. And this without considering that the damaged firm image will reduce its sales, cause the losing of market share and limit the growth capacity of the firm, what would affect considerably the shares relative price. In this way we have expanded the analysis looking for causes at the bottom of the pyramid.




 
Although we believe in the potential of the static, past information based analysis as a picture of the current economic, financial and environmental situation of a firm, that can provide valuable insights about its future developments, we are also conscious that a more dynamic perspective is required. In this way, we propose a three dimensioned model of financial diagnostic based on three perspectives:




 
CONCLUSIONS
The financial analysis, despite the critics it has frequently received regarding its reliance on past and accounting information, has traditionally been considered an appropriate tool to assess a firm’s financial and economic situation, and so it could also provide with valuable information when analysing the firm’s environmental and social performance and its relationship with financial performance. The ratio analysis and the cause-effect rationale are a valid alternative for the development of the financial analysis of sustainability, as they allow to identify the sustainability activities that generate significant financial and/or non-financial benefits and they provide the financial community with an appropriate decision making tool to evaluate a company’s sustainable management system and the impact of sustainability issues on financial performance.
As long as the environmental reporting and the availability of adequate information  becomes the rule and not the exception, our model of financial  analysis of sustainability will help uncover the true financial, environmental and social situation of the firm and, thus, drive to better decisions and contribute to the simultaneous achievement of financial and sustainability objectives.







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