Non-nancial Performance Ratios

as a Management Tool
Franko Milost
University of Primorska
Slovenia
This paper argues that annual nancial statements do not provide
a true picture of a companys operations in the past. Account-
ing data, on the basis of which nancial statements are drawn up,
cannot be seen as a suitable source of accounting information for
making decisions about the future. In addition, this means that
the nancial ratios based on such sources are not sucient to sat-
isfy the information needs of the users. As a consequence, an in-
creased number of non-nancial ratios or ratio systems are being
developed. While non-nancial ratios can be seen as completing
the nancial ones, they certainly cannot replace them. This im-
portant restriction of using non-nancial ratios is often neglected.
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Accounting is a process of recording and studying nancial data related
to a companys operations. Its aims are above all:

to provide information about the events in company business life

in an agreed language comprehensible to accounting information
users, and

to provide information which is vital to business decision making.

The rst aim of accounting relates to the past, the second to the fu-
ture. If we consider reaching the above mentioned aims in theory, we
can establish that it is not easy to reach them. Accounting is not an exact
science, which means that approximations or planned amounts are very
often used as its tool. In addition, as the future is uncertain, we cannot
determine the exact value an asset is about to achieve when converted
into monetary form, nor we can dene the amount which will be re-
quired to discharge a certain liability.
In practice, the problem is even more serious. According to recent
American studies in this eld, the average ratio between the book and
I
Franko Milost
market values of companies is I : o., and is even higher in companies
with high added value per employee, which can be as high as I : ,o.
Obviously, we should ask ourselves if companies annual nancial
statements show a true picture of companies past operations. Moreover,
another question should be raised: Is it possible to provide appropriate
accounting information for making decisions about the future on the
basis of such accounting data?
Both answers are negative. Information provided by accounting (i. e.
traditional accounting) does not show a true picture of a business op-
erations in the past, neither does it forman appropriate basis for decision
making in the company about its future. In other words: nancial ratios
based on traditional accounting data can no longer meet information
needs, above all, the information needs of the internal users of account-
ing information.
The problem can be solved in two ways.
The rst option is to reshape the philosophy of accounting practices.
This includes the change of generally accepted accounting principles and
approaches to valuing balance sheet categories. This option faces two se-
rious obstacles:
I. Conservatism, which has always been a signicant feature of ac-
counting practice: accountants have never been very innovative;
moreover, they tend to resist change quite irrationally; conse-
quently, carefully veried approaches have always been used in ac-
counting; a serious disadvantage is slow adaptation of the account-
ing profession to the rapidly changing circumstances in companies
operations.
:. Objective diculties in accounting of intangible long-term assets:
the present value of future services (economic benets) which will
be provided for its owners by these assets, can be dicult to estab-
lish; there are various views concerning the value of employees and
their abilities and how these values appear or do not appear in a
companys nancial statements.
The second option, in traditional accounting, is to explain nancial
ratios in a non-nancial, i. e. descriptive way.
There is a question of the suitability of the above mentioned options.
The professional community tends to consider applying the second op-
tion, which results in an increasing number of non-nancial perfor-
mance ratios or non-nancial ratio systems. Nevertheless, is it possible to
:
Non-nancial Performance Ratios as a Management Tool
replace nancial performance ratios by non-nancial? Can we use non-
nancial performance ratios where nancial ratios are not applicable?
Interestingly, non-nancial performance ratios are mostly not in the
domain of accountants. It is entrepreneurial economists in the eld of
management who develop and promote these ratios.- They are increas-
ingly aware of the ineectiveness of traditional accounting information
about the past and its uselessness when taking decisions about the fu-
ture. The accounting profession does not respond to the challenges of
modern entrepreneurialship, therefore, the job is mainly done by non-
accountants.
In the further text, performance ratios, including non-nancial per-
formance ratios, will be dened. We will also consider the need for de-
veloping non-nancial performance ratios. This will be followed by con-
sidering their advantages and disadvantages, and nal ndings.
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Performance ratios can be dened in a narrow or broad sense. In a broad
sense, they include absolute and relative gures, in a narrow sense, they
include only relative gures. An absolute gure can be a particular gure
(e. g. price), dierence (e. g. operating result) or mean value (e. g. the av-
erage amount of receivables) while relative gures are: participation rate,
index and coecient. In this article, a broad denition of performance
ratios was applied.
Performance ratios can be subdivided into nancial and non-nan-
cial. By using nancial ratios, we compare value-expressed amounts,
while non-nancial ratios are descriptive. Financial ratios can be ex-
pressed as absolute and relative gures, on the other hand, non-nancial
ratios are expressed as absolute (e. g. customer satisfaction) or relative
(e. g. the number of complaints per Iooo products sold). These ratios are
presented in gure I.
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In the accounting community, there is a common belief that employees
cannot be considered as company assets. The same is true for investment
in people (human capital), implementing new approaches (in terms of
accounting, we can refer to target costing, activity-based costing of a
,
Franko Milost
Performance ratios
Financial Non-nancial
Absolute
gures
Relative
gures
Absolute Relative
Figure I: Performance ratios
business process, and the like), investment in reorganization, etc. Nev-
ertheless, the increasing by unbalaced relationships between the book
value and the actual market value of companies indicate that companies
actually have large asset values at their disposal, which are not stated in
a traditional balance sheet. Understated assets also aect the operating
result of a company.
Moreover, it is not only annual nancial statements which do not pro-
vide a clear picture of a companys nancial position; the same is true for
the values of nancial performance ratios, which are based on the data
provided in the above mentioned annual nancial statements.
The professional community has responded to this fact in a quite gen-
uine and interesting way. This has resulted in developing numerous non-
nancial performance ratios or even integrated ratio systems. They are
to meet the needs of users, who are becoming increasingly dissatised
with accounting information. In other words, traditional nancial state-
ments provide a very poor picture of a companys operations in the past.
Moreover, accounting information does not provide their users (man-
agement) with an appropriate source as a starting point for their business
decisions. Therefore, we should nd out if non-nancial performance
ratios provide all the information which cannot be provided by nancial
performance ratios. Can they simply replace nancial performance ra-
tios or in other words, is their applied value limited? We believe that this
is closely related to asset denition and asset value.

Non-nancial Performance Ratios as a Management Tool

There are various asset denitions in the professional literature; nev-
ertheless, what we can establish from these denitions is that an asset has
the following characteristics:

it is controlled by the entity,

it is a scarce resource,

possessing assets may be associated with creating economic bene-

ts,

its cost of acquisition can be measured with certainty and exactness.

Asset value can be dened as the present value of future services (eco-
nomic benets) provided by the asset to its owner in the whole period of
its usefulness.
We have already mentioned that it is non-nancial performance ratios
that are expressed descriptively. They were designed to explain, in a non-
nancial way, certain relationships which are not satisfactorily explained
in terms of nance (referring to value) in traditional accounting.
Theoretically, it is possible for non-nancial performance ratios to
replace nancial ones, which is only possible on condition that the re-
lationships among particular occurrences included in nancial perfor-
mance ratios or their absolute values can with certainty state the present
value of economic benets which are to be gained in the future. Such re-
lationships can be treated as company assets. Unless non-nancial ratios
have this feature, their information power is limited. In terms of infor-
mation gap lling created by nancial performance ratios, such ratios
are useless.
The users of non-nancial performance ratios do not include the re-
lationships among individual occurrences (which are included in these
ratios or their absolute values) in company assets. Therefore, we can con-
clude they are not aware of the present value of a companys future eco-
nomic benets, which leads to two essential ndings:
I. The applied value of non-nancial performance ratios is limited,
and obviously falls short of our expectations and it often does not
justify the investments connected with developing these ratios and
their practical usage.
:. Applying non-nancial performance ratios as a means of explain-
ing unbalanced relationships between book values and market val-
ues of companies, or as a means of information design for business
decision making about future, is a poor choice.
,
Franko Milost
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Although designing non-nancial ratios of performance is useful, their
application faces some limitations. Nevertheless, there are both advan-
tages and disadvantages to it.
Their rst advantage is explaining or trying to explain certain relation-
ships or occurrences which are not evident from nancial statements.
For instance, from nancial statements (or accounting information in
general) we cannot read about the companys coexistence with the local
community and wider environment, about the companys technological
development, employee satisfaction, health and safety at work, etc. There
is also not much information on competitive advantages and companys
weaknesses, its market share, customer satisfaction, new products, qual-
ity control expenses, branch development and the like. Financial state-
ments do not show the value of investment in employees, nor do they
show their knowledge and skills. Non-nancial ratios of performance
provide information on events referring to essential aspects of the com-
panys performance.
The second advantage of non-nancial performance ratios is the fact
they reveal a deep crisis in traditional accounting, which does not re-
spond to the challenges and changes of companies operations. The tra-
ditional accounting played a purposeful role especially during the period
of early capitalism when the two most important factors of production
were material and work (in the sense of using the physical potential of
employees). By a rapid increase in the share of knowledge included in
the prices of business eects and by a sharp increase in the share of in-
tangible long-term assets in the companys asset structure, the value of
accounting information is decreasing.
Developing non-nancial performance ratios involves some disadvan-
tages. Let us focus on the major ones.
The rst disadvantage of non-nancial performance ratios has already
been mentioned in the previous section. It refers to the fact that these
ratios cannot reect the present value of future services or economic
benets for the company, resulting from the absolute value of a ratio
or relation. The usefulness of such ratios is thus limited. Moreover, non-
nancial performance ratios are too often used to record occurrences
(relations) which should be shown among assets if they are to gain fu-
ture economic benets. Non-nancial performance ratios can be a useful
o
Non-nancial Performance Ratios as a Management Tool
complement to nancial ones, above all when they indicate the present
value of future economic benets (services) for the company.
The second disadvantage is their inability to aect (at least not di-
rectly) a companys assets and nancial position as well as its perfor-
mance, which might all be the result of the value of some non-nancial
performance ratios (customer and supplier satisfaction, the number of
complaints, etc.). In general, non-nancial performance ratios only ex-
plain these factors. For instance, company performance thus depends on
its market share and customer satisfaction. Nevertheless, it is much more
aected by the approaches selected to evaluate particular economic cat-
egories. A non-nancial performance ratio, which reects customer sat-
isfaction, only explains the achieved sales revenue, which is ascertained
nancially. Higher values of most non-nancial performance ratios do
not necessarily mean enhancing company performance, taxation, and
similar.
Their third disadvantage is the fact that they are used in external nan-
cial reporting. Their applicability is therein limited due to the fact that
they cannot be veried by external auditors, and their credibility cannot
be easily veried when considering numerous ratios.
The fourth disadvantage of non-nancial performance ratios is their
connivance to accounting professionals who, in turn, do not tackle the
problem in an appropriate way. Moreover, these ratios are often used
to explain the dierence between the companies book values and their
much higher market values. To sum up, the mentioned fact reects a
serious crisis in the accounting profession.
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The last decade has witnessesed the development of non-nancial per-
formance ratios or ratio systems. These ratios are an important comple-
ment to the nancial ones. Nevertheless, their development and subse-
quently their application face a serious problem: they are overused, i. e.
too much signicance is ascribed to them.
Although non-nancial performance ratios are an important comple-
ment to the nancial ones, they cannot replace them. From the relation
expressed in a non-nancial performance ratio or its absolute value we
cannot ascertain the present value of a companys future economic bene-
ts. Moreover, this means that non-nancial performance ratios cannot
provide a satisfactory explanation for unbalanced relationships between
,
Franko Milost
a companys book value and its market value, nor do they provide infor-
mation required for business decision making about the future.
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I. Financial statements, as well as nancial performance ratios based
on these statements, generally show only I, percent of a companys
past events. This percentage relates to the United States, while
the percentage for Slovenia is much higher. Therefore, we should
consider the benets of such an information system for manage-
ment. Are these benets comparable with the increasing costs (sta
salaries, training, information technology and the like) of business
operating? Is thus accounting, as it used to be in the past, mainly in
the service of external users?
:. There are several non-nancial performance ratio systems. For
instance: the Navigator which was developed in a Swedish insur-
ance company Skandia (The Danish Trade and Industry Develop-
ment Council I,,8), and Balanced Scorecard by Kaplan and Norton
(:ooo).
,. According to the Dictionary of Accounting, Finance and Audit-
ing, nancial ratios are ratios used in decision making in the eld
of nance (Turk :ooo, Io,). Our denition of nancial ratios is
thus wider. The dictionary does not dene the conception of non-
nancial ratios.
. David Wilson, a certied accountant and partner with Ernst &
Young, which is among the ve biggest consulting and auditing
companies, comments (Stewart I,,,, ,8): It has been ve hundred
years since Paccioli published his seminal work on accounting and
we have seen virtually no innovation in the practice of accounting
just more rules none of which has changed the framework of
measurement.
vvvvvvxcvs
Kaplan, R. S., and D. P. Norton. :ooo. Uravnoteeni sistem kazalnikov.
Ljubljana: Gospodarski vestnik.
Stewart, T. A. I,,,. Intellectual capital: The new wealth of organizations.
London: Doubleday.
8
Non-nancial Performance Ratios as a Management Tool
The Danish Trade and Industry Development Council. I,,8. Intellec-
tual capital accounts: Reporting and managing intellectual capital.
http://www.videnskabsministeriet.dk/fsk/publ/I,,8/
intellectualcapitalaccounts/videnregn_eng.doc.
Turk I. :ooo. Pojmovnik racunovodstva, nanc in revizije. Ljubljana:
Slovenski intitut za revizijo.
,