Facilitating Value Creation
By Lloyd Macfarlane
UNDERSTANDING THE CONCEPT OF FINANCIAL CAPITAL FOR CORPORATE REPORTING
Traditional accounting practices place large emphasis on the extent to which good financial capital man- agement is responsible for the economic success of the business – traditionally the main issue of concern for shareholders and investors. However, companies are increasingly required to take a more holistic approach to the many forms of capital in the business, and to do so with key stakeholders in mind. The corporate sustainability agenda is changing the way that companies contemplate and report on financial capital, so what is financial capital in the context of value creation and sustainability?
Financial capital is used by people, organizations, corporations, and governments, to build and maintain their livelihoods. This includes all financial assets, instruments, and resources (including loans, bonds, stock, expenses, assets, equity, and cash flows) used throughout the organisation’s activities. It could be said that financial capital reflects the productive power of all other types of capital in the business, although technically there may be exceptions to this Financial capital plays an important role in our economy, enabling the other types of capital to be owned or traded. Proper management of financial capital is crucial to maintaining effectiveness, efficiency and economic sustainability in the organisation.
Generally speaking financial capital has no value of its own (except if the company’s business is a holding company or a bank). It is not productive, for instance, in the sense that a manufactured product produces value. Instead, the value of financial capital lies in the facilitation of economic production. Financial capital controls ownership of physical capital and is a representation of the value of the other four capitals. In other words, money has to go out before more can be brought in.
Companies may have access to many forms of financial capital but little can happen without expendable cash as a resource (particularly in terms of operations). Financial capital can be obtained through earnings, banks (in the form of short or long term loans), private equity (and venture capital transactions) and grants.
The integration and management of all types of capital is essential if a company
is to target sustainability, and so any discussion about financial capital should reference this integration. The IIRC’s Integrated Reporting Framework <IR> tackles the concept of integrated thinking and sustainability performance by focusing on the ‘six capitals’: financial, manufactured, human, intellectual, natural and social.
There is mounting evidence that companies with strong sustainability performance deliver improved long-term financial returns. For example, a July 2013 Harvard Business School study found that “High Sustainability” companies significantly outperform their peers over the long-term,
in both stock market and accounting terms (Eccles, Ioannou and Serafeim, 2013).
Whilst there is still some discussion about what in fact causes this performance, these companies are generally managing risk more effectively and positioning themselves advantageously in their respective value chains – objectives that are ultimately linked to the corporate sustainability agenda.
If the primary objective of business is value creation then financial capital is the tool with which this takes place. Sustainable businesses create value for all key stakeholder groups and not just shareholders – this is where the direction of financial capital is becoming increasingly important. The returns on investments in employees or local communities for example can be difficult to quantify, however the risks of ignoring these investments can be meaningful and even critical for the business.
Although the way an organisation applies other forms of capital may be in stark contrast to the way it deals with financial capital, all these components are often connected to expenditure – investing in “any other form of capital usually requires good management of financial capital.
THIS MEANS THAT AN INVESTMENT IN RELATIONSHIPS WITH THE COMMUNITY OR OTHERS MAY BE GOOD FOR REPUTATION AND IMPROVED SALES, BUT ONLY UP TO A CERTAIN LEVEL, says Pieter Conradie,
Programme Director for Integrated Reporting at the Albert Luthuli Centre for Responsible Leadership (University of Pretoria). There is risk in expending too much financial capital in order to fund corporate social investment projects for example.
“This is of course a very pragmatic or instrumental way to look at investments, but in my mind this is also the way that most executives look at things, because proving a positive ROI from investments in social projects can be very tenuous because of all the extraneous variables at play,” says Conradie.
All of the <IR> capitals are connected to financial capital in some way. Conradie suggests that “the obvious challenge is to determine the causality between the other capitals and financial capital, especially in determining how an investment in other capitals may lead to returns in financial cap- ital.” This is the holistic aspect of integrated reporting and the relationship between financial and non-financial information. Everything about a company’s performance is intrinsically linked.
A company’s annual report has traditionally been enough for investors and shareholders who until recently haven’t been that interested in sustainability reporting. This is changing as shareholders realise the extent to which their investments are impacted by the stability and value created by the business for other key stakeholder groups.
Recently appointed Chief Executive of the Global Reporting Initiative (GRI), Michael Meehan says that one of the reasons that organisations report is to understand their commitment to sustainability. “Over the years, for better or worse, GRI has become synonymous with the report. To me, that
is not what’s important.
What’s important is the process by which you understand the information, collect the information and communicate it,” says Meehan Corporate reports have historically been comprehensive but cumbersome and now the integrated reporting process aims to change this, by providing more focus and more relevance in a format that has more application. Even if the report is not written for, or read by other key stakeholder groups, it should at least deal with financial capital in terms of how it relates to the other capitals of the business.
Source: Green Economy Journal
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