Corporate Governance and Firm Performance



Literature Review

1. Corporate Governance and Firm Performance

Despite increasing attention in corporate governance literature to broad stakeholder concerns, including corporate social responsibility (Bhasa, 2004; Kakabadse & Kakabadse, 2003), it is the financial performance of the firm that provides the resources with which these broader issues and interests can be addressed. If the firm is under-performing from a financial perspective, efforts to address broader stakeholder concerns may not be sustainable due to lack of financial resources. It is also important to recognize that the fiduciary responsibility of the board of directors under Canadian law is to the corporation rather than to shareholders or stakeholders ("Canada business corporations act", 1985). Being consistent with this fiduciary duty means assessing performance from the company perspective, leading to a longer term view than that which might expected if performance were to be assessed from the shareholder perspective. Indeed, measuring performance from a shareholder perspective can be a very difficult if not impractical undertaking when some shareholders own stock for a very short period of time and others take a very long-term view of performance. It becomes a daunting task to act in the best interests of all shareholders when there is a broad mix of interests, many of which would be in conflict. Consequently, the approach under Canadian law simplifies the directors' duties since being faithful to fiduciary duty requires focus on the firm and does not require that diverse shareholder interests be addressed directly (Tam, 2007).

There are numerous measures of financial performance that have been used in governance studies. Bhagat and Black (2002) for example, assessed firm performance using Tobin's Q, return on assets, the ratio of sales to assets, and market-adjusted stock price returns (Short, 1999).

Gugler, Mueller and Yurtoglu (2003) used returns on investments, Ross and Weill (2004) used return on assets, while Foerster and Huen (2004) used total shareholder return. None of the measures used by these authors would adequately address performance from the perspective of the fiduciary duty of Canadian directors. Tobin's Q for example, is the ratio of market value to book value and is therefore an assessment of valuation which does not directly measure performance. Market adjusted price returns and total shareholder returns are performance measures from the investors' standpoint (Shleifer, 1997). The ratio of sales to assets measures an aspect of performance from the firm's perspective, but without taking costs into account, this ratio is an incomplete performance measure. Return on assets and return on investments are also incomplete measures because these are calculated before dividends are considered (Shleifer, 1986).

A performance measure that reasonably aligns with directors' fiduciary responsibilities is sustainable growth. This calculation takes a company- focused view of returns because it factors out dividends from the return on equity (Higgins, 1977; Kyd, 1981; Sampath & Kambil, 2005). Sustainable growth from one year measures how much a company can grow its revenues in the subsequent year without issuing new equity, taking on more debt in order to finance the growth, or modifying ...