Financial performance measures - Short-termism vs long-term ...

Learning Outcomes

After reading this article, you will be able to explain how financial performance indicators (FPIs) are used to evaluate business results, identify the risks of short-termism, and understand how an excessive focus on short-term outcomes can undermine long-term value creation. You will learn key terms, interpret measured results, spot signs of manipulation, and discuss approaches for aligning performance measurement with sustainable strategy.

ACCA Performance Management (PM) Syllabus

For ACCA Performance Management (PM), you are required to understand how financial performance indicators relate to decision making and sustainable success. Specifically you should be able to:

• Describe and interpret main FPIs for profitability, efficiency, liquidity, and gearing
• Analyse the causes and problems created by short-termism
• Recognise signs and problems of financial manipulation
• Discuss the impact of solely using FPIs versus a balanced approach
• Suggest ways to encourage a long-term outlook in performance assessment

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following is not a likely risk if management targets only current year profit targets at the expense of investment?
   1. Deteriorating asset quality
   2. Reduced staff turnover
   3. Reduction in product development
   4. Deferred maintenance costs
2. Which FPI compares operating profit to the capital invested, and can encourage short-termism if incorrectly used?
   1. Asset Turnover
   2. Current Ratio
   3. Return on Capital Employed (ROCE)
   4. Gearing

3. Give two examples of manipulative actions managers might take to boost short-term reported profits, and explain their potential downside.

4. Briefly define "short-termism" in the context of performance management.

Introduction

Financial performance indicators are essential for assessing profitability, liquidity, and efficiency, but relying solely on them can create significant risks for an organisation. Over-emphasis on meeting annual or quarterly profit or ROCE targets can tempt managers to pursue actions that improve numbers in the short term while undermining the business’s future. The ACCA PM syllabus requires you to understand how short-termism threatens long-term value and what can be done to prevent it.

Key Term: short-termism
Focusing management decisions and actions on achieving short-term financial targets at the expense of long-term value and sustainability.

FINANCIAL PERFORMANCE MEASURES AND THEIR LIMITS

Financial performance indicators (FPIs), such as ROCE, profit margins, and asset turnover, form the basis for most management and investor assessments of a company’s success. They allow comparisons with budgets, prior periods, and competitors.

Key Term: Return on Capital Employed (ROCE)
Operating profit as a percentage of capital employed; used to measure how efficiently a business generates profit from its assets.

Key Term: financial manipulation
The use of accounting choices or timing of transactions to make short-term reported financial results look stronger, without genuine fundamental improvement.

Unlike non-financial indicators, FPIs are quantitative and attract close attention from boards, shareholders, and analysts. However, they pose two key risks:

• They encourage short-term decisions that harm the long-term business.
• They are open to manipulation that distorts true fundamental performance.

Short-termism: What Is It and Why Does It Matter?

Short-termism arises when management prioritizes the achievement of annual, half-year, or quarterly targets, such as profit or ROCE, over investment in areas that generate sustainable returns – like R&D, training, or asset renewal.

Examples of short-term behaviour:

• Delaying necessary maintenance or investment to avoid expense this year.
• Cutting spending on staff, training, quality, or marketing.
• Reducing research and product development.
• Accelerating revenue by pushing sales at year-end, with discounts or early recognition.
• Deferring or capitalising costs that should have been expensed.

Worked Example 1.1

A company’s divisional manager is evaluated on annual ROCE. The current ROCE is 19%. An opportunity arises to invest $500,000 in new machinery delivering 15% return. The company's cost of capital is 10%. Should the manager undertake the investment if focused solely on ROCE?

Answer:
The investment delivers 15%, above the cost of capital (10%), so benefits the company in the long-term. However, since it would dilute the division’s reported ROCE from 19% toward 15%, the manager may reject it if personal bonuses and assessment are linked to ROCE alone. This is a classic example of short-termism.
The correct decision is to accept the investment. To avoid dysfunctional decisions, management should consider wider criteria (e.g., residual income, NPV) and long-term value.

THE PROBLEMS CREATED BY SHORT-TERMISM

1. Neglect of Long-Term Value

Short-termism leads to deferral or avoidance of investments in areas that are not immediately profitable. This creates future problems:

• Asset base becomes outdated, leading to reliability issues.
• Staff morale drops, increasing turnover and reducing customer service.
• Market share and reputation deteriorate due to lagging product innovation.
• Profit manipulation increases, eroding trust.

2. Inducement to Financial Manipulation

When the focus is on the current period’s results, managers may employ tactics that boost profits in the short term but are unsustainable or even damaging. These can include:

• Deferring or underprovisioning for necessary expenses.
• Delaying supplier payments to improve cash/working capital ratios.
• Accelerating revenue recognition.
• Revaluing assets or adjusting depreciation policies to boost income.

Worked Example 1.2

A company’s actual operating profit is projected to fall short of target. The finance manager proposes to defer recognition of a significant expense until after year-end to meet the bonus-linked profit target. What problems can result from this action?

Answer:
This action is a form of financial manipulation. While it increases apparent profit in this period, it simply defers the expense—leading to an even greater challenge next year. It also undermines the reliability of the accounts and the credibility of management. Repeated manipulation reduces stakeholder trust, potentially damaging share price and long-term financing options.

REDUCING SHORT-TERMISM AND SUPPORTING LONG-TERM VALUE

Organisations must balance short-term results with long-term health. ACCA examiners expect you to identify both the symptoms of short-termism and measures to encourage a sustainable view.

Keys to Moving Beyond Short-Termism

• Set targets that reflect strategy and multi-year performance. Avoid bonuses based solely on single-year profit or ROCE. Instead, use a mix of measures, such as economic value added (EVA) or residual income, that take the cost of capital and investment horizon into account.
• Include non-financial and leading indicators. Customer satisfaction, quality, employee development, and innovation targets provide a broader view of value creation.
• Tie rewards to sustainable behaviours. Link part of incentive schemes to strategic milestones, quality improvements, or successful new product launches.
• Incorporate a balanced scorecard or similar model. Combining FPIs and non-financial dimensions, such as the balanced scorecard or Fitzgerald and Moon’s Building Block model, helps link day-to-day performance with long-term goals.
• Ensure transparent reporting. Regular review by internal/external audit and adopting transparent disclosure policies enhances credibility.

Worked Example 1.3

A technology firm moves from a pure profit-based bonus to a mix of indicators, including customer retention and the 3-year average ROCE. What outcome should management expect?

Answer:
Managers now have incentive to invest in customer service and sustainable competitive advantage, since customer retention is factored into bonuses. Using 3-year average ROCE also reduces the temptation to defer necessary spending and improves decision-making around long-term projects, supporting true value creation rather than short-term gains.

Revision Tip

If a question asks how to prevent dysfunctional short-term behaviour, always mention aligning incentives to long-term value, using multiple–year targets, introducing non-financial measures, and improving transparency.

Exam Warning

Do not assume that higher profit, ROCE, or EPS always means better long-term performance. Only focus on the number's meaning and its alignment with sustainable strategy.

Summary

Financial performance indicators are powerful tools, but a narrow or short-term focus creates risks that can damage stakeholder value. Short-termism encourages manipulation and underinvestment, harming the business in the long run. Effective performance management balances short and long-term indicators, includes non-financial measures, and rewards actions supporting strategic goals and sustainability.

Key Point Checklist

This article has covered the following key knowledge points:

• Define and explain short-termism as a risk in performance management
• Describe how exclusive reliance on FPIs such as ROCE can lead to suboptimal, short-term decisions
• Identify common forms of short-term manipulation and their drawbacks
• Suggest practical measures to encourage long-term value creation, including use of balanced scorecard, multiple year targets, and non-financial KPIs
• Recognise exam pitfalls regarding interpretation and use of FPIs

Key Terms and Concepts

• short-termism
• Return on Capital Employed (ROCE)
• financial manipulation