The Impact of Corporate Governance Practices on Financial Performance in Western Balkan Countries

In this section, the works of different authors in the field of corporate governance and financial performance will be analysed in theoretical and empirical terms. Within this literature review, we will include the concepts of corporate governance and governance mechanisms and their role in financial performance. We will link this study with the agency and administration theories which largely explain corporate governance and the avoidance of problems that may occur as a result of non-genuine corporate governance. Corporate governance refers to the systems, mechanisms, processes and structures by which companies are managed and directed [5]. It also includes reviewing the organisation's practices and policies regarding ethical standards and principles and compliance with its code of conduct [6]. The Cadbury Committee on Corporate Governance defines corporate governance as the process and structure used to direct and manage the company's business affairs towards increased prosperity and the accounting of the corporation with the ultimate objective of realising long-term shareholder value, taking into consideration the interest of other interested parties known as stakeholders (the board of directors, management, employees, customers, suppliers and the community) [7]. Corporate governance identifies the role of directors and auditors in relation to shareholders and stakeholders. It is important for shareholders as it increases confidence in the company for a better return on investment. For stakeholders such as employees, customers, suppliers, the community and the environment, corporate governance ensures that the company behaves in a socially and environmentally responsible manner [8]. The corporate governance system of modern corporations is divided into two parts, namely, the internal and external governance mechanisms. Internal corporate governance mechanisms include the degree of shareholder concentration or ownership structure, such as the percentage of institutional shareholders and foreign, external and internal shareholders. It also relates to the composition of the board of directors, such as board size, board composition (the percentage of non-executive directors), board committees and board leadership structure [9]. Three types of board-level committees – audit, nominating and remuneration – are most commonly required by law or recommended by corporate governance codes in most jurisdictions [10]. Auditing is a systematised process of collecting and creating arguments in relation to economic activity. It results in ascertaining the balance between the enterprise's business and the previously presented criteria, and the information is sent to interested users [11].

On the other hand, external governance mechanisms consist of the capital market, the public sector, legislation and the labour market [12]. Consequently, corporate governance mechanisms are issued by national and international authoritative bodies. These mechanisms contain principles or legislation for good corporate governance mechanisms that major or listed companies are encouraged or mandated to adopt or implement [13].

2.1 Agency theory

To investigate the effect of corporate governance (relationships between owners and managers) on financial performance, we used agency theory as a theoretical framework. Agency theory represents the most popular theoretical perspective of corporate governance. Authors define the agency relationship as a contract under which one party (the principal) engages another party (the agent) to perform certain services on their behalf [14, 15]. Moreover, they add that shareholders are the managers and managers are the agents who work on behalf and for the interests of the managers. Agency problems arise when management and shareholders have different goals, and monitoring management's activities is difficult and costly for shareholders [16]. The presence of an asymmetry of information and self-interest between shareholders and agents means that principals have no reason to trust their agents, leading to increased concerns about the reliability of the information provided by the agent and the degree of trust placed by principals in their agents, resulting in increased agency costs. These agency costs are even higher in countries with weak investor protections and ineffective legal systems [17]. Useful and effective corporate governance mechanisms can help to control the rift between management and shareholders [18]. Better corporate governance reduces agency costs, increases investor confidence, improves firms' access to cheaper financing sources, and reduces the need to use leverage to discipline managers [19]. Corporate governance mechanisms such as the ownership structure, managerial ownership, board of directors, debt financing and financial information quality affect the mitigation of agency problems [20]. In addition, as it involves a high audit quality and the reduction of information asymmetry, corporate governance positively affects the attraction of new investments. It leads to a rise in the volume of investments in companies, which increases the company's value [21].

2.2 Stewardship theory

Stewardship theory was introduced as a normative alternative to agency theory [22]. Like agency theory, stewardship theory emphasises the need to align principal and agent goals, but unlike agency theory, stewardship theory assumes that boards and managers are stewards whose behaviour is automatically aligned with their principals' objectives [23, 24]. Stewardship theory suggests that owners' interests are aligned with those of managers since managers are custodians or administrators of the firm. So, managers/directors have a fiduciary duty to the shareholders of the company in which they are employed [25]. Managers are expected to increase performance to ensure higher profits, as they are imbued with the desire to protect the interests of shareholders and ensure the continued prosperity of the firm.

2.3 The impact of corporate governance practices on financial performance

In general, corporate governance is considered to be an important variable affecting an economy's growth prospects because better governance practices reduce the risk for investors, improve financial performance and help attract investors [26]. Companies with good corporate governance have a greater shareholder value due to a higher cash flow and reduced cost of capital [27]. If corporate governance is considered good, it reduces the cost of capital to the extent that it reduces shareholders' monitoring and auditing costs [28]. Conversely, companies with weak corporate governance structures cannot guarantee shareholders sustainable wealth creation, as governance mechanisms will be insufficient to hold executives accountable for their stewardship [29]. The fundamental objective of good corporate governance is to promote transparency and public accountability [30]. The more transparent the companies' activities, the more accurately their securities will be valued in the markets [31].

Additionally, disclosing corporate governance practices provides investors with information about the corporate ownership structure, management structure, management composition, and internal audit and control [32]. On the other hand, this reporting of governance practices also enables corporate managers to provide information on how they carry out their responsibilities to their stakeholders, otherwise known as their accountability. Analysis from an economic policy perspective concludes that a weak corporate governance framework will severely hinder all stages of the investment process and, thus, the overall prospects of the economy to build a strong private sector base for economic growth [33]. Consequently, it will impair the capacity to mobilise savings, hinder the efficient allocation of financial resources and prevent the proper monitoring of corporate assets.

2.4 Review of empirical studies

In the empirical literature, a limited number of works are considered that analyse the impact of a set of corporate governance standards on the financial performance of firms. While most works consider the impact of governance characteristics on financial performance, this paper will focus more on the impact of governance standards or practices on firms' financial performance. Patel and Dallas [34], in their study of American companies, examine the role of transparency and the disclosure of the information using an index consisting of 98 questions grouped into three categories: ownership structure and investor rights, financial transparency and disclosure and board and management structure and processes. Based on the results, they find that firms with a high index rate have a lower market risk and higher price-to-book value, so companies should improve disclosure and transparency to reduce the cost of capital [35]. La Porta et al. [36] have investigated differences in governance standards using a sample of 371 large firms from 27 countries with rich economies. Governance standards are presented through the legal protection of minority shareholders and the ownership of cash flow by a controlling shareholder, which have influenced the valuation of firms. Their data test shows that firms incorporated in countries with better governance standards (better protection of minority shareholders and weaker evidence of the benefits of higher cash flow ownership by controlling shareholders) tend to have a higher rating. Beiner et al. [37] have developed a corporate governance index and analysed the impact of different corporate governance mechanisms on the value of firms in Switzerland as measured by Tobin's Q. Some of the governance mechanisms utilised include the shares of the largest shareholder, outside block holdings, leverage, board size and the share of outside directors on the board. Based on the results, they find a positive and significant correlation between corporate governance and Tobin's Q. Chauhan et al. [38] have explored the effect of firm-level corporate governance practices on the financial performance of 84 publicly traded Indian firms for the period 2003–2013, focusing on founder ownership. Comprehensive corporate governance practices measured through the governance index (which includes boards of directors, audit committees, remuneration committees, general meetings and disclosure of financial information) have a positive relationship with the financial performance of these firms, as measured by the return on assets (ROA), Tobin's Q and firm size. This relationship becomes stronger when founder ownership is high. Monda and Giorgino [39] have designed a multidimensional index to measure the quality of corporate governance systems adopted by firms and use it to investigate the correlation between the quality of corporate governance and firm value. This complex index (CGI) comprises 39 variables referred to four dimensions: board, remuneration, shareholder rights and disclosure. To assess the data, they applied the panel and ordinary least squares (OLS) models and fixed- and random-effects models. They have analysed a sample of 100 large companies listed on the main stock markets in five different countries (France, Italy, Japan, the United Kingdom and the USA) for three years (2009–2011), and based on the results, confirm the widespread hypothesis of the existence of a positive and statistically significant relationship between corporate governance, evaluated by a subset of 12 variables, and firm value, measured by Tobin's Q.

Results of the first multifactorial model – return on equity (ROE) are shown in Table 2.

Table 2. Descriptive statistics of the model

Source: Authors' calculations in SPSS (2023)

Skewness and Kurtosis Coefficient

Coefficient of Curvature (Skewness) = Statistic/Std. Error = 0.282/0.396 = 0.708 (-1.96...+1.96). The results imply that these data are within the standard deviation - 1.96 to + 1.96, which means that the curve has a normal distribution.

Coefficient of Kurtosis = Statistic/Std. Error = - 0.520/0.778 = - 0.668. Based on the results, it is implied that these data are within the range of -1.96 to + 1.96, and since the value is negative, the curve is more depressed.

The linear regression equation for this regression model is:

$Y 1_{(R O E)}=2.573+0.574+0.018-0.512+1.250+\varepsilon$

P-value < 0.05 » H0 x, H₁ √ / P-value > 0.05 » H0√, H₁ x.

X1 (0.074 < 0.10) » H0 x, H1(a) √ – Based on the significance results, H0 is rejected, and HA is accepted because the significance value for X1 is less than a P-value of 0.10.

X2 (0.884 > 0.05) » H0 √, H1(b) x – Based on the significance results, H0 is accepted and HA is rejected.

X3 (0.225 > 0.05) » H0 √, H1(c) x – Based on the significance results, H0 is accepted and HA is rejected.

X4 (0.010 < 0.05) » H0 x, H1(d) √ – Based on the significance results, H0 is rejected, and HA is accepted because the significance value for X4 is less than a P-value of 0.10.

Based on the generated results of the coefficients, financial leverage (at the 10% significant level) and the disclosure index (at the 5% level) are the only variables that have influenced the ROE. If financial leverage and the index increase, this will also affect the rise in ROE (Table 3).

Coefficient of Correlation and Determination, their interpretation (Table 4):

• The correlation coefficient value is 66.8%, which shows that the variables YROE, X1-financial leverage, X2-liquidity, X3-total assets and X4 index of financial disclosures have an average positive relationship.
• The value of the coefficient of determination is 44.6%, which shows that YROE has an average level of dependence on X1-financial leverage, X2-liquidity, X3-total assets and X4 index of financial disclosures. So, for the value of 44.6%, financial leverage, liquidity, total assets, and disclosure index explain the ROE.

Based on Table 5, we can conclude that the value of the Pearson correlation coefficient for the dependent variable YROE and the independent variable X1 financial leverage is 0.074, indicating a very weak positive relationship. For the second variable, on X2, liquidity is -0.333, which demonstrates that there is a very weak negative relationship, while on X3, total assets is 0.051, which also shows that there is a very weak positive relationship, and on X4, the disclosure index is 0.538, which reveals that there is an average positive relationship.

Table 3. Coefficients

Source: Authors' calculations in SPSS (2023)

Table 4. Model Summary

Source: Authors' calculations in SPSS (2023)

Table 5. Correlations

Source: Authors' calculations in SPSS (2023)

Table 6. Analysis of variance (ANOVA)

Source: Authors' calculations in SPSS (2023)

Based on the overall significance of the analysis of variance (ANOVA) (Table 6), we conclude that the entire model has accuracy since the significance value is less than 0.05. P-value (0.041 < 0.05).

The fixed-effects model, in this case, would be:

$\begin{gathered}Y_{i t}=47.860+30.592 D_{1 i}+3.499 D_{2 i}-7.425 D_{3 i}+22.871 D_{4 i}+ \\ 21.343 D_{5 i}+2.349 X_{1 t}+1.401 X_{2 t}-0.031 X_{3 t}+0.085 X_{4 t}- \\ 5.391_{i t}\end{gathered}$

$e=100 \%-R^2=100 \%-93.5 \%=6.5 \%=0.065 i t$

where:

D1 – Albania, D2 – Bosnia and Herzegovina, D3 – Montenegro, D4 – North Macedonia, D5 – Serbia and D6 – Croatia, and as a reference state, we have taken Kosovo, with which these six states will be compared. More specifically, we aim to see if there is a difference between the ROE of the six states and Kosovo (Table 7).

$\alpha 0$ – The average value of ROE in Kosovo is 47.860% (P-value = 0.323 > 0.05).

$\alpha 1$ – This regression coefficient represents the ROE difference between Albania and Kosovo. In Albania, ROE will increase by 30.592% compared to ROE in Kosovo. The average value of ROE in Albania is 47.860%+ 30.592% = 78.452% (P-value = 0.411 > 0.05).

$\alpha 2$ – This coefficient represents the difference between Bosnia and Herzegovina and Kosovo. In Bosnia and Herzegovina, ROE will increase by 3.499% compared to ROE in Kosovo. The average value of ROE in Bosnia and Herzegovina is 47.860% + 3.499% = 51.359% (P-value = 0.818 > 0.05).

$\alpha 3$ – The regression coefficient between Montenegro and Kosovo. In Montenegro, ROE will decrease by 7.425% compared to ROE in Kosovo. The average value of ROE in Montenegro is 47.860% - 7.425% = 40.435%. (P-value = 0.034 < 0.05).

$\alpha 4$ – This regression coefficient represents the difference in ROE between North Macedonia and Kosovo. In North Macedonia, ROE will increase by 22.871% compared to ROE in Kosovo. The average value of ROE in North Macedonia is 47.860 + 22.871% = 70.731%. (P-value = 0.440 > 0.05).

$\alpha 5$ – The difference between Serbia and Kosovo. In Serbia, ROE will increase by 21.343% compared to ROE in Kosovo. The average value of ROE in Serbia is 47.860 +21.343% = 69.203%. (P-value = 0.576 > 0.05).

$\alpha 6$ – The difference between Croatia and Kosovo. In Croatia, ROE will increase by 2.349% compared to roe in Kosovo. The average ROE value in Croatia is 47.860 + 2.349% = 50.209%. (P-value = 0.901 > 0.05).

$\alpha 7$ – This regression coefficient represents the predicted value of ROE when financial leverage increases by 1%. This statement is correct because the level of significance is within the confidence interval (P-value = 0.054 < 0.10).

Table 7. Coefficients

Source: Authors' calculations in SPSS (2023)

Table 8. Empirical econometric model results

Source: Authors' calculations in SPSS (2023)

Based on the results generated by the Stata program, in which the data have been subjected to three econometric analyses, including linear regression, as well as regression with random and fixed effects, we can conclude that from all the variables selected to analyse their effect on the ROE, financial leverage is significant in two of the three selected analyses with 5% and 10% significance. This shows that the debt/equity ratio is crucial to a firm's financial performance. This result is also in line with the findings of Kiprotich [40] (Table 8).

The Second Econometric Model

In the following section, we will present the results obtained using the SPSS program for our second econometric model, where the dependent variable this time is the ROA.

Based on the overall significance of the ANOVA (Table 9), we conclude that the whole model has no accuracy since the significance value is greater than 0.05 (P-value 0.113 > 0.05).

Table 9. ANOVA

Source: Authors’ calculations in SPSS (2023)

The regression equation for model II is specified in this form:

$\gamma_{(\text {ROA })}=\beta_0+\beta_1 X_{1 \text { (Financial Leverage })}$

$\begin{aligned} & +\beta_2 X_{2(\text { Liquidity })} \\ & +\beta_3 X_{3(\text { Financial Disclosure Index })} \\ & +\beta_4 X_{4(\text { Total Assets })}\quad+\varepsilon\end{aligned}$         (3)

Table 10. Coefficients

Source: Authors' calculations in SPSS (2023)

Based on the generated results of the coefficients table, we see only that the financial leverage is a significant variable, where the increase in the leverage would also raise the ROA for the countries of the Western Balkans (Table 10).