Importance Of Good Corporate Governance And How To Spot The Red Flags

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  • 22 Feb 2023

Corporate governance is nothing but the way in which a company functions. It includes a system of rules and processes that direct and controls a firm. The aim of enforcing corporate governance is to balance the interests of a company’s shareholders, customers, suppliers, etc. It lays down the objective with which a company begins work and functions. It is a part of every sphere of the management from its action plans to the way in which performances will be measured.

The set of rules, policies, and controls are put in place to dictate the ideal corporate behaviour. The board of directors of the company plays a major role in laying down these rules in which a corporate will function.

The motive underlying corporate governance is to increase the accountability of a company and to avoid major disasters before they occur. The aim of good corporate governance is to pinpoint the problems and eliminate them without any prejudices. In addition, it addresses the needs and requests of the performing parties like suppliers, customers, and leaders.

In order to build good corporate governance, a company and its board of directors must keep these principles in mind:

  • All board members and majority shareholders should have a clear idea of what their responsibilities are. It is important that all the key members are on the same page and participate in fulfilling the vision of the company.

  • The main role of the board is to monitor if the operations of the company are being carried out smoothly or not. Their responsibility also includes keeping a check on whether these operations are in compliance with the mandates laid down by the company and other shareholders. The CEO is the position that runs all these operations, which is why combining the powers of a CEO and chairman will be an abuse of power. This way the operations and its monitoring activities will be two independent forces making corrective measures clearer to implement.

  • A company should also consider appointing independent directors since they broadly fit into everything corporate governance would try to achieve. By appointing independent directors, the company can bring in a more balanced and effective composition of the board. Since the board is the most important body of the company, its monitoring becomes even more important. They challenge the way in which policies and company strategies are developed along with scrutinizing the way in which the management performs.

  • An independent auditor is appointed with the same intention that an independent director is appointed; to maintain transparent and unbiased management. An auditor closely scrutinizes every detail of any collapse or mishap in the company’s accounts. They also evaluate and comment upon the way in which the management functions bringing in suggestions of regular financial audits if need be.

  • Ethical behavior violations should strictly be avoided as they can land the company in severe civil and legal problems. The company should shun away from underpaying and abusing outsourced employees. There should be a common code of conduct for all members of the organization, including the board members.

  • A very easy and strong way to gain the trust of shareholders is by building transparency in business. The earnings and records of the company should be made available to all shareholders without any exaggerations.

  • A company’s stock prices can be maintained only by encouraging the participation of all shareholders. By providing them with a place to voice their opinions at general meetings the company paves the way for taking care of the interests and goals of all shareholders.

  • It is important for the company to take time out to address non-equity stakeholders of the company like the directors, employees, owners and suppliers. This can help in establishing a positive relationship with the community.

Many processes get streamlined by bringing in structured corporate governance into any organization. Let’s look at why a corporate company needs good governance:

  • With company ownership structures going through significant changes, corporate governance has been the new pressure point to make companies more efficient, transparent, and accountable. Public financial institutions and mutual fund houses are the major shareholders that propagate consumer-friendly policies to protect all social groups as well as the environment for a company.

  • Social responsibility is now a topic of huge importance, which encourages that the board of directors of a company protect the rights of its employees, customers, shareholders, etc.

  • In a world of growing scams, it has become important to build governance that shields a company from getting into fraudulent and corrupt practices. Many companies have moved towards corporate governance in order to avoid these mishaps.

  • It is important to protect all the stakeholders of the company since they are only entitled to attending annual meetings where the proxies are not allowed to speak and a postal ballot is also absent. Corporate governance in India thus makes it easier for the shareholders to exercise their rights.

  • Corporate governance in India helps companies to survive and function in the global markets. Several companies sell their goods and service outside the country as well which makes it necessary for them to follow foreign rules and regulations as well. This also helps them attract foreign investors.

  • Takeovers and mergers are a part and parcel of the corporate world, more often than not. Corporate governance in India helps companies protect the interests and goals of all the parties involved.

  • SEBI has made it compulsory for several companies to follow corporate governance in India in order to protect the interest of the investors.

Bad corporate governance can affect the company’s financial health and bring doubts about its reliability and integrity. When corporate governance does not account for strict intolerance of illegal activities, it can lead to huge scandals and have severe implications for the company under the lens.

A company with bad corporate governance is often known to not cooperate with auditors and often ends up publishing non-compliant financial results. Another indication of bad governance is that the board is poorly structured because of which the ineffective shareholders cannot be eliminated effortlessly.

As opposed to a company with good corporate governance in India, one with bad corporate governance creates several entangled policies that make the end-user wander and never encourages get their interests.

An investor puts money in the company after thoroughly researching the company’s long-term potential. The investment will be fruitful if the company is governed efficiently. So, an investor needs to understand what the red flags are and the organization should focus on eliminating them.

When investors get an idea that a company is deviating from its goals, they can take an informed decision in time. It is always better to go slightly deep into the company’s governance rather than relying on what a public website holds. A good idea is also to compare it with that of its competitors.

Let’s look at a few factors that are important to consider and what the red flags of bad corporate governance are before investing in a company on a long-term basis:

  1. The first thing to look at is the company’s past history and current culture. It is important to keep a tab of all news regarding the company’s developments and frictions as well. A disturbed board indicates doubtful governance. A company with good corporate governance ensures transparency in the ethics of the corporation and voluntarily makes disclosures. The way in which the board handled an errant official in the past is also something to consider since it displays whether the board is capable of solving conflicts without any baggage or not.

  2. It is important to understand how the dividends are getting funded. One must understand whether dividends are paid out from the surplus cash or with the earnings in the current period or with debt. The investor should look at the debtor to sales ratio to understand whether the debtors are fictitious or non-existent.

  3. An investor must look at the compensation and its growth, whether the amount is being paid off out of the cash generated by the company or through debt (in some cases). The compensations to the Director, CEO, and Managers indicate how a company channelizes its funds.

  4. The leadership of a company determines what the fate of the company will be. It is important to look at the experience of the director who is entrusted with the responsibility of lead the management. It is also advisable to check their past experiences and accolades. If a company opts to stick to an incapable director, then it indicates bad corporate governance.

  5. This is where peer analysis of the company is helpful - payments made to the audit department. Organizations often overpay the auditors to hide poor performance. It is should also ring a bell if the auditors are changed since it can often be interpreted as an attempt to eliminate a potential whistle-blower.


The need for corporate governance in India has increased over the last few years since concerns of non-compliance have risen substantially. This has been noted through the lack of compliance with the standards of financial reporting and accountability by the board members, which results in a huge loss for the investors.

All the individuals who invest in an organization and are the shareholders, deserve protection from any malpractice that may result in huge losses for them. To ensure the protection of the investors’ interests, several committees like the Kumar Mangalam Birla Committee, Naresh Chandra Committee, and Narayana Murthy Committee came into existence through initiatives taken by the SEBI.

With investors equipped with awareness and consensus on how’s and where’s of investment, companies having good corporate governance has emerged to be of utmost importance. Good corporate governance not only takes the investors’ interests into the kitty but also their grievances.

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