Just how financially healthy is your company? The answer to that question isn’t always clear. Maybe the business recently had great revenue growth or paid off a large portion of its debt. But hidden under those positive signs could be cash flow problems and working capital inefficiencies. To get a full picture of a company’s overall financial health, business managers must analyze the company’s entire financial performance.
What Is Financial Performance?
Financial performance takes a broad look at a company’s standing through analysis of its assets, liabilities, revenue, expenses, profit and more. Generally, financial performance analysis is based on four sources: the balance sheet, cash flow statement, income statement and, for publicly traded companies, 10-K or annual report. Whether you’re doing in-house financial analysis or trying to show the value of your company to external investors or lenders, having a detailed understanding of the business’s financial performance can help ensure that every stakeholder gets an accurate and in-depth picture.
- Analyzing financial performance should create an in-depth picture of a company’s general health and financial strength.
- The foundation of financial performance analysis comes from the balance sheet, cash flow statement, income statement and annual report.
- Various KPIs (key performance indicators), financial ratios and other metrics are used to give internal analysts or external investors a detailed look at companies’ financial performance.
Financial Performance Explained
When a business examines its financial performance, many factors come into play, including measures like profitability, liquidity and efficiency. The business may be profitable, but inefficient accounts receivable processes could leave it without the cash to pay bills on time. So, for example, even with strong growth in sales, a company that lacks efficient cash management may not have the cash on hand to pay employees, restock inventory or pay suppliers. Financial performance takes all these aspects into account when determining a company’s financial strength by analyzing the business’s financial statements and other data.
A company in good financial health will pay its bills on time and maintain good business credit. Analysis of financial performance metrics can be used to identify internal investment opportunities, like automating repetitive processes to increase productivity, and can help maintain positive cash flow. In other words, it can keep the business’s operational and financial aspects in sync.
Why Measuring Financial Performance Matters
The primary reasons to measure financial performance are to show external investors and/or lenders why a company would be a good investment and for internal analysis to better understand a business’s strengths and weaknesses. While external and internal stakeholders may have different objectives, both examine a company’s past financial performance metrics and compare them to relevant industry metrics and competitors’ financial performance to glean insight into a business’s financial strength.
What emerges from that analysis are patterns in cash flow, profitability, liquidity, growth and other critical metrics. External investors and lenders can use these patterns to set expectations for potential return on investment or creditworthiness. For internal analysts and managers, financial performance can help illustrate what went wrong and what went right over a specific time period. A small business may find that “back-of-the-envelope” calculations are more than enough to maintain success but, as a company grows, it requires more sophisticated analysis — with more data than can fit on an envelope — to take them to the next level. Financial performance gives decision-makers the information they need to implement intentional and focused improvements and grow their business.
For example, two local hardware stores may both have a year of increased sales and profits, but without detailed financial performance measures the owners might have difficulty maintaining their success going forward. With detailed analysis of monthly financial performance, however, owner A can see the effects of seasonality on demand and adjust inventory levels to avoid stockouts during peak seasons while reducing overall carrying costs, resulting in higher revenue and improved profitability. But owner B lacks that in-depth information, so chooses to increase inventory, keeping stock at a consistent level throughout the year. This not only results in higher carrying costs and less profit, but needlessly ties up cash.
How to Record Financial Performance
For a business to assess its financial performance, it first must record its finances to create a baseline for comparison and analysis. Publicly traded companies are required to submit financial statements to the Securities and Exchange Commission (SEC) each quarter and annually, using Form 10-Q(opens in a new tab) and Form 10-K(opens in a new tab), respectively. Once received, the forms are added to the SEC’s EDGAR database(opens in a new tab) and can be accessed by the public. While private companies generally aren’t required to publish financial statements, most prepare monthly reports to help internal stakeholders and others analyze financial performance. Private companies can use many of the same financial metrics as public companies to track their results, provide to potential investors and lenders, and for tax purposes.
Form 10-K is made up of five sections — business, risk factors, selected financial data, management’s discussion and analysis (MD&A), and financial statements and supplemental data. Each section provides a foundation for comparison with other businesses in the same industry or can establish how a business’s financial performance has changed over time.
- Business. This section is an overview of a company’s primary operations, such as the business’s main products and services, the markets in which it participates and any subsidiaries. It may also include competitors, recent events, regulations and more “big picture” information on a business. This can help determine how well a business’s finances can be used in a comparison with another company’s performance.
- Risk factors. The list of risk factors usually includes industry-specific, geographical and economy-wide risks the company currently faces or expects to face in the foreseeable future. This information will inform the MD&A section, where a company makes its case about how well it believes it can handle these risks.
- Selected financial data. This section includes the company’s financial information from the previous five years, detailing items like owned properties, equity securities, dividends and legal proceedings. More detailed financial records are found in the “Financial Statements and Supplementary Data” section.
- MD&A. This section is management’s perspective on the business’s most recent year’s financial results. It lays out assumptions and estimates, and explains any major changes in financial performance. This section provides context for the other sections when the numbers can’t speak for themselves. When comparing two businesses’ performance, the MD&A section can give valuable insight into why and how they differ.
- Financial statements and supplementary data. Form 10-K requires public companies to include their balance sheet, cash flow statement, income statement and a statement of stockholder’s equity. Also included are financial notes that provide additional context for the statements through annotations and explanations, like accounting methods used (when multiple options are allowed) and supporting details. Collectively, these statements serve as the foundation for financial performance analysis, both through historical internal data and industry comparisons.
Once a company has its financial statements and notes prepared, analysts can begin looking at the business’s performance and then layer their findings throughout these documents. Remember, financial performance paints a picture of a company over time, typically comparing it to other businesses in the same industry. For example, a law firm wouldn’t care about “inventory turnover,” while a retailer would, so a side-by-side comparison of the two businesses is unlikely to provide useful insights. But comparing the financial performance of a chain of grocery stores with a similar chain in the same region could give valuable insight into financial efficiency.
Financial statements are valuable not just for the data they contain, but for how they’re organized. They have a similar structure and provide the same data elements for every company, making side-by-side comparisons easier. While private companies don’t necessarily need to adhere to U.S. Generally Accepted Accounting Principles (GAAP), doing so is considered a best practice, as lenders and potential investors who review financial statements expect companies to comply.
Internally, managers and decision-makers use financial statements for analysis and budget planning. Many companies use automated systems to help generate their financial statements. Manually entering and formatting data is time-consuming, and delays make it difficult for managers to quickly identify trends and potential problems, resulting in lost revenue or unnecessary expense. Additionally, manual data entry is less accurate, and errors can lead to managerial “fixes” that don’t address a problem’s root cause — or may even make it worse.
The four main statements used for financial performance are:
The balance sheet shows assets, liabilities and owner’s equity as of a certain date. The balance sheet will always balance using the following “accounting equation”: Assets = Liabilities + Owner Equity. This statement typically separates liabilities into those that will be paid within a year, like vendor bills, and those to be paid long-term, like mortgages. Differentiating between short-term and long-term liabilities helps with cash flow forecasts and can indicate whether the business will need additional working capital, such as a loan or line of credit. Assets are similarly compartmentalized into current and long term and, by comparing short-term assets to short-term liabilities, potential creditors or investors can see how liquid a business is and whether it’s a good risk. The listed equity includes measures like retained earnings and share capital, which can be used to assess the valuation of a business. A healthy company usually has positive equity, demonstrating that it’s worth more than it owes. Careful study of the balance sheet over time can help a business avoid long-term financial struggles by identifying growing liabilities or shrinking assets.
Cash Flow Statement
The cash flow statement shows all the funds coming in to and going out of a business over a given period, with beginning and ending cash balances. This statement can yield valuable information on a company’s sources of cash, whether it generates enough cash to cover operating costs and how much cash it has on hand. It’s important to note that cash flow is different from profit. If a business makes a sale, but has not been paid for it, that sale will show as revenue and affect profitability but won’t increase the company’s available cash until payment is received from the customer.
There are three primary sections in the cash flow statement:
- Cash flow from operating activities captures cash inflows and outflows from a company’s core business, changes in current assets and liabilities, and total depreciation/amortization expense during the period.
- Cash flow from investing activities includes gains and losses from the purchase and/or sale of capital equipment and securities, and from mergers and acquisitions.
- Cash flow from financing activities shows transfer of cash between a company and its owners, investors and creditors. Sale of stock, debt issuance and any dividend payments appear in this section.
Taken as a whole, the sum of the three sections of the cash flow statement show the business’s net increase or decrease in cash for that period.
The income statement, commonly called the profit and loss (P&L) statement, records the financial results of all business activity over a given period, including all revenue and expenses as well as any gains or losses. This is where the “bottom line” for a business comes from, as net income is literally the last line on the income statement. The income statement shows a company’s total revenue, operating costs, margins, non-operating expenses and profitability for a given period, and will usually show comparisons with previous periods, like the previous year or quarter. Businesses can use the income statement to see how changes implemented at the beginning of a measured financial period affected the bottom line, thus informing future decisions and forecasting future income.
Annual reports are less standardized than other financial documents but are a common way for a business to give external stakeholders a more accessible look at the past year’s financial performance, along with a glimpse into future performance. Annual reports usually include the balance sheet, cash flow statement and income statements, but can also have charts or graphs to make the data more understandable for non-accountants than typical numbers-heavy statements. Plus, their production values are usually closer to what might be seen in a glossy magazine. Annual reports also usually include qualitative statements to showcase a company’s values, future plans, noteworthy achievements from the previous year and anything else the company’s management wants to spotlight. While public companies must follow SEC guidelines for their annual reports, private companies can take liberties with what they include — if they produce an annual report at all. Typically, smaller private businesses don’t create annual reports. But large private companies may do so to showcase their activities and future plans for existing or prospective customers, suppliers or the community in which they operate — anyone they want to inform about what and how the business is doing.
12 Measures of Financial Performance
Financial statements are packed with information. Here’s a look at a dozen of the metrics and KPIs shown in financial statements and the helpful clues they can give into a business’s financial performance. When reviewing these, keep in mind that they’re generally used to measure and report performance over the short or medium term — but companies also have long-term strategies and initiatives that can throw short-term views out of kilter. For example, a company may have R&D or marketing expenses that reduce profits in the current period but are expected to improve future profits. So it’s important to consider long-term strategy when evaluating the true meaning conveyed by these metrics.
Working capital is all the funds available to support day-to-day operations. It’s used to pay immediate bills and obligations and can be calculated by subtracting current liabilities from current assets. While positive working capital covers a business’s liabilities, and then some, a large excess of working capital may indicate that a business is not effectively reinvesting its resources. A working capital deficit suggests that a company may not be able to meet its current obligations. Companies can juggle such imbalances over the short term, but a recurring working capital deficit is not sustainable over the long run as the organization will eventually run out of money to pay its bills.
Gross Profit Margin
Gross profit margin is a crucial measure of the percentage of direct profit a company obtains from the sale of its products. To calculate gross profit margin, first work out gross profit — the direct cost of goods/services sold (COGS) subtracted from the net sales produced by those goods or services — and divide the result by net sales. To illustrate, if a company sells $1 million worth of widgets, whose COGS is $500,000 (including direct manufacturing, selling, marketing and delivery expenses), it has a 50% gross margin ($1,000,000 – $500,000 = $500,000, and $500,000/$1,000,000 = 0.5, or 50%). Companies with higher gross profit margins than their direct competitors would be more profitable, all other factors being equal, and have a higher return on assets.
Net Profit Margin
Net profit margin is part of a company’s bottom line: net income divided by revenue. Since net income is the result of subtracting all company expenses from its top-line revenue, comparing the net profit margins of similar businesses differentiates which have the most efficient operations.
Current ratio, also called working capital ratio, is a measure of liquidity similar to working capital (No. 1, above). Both are determined using current assets and current liabilities, but where working capital is calculated by subtracting liabilities from assets, current ratio results from dividing assets by liabilities. For example, a business with $1 million in current assets and $1 million in current liabilities has a current ratio of 1. A ratio above 1 shows that a company has more than enough assets to cover its liabilities; if the ratio is below 1, there are not enough assets to cover liabilities.
The quick ratio, also known as the acid test ratio, deals only with assets that can be quickly converted to cash without reducing their value, usually in less than 90 days. They’re therefore known as quick assets, and they typically include current assets like cash, accounts receivable and marketable securities (but not inventory, even though it is a current asset). Dividing quick assets by current liabilities shows the quick ratio, a measure of solvency for a company. The quick ratio is most useful when looked at next to the current ratio, as together they will show how liquid a company is and attest to the “quality” of its liquidity. Two grocery stores, for example, might have similar current ratios but different quick ratios. The one with the lower quick ratio would typically have higher inventory, which ties up cash and lowers the quality of its liquidity.
Inventory Turnover Ratio
Inventory turnover shows how often a business sells its entire inventory over a given period, an important measure of efficiency. Inventory turnover ratio (ITR) can be used to determine the average time, in days, it takes for inventory to sell. ITR is calculated by dividing COGS by the average inventory balance. For example, if the COGS for a given period is $28,000 and the average inventory balance is $14,000, ITR would be 2. Divide ITR into 365 days per year to get an expected average inventory period of 182.5 days. A high ratio shows strong sales but could also show that demand exceeds supply, while a low ratio implies excess inventory and potentially wasted supply. Studying the inventory turnover ratio over time can help managers plan inventory allocation because a decreasing ratio points to a lower turnover rate — either from overproduction or decreasing sales. By identifying changes in ITR and comparing it with competitors’ ITRs, a business can adjust its production and keep inventory in sync with sales patterns.
Return on Assets
Another profitability ratio, return on assets (ROA) shows how well a business is utilizing its assets to earn a profit. To calculate ROA, first find the business’s average total assets by adding the beginning and ending asset values over a given time period and dividing by 2. Then, divide the result into net income for the same period. For example, if a company begins the year with $750,000 in assets and ends the year with $850,000, its average total assets for the period is $800,000. If, during that same period, the business had a net income of $250,000, ROA would be calculated by dividing $250,000 by $800,000 to get a ROA of 0.3125 or 31.25%. Analysts use ROAs to compare how businesses are using their assets to make money. If a business has a lower ROA than its competitors, it could signal that their assets are not generating the profits that they should, given their value, and efficiency fixes should be implemented. Every industry is different, as some require heavy assets, like transportation companies, while others, like financial consultancy firms, may expect a higher ROA due to lower asset costs. So be sure to only compare companies in similar industries when analyzing ROA.
When debt is used to finance assets, it increases a business’s financial leverage, also called the equity multiplier. Leverage is usually measured as total assets divided by total equity. If the resulting ratio is above one, investors can see that the company is financing assets with debt. Higher leverage implies higher risk. If a business wants to increase its creditworthiness or woo investors, it may need to reduce leverage by paying down debt.
Return on Equity
Return on equity (ROE) is a way to measure the business’s return on net assets (which is assets minus liabilities). ROE is found by dividing net income by total equity. ROE shows how effectively a company is using equity and generating income over a given period of time. For example, if a business generated net income of $600,000 and had total equity of $4.8 million for the fiscal year, dividing the former by the latter would give a ROE of 0.125 or 12.5%. That means that for every dollar of equity in the business, the company has generated 12.5 cents. Many investors look at ROE compared both to that of similar companies and to an industry average when choosing where to invest, so ROE can be a valuable measure for a business to consider when seeking external investors.
Earnings Per Share
Earnings per share (EPS) shows the relationship between income over a period of time and shares of outstanding stock. Often calculated quarterly and yearly, EPS is simply net income divided by the number of shares outstanding. It shows the amount of income that could theoretically be attributed to each share, if all the income were to be distributed as dividends, and is therefore seen as a proxy for company value.
The price-to-earnings ratio, typically written as P/E, is an investment ratio found by dividing earnings per share into a single share’s market price — so, by definition, it applies only to public companies. Many investors look for stocks that are priced low relative to their earnings and use P/E ratio to tell whether a stock is a good deal. For example, if a stock’s EPS is $1.50, and a share costs $10, the P/E ratio would be 10/1.5, or 6.7. On its own, P/E is not very useful, but, when compared to other companies in an industry, it helps investors decide where to invest.
Free Cash Flow
Free cash flow (FCF) is the remaining cash after short-term liabilities and capital expenses are paid. FCF is calculated by subtracting capital expenditure from operating cash flow. FCF is an important measure of liquidity, as it shows how much cash a business has left after operating expenses, like payroll, and capital expenses, like new equipment acquisition, are paid. The higher the FCF, the more money decision-makers have for things like expansion projects, paying debt and dividends, or share buybacks. For these reasons, a high FCF can make the business more enticing to investors.
Examples of Financial Performance
Financial statements are too detailed for readers to quickly extract meaningful insights, so a good financial performance analysis typically distills key metrics from the statements for closer scrutiny. The example shown in the table below looks at the 12 financial performance metrics just discussed, from two companies in the same industry, using a side-by-side format.
Example of Financial Performance Analysis
|Measure of Financial Performance||Company A||Company B||Analysis|
|Working Capital||$200,000||$350,000||Both companies have a positive working capital. But company B may have an excess of working capital, which could point to current assets sitting idly and not being reinvested.|
|Gross Profit Margin||0.46||0.55||Company B is earning a higher gross profit margin.|
|Net Profit Margin||0.30||0.22||While Company A had a lower gross profit margin, it had a higher net profit margin than Company B. This could be the result of, for example, lower operating expenses, other non-operating gains during the period, or non-operating losses for Company B.|
|Current Ratio||1.50||2.10||Both companies have a current ratio above 1 and therefore have enough assets to cover their liabilities. However, Company B may have an excess and may want to reinvest some of its working capital.|
|Quick Ratio||0.75||1.60||Company B has enough “quick” assets to cover its obligations, like cash or accounts receivables, while Company A has more assets tied up in inventory.|
|Inventory Turnover Ratio||2.25||4.00||Company B has a higher ITR, showing that it sells all of its inventory more quickly than Company A.|
|Return on Assets||0.35||0.27||Company A has a higher ROA, signifying more efficient use of assets. Company B may have more funds tied up in assets or may not be managing them as well as Company A.|
|Leverage||0.90||0.60||Company A has higher leverage, so more of its business is being financed through debt than Company B.|
|Return on Equity||0.14||0.19||Company B has higher ROE, which means it’s generating more income relative to shareholder equity.|
|Earnings Per Share||$2.12||$2.25||Each share of Company B earns 13 cents more than each share of Company A, if all earnings were distributed.|
|Price-to-Earnings Ratio||4.32||6.25||Company A has a lower P/E, so shareholders earn a higher return relative to the price of the share.|
|Free Cash Flow||$100,000||$200,000||Company A has lower FCF, so after paying operating and capital expenses, it has less money for things like paying dividends and expansion.|
For these two companies, the performances vary depending on which measures are being evaluated. Company A has lower overall working capital but also a current ratio closer to 1, showing that it is more effectively utilizing its working capital. Company A also has a higher net profit margin, higher return on assets and a higher P/E, showing that it may be a better value for an interested investor. But Company B has a higher gross profit margin, a higher inventory turnover rate and higher free cash flow — all of which point to strong sales. Coupled with higher earnings per share and less leverage, some investors may think Company B is a better investment.
What Financial Performance Means for Investors
All investments bear some level of risk. A good analysis of a business’s financial performance helps investors get a sense of how much risk they would be buying into if they invested in the business. Different investors may weigh the importance of the various financial metrics differently, and all investors generally take more than one measure of financial performance into account when evaluating a business. So, investors typically look for a fuller picture, often gained through side-by-side comparisons of information from multiple companies’ financial statements — the balance sheet, income statement, cash flow statement — and annual reports. While past performance is not a guarantee of future earnings, trends and historical data from recurring financial statements can show how effectively a business has utilized its assets to gain ROIs of its own, which can go a long way toward convincing investors of a given business’s value.
Financial Performance Analysis
Businesses use all these reports and data about financial performance to continually analyze how to strengthen the company. Analyses of financial performance data can answer questions like, “How efficiently does the business use its assets?” “How profitable is product A versus product B?” “Is our capital structure sufficient to fund our growth plans?” and many others. The following four forms of financial performance analysis are often used to help internal business managers and external investors make strategic business and investment decisions.
Working Capital Analysis
Working capital is a simple metric, in theory (current assets minus current liabilities), but analysis of working capital can yield essential details. Working capital analysis can help managers and investors understand a business’s liquidity, its ability to pay its bills, and can contribute to other valuable KPIs, like the working capital/current ratio. A working capital ratio below 1 suggests that a company may struggle to cover its debts and obligations, while a ratio above 2 might indicate that assets are not being used to their full potential.
Financial Structure Analysis
The term “financial structure,” also called capital structure, refers to how a business is financed, specifically through its mix of equity and debt. Financial structure analysis can show a business’s value and its risk. For example, a business that funds all its growth with the profit it generates is growing via all equity and no debt; it is financially strong and carries inherently low risk. Businesses that use a high level of debt financing could raise a red flag for potential investors, depending on the nature of the business and the mix of equity and debt financing that is typical for their industry.
Activity analysis breaks down all the direct and indirect input costs that go into each product/service that the business offers. During activity analysis, a share of overhead costs is allocated to products to show the actual, “all-in” costs of producing them, relative to their respective prices. If a business bundles multiple products or services into a single customer sale, its activity analysis may need to start by allocating a portion of the sale price to each element in the bundle. Activity analysis can help internal management make determinations on efficiency, and can help show the team where costs can be trimmed or which products are accruing the highest costs. How useful an activity analysis is may depend on the organization’s ability to scale its shared costs up or down — some shared costs may be fixed and therefore difficult to change, while others may be variable and easy to adjust.
Profit is usually at the forefront of performance analysis. Profitability analysis shows which product- or service-specific revenue streams are most profitable, which assists managers who forecast future profit levels and predict how to utilize assets more effectively. A business can use profitability analysis to decide whether to increase or decrease investment in a particular product or service, but it must also take market potential into account when doing so. For example, if the most profitable product in a company’s portfolio has 90% market share, there will be little room for growth even with higher investment; but if a highly profitable product has low market share, it may be ripe for that investment.
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Analyzing a business’s financial performance answers the question, “Is this business financially healthy?” Financial performance analysis uses many metrics, most based on core financial statements. Whether it’s for an internal manager, a potential investor assessing your company or a lender deciding whether to approve a loan application, strong financial performance analysis can show detailed information on where a business’s strengths and weaknesses lie and give a good sense of where it’s headed. Unlike public companies, private businesses are not legally obligated to report financial performance information. But they can use the same accounting practices to create a stronger, financially healthier company.
Financial Performance FAQs
Why is financial performance important?
Financial performance tells a company’s senior managers how well the company is doing. Without proper understanding of its financial performance, the business will struggle to identify how to improve operations. Investors also want to see strong financial performance to justify their investment in the company, and lenders use it to assess the risk of loaning money to the company.
What is meant by financial performance?
Financial performance is the overall health and strength of a company’s finances. Financial performance looks at data from financial statements and other reports to assist internal company managers whose goal is to strengthen the business, or to inform external investors and lenders. A typical financial performance analysis will compare financial data from a company’s current fiscal period (perhaps a month, quarter or year) to previous periods and/or to competitors’ data.
What measures financial performance?
Financial performance is measured by many KPIs, but the main financial sources are the balance sheet, income statement and cash flow statement. The data found on these statements can be compared against competitors’ statements to assess a company’s financial strength relative to its peers.
What is a financial performance example?
Financial performance can take many forms but tends to show quarterly or yearly metrics and how they’ve changed. For example, Meta’s second quarterly report of 2022 showed a revenue drop of 1% and an expense increase of 22%, contributing to a 32% decrease in diluted earnings per share.
What are the three elements of financial performance?
When business managers or investors think about the three main elements used to measure financial performance, they’re usually thinking of the primary financial statements: the income statement, which is the one with the top and bottom lines; the cash flow statement, which illuminates the business’s sources of cash coming in and going out; and the balance sheet, which lists the business’s assets, liabilities and equity.
What are financial performance indicators?
There are many effective financial performance indicators, but some of the most important KPIs are working capital, gross and net profit margins, current ratio, quick ratio, inventory turnover ratio, return on assets, return on equity, leverage, earnings per share, price-to-earnings ratio and free cash flow.
How can a business improve its financial importance?
By studying core KPIs like net profit margin and return on assets, a business can focus on where it is most efficient and where it needs improvement. With proper management, financial performance analysis can help create a roadmap to ways a company can strengthen and grow.