Financial Performance

What Is Financial Performance?

Financial performance is a comprehensive measure of a company's fiscal health and operational efficiency. It encompasses various aspects such as profitability, liquidity, efficiency, solvency, growth, return on investment, cash flow, and market performance.

Profitability indicators like net income and profit margins reveal how effectively the company converts revenue into profits, while liquidity metrics such as the current ratio assess its ability to meet short-term obligations.

Efficiency ratios, like asset turnover and inventory turnover, gauge how well the company utilizes its resources to generate revenue, indicating operational effectiveness.

Solvency ratios, such as the debt-to-equity ratio, provide insights into the company's long-term financial stability and its ability to meet long-term obligations.

Growth metrics, including revenue growth rate and earnings per share growth, indicate the company's expansion and future potential. Cash flow analysis helps assess the movement of cash within the company, vital for sustainable operations and growth.

Comparing financial performance over time periods, against industry benchmarks, or with competitors is crucial for stakeholders to understand the company's relative strengths and weaknesses.

Understanding of financial performance enables informed decision-making by investors, management, and other stakeholders regarding resource allocation, strategic planning, and risk management.

By monitoring and analyzing financial performance, companies can adapt to changing market conditions, mitigate risks, and enhance their competitive position in the marketplace.

Understanding Financial Performance

Understanding financial performance is crucial for businesses and investors alike. It helps to assess how well a company is managing its resources and generating returns. Key aspects include answering the following questions: 

• How well is the business doing? (profitability ratios)

• How well is the business doing in generating cash flows? ( Cash and cash flow ratios)

• What kind of resources does the company own? What amount does the company owe? (Vertical and horizontal Analysis)

• Capital structure proportion. What would be the optimal proportion of capital structure?

These performances are compared with the firm's earlier performances or the industrial averages to determine the effectiveness and efficiency of the business operations.

Financial performance is a purely quantitative assessment. The numbers are taken into consideration through which a conclusion can be made.

The statements presented represent a numerical picture of the company and its performance. But, a person should also consider qualitative factors before making any decision.

These financial performances aid the internal and external stakeholders in making decisions. The decisions could be related to investing or not, to buy or sell the stocks of the company.

These performances are supposed to provide the investor with insight into the well-being of the organization.

Assessing Financial Performance

Financial Performance assessment provides an in-depth assessment of an organization's revenues, expenses, interest coverage ability, assets, liabilities, equity, and profitability on the whole.

Performance is assessed purely in monetary terms, and as mentioned above, it's quantitative and subjective. It's the process of measuring a firm's decisions related to the policies and processes in quantitative terms.

It is the degree to which the financial objectives are being achieved or have already been accomplished. This helps a great deal in financial risk management because this can help firms understand where they are going wrong and take corrective actions.

These measures can also be used to assess the firm's financial health over a given period and compare the figures. The figures can be used in comparison with internal data and industrial averages as well.

The performance evaluation can also mean how well the organization is using its assets and generating revenues. And also how well it can manage its short and long-term debt payments.

The shareholders, investors, employees, management, and potential investors are all interested in the organization's performance in financial areas. Such performance, from a financial perspective, highlights how efficient the firm is in the following areas:

• Generating revenues

• Managing expenses

• How liquid is the organization?

• Managing its short and long-term obligations

• Meeting the financial covenants

There are many ways through which financial performance can be assessed. But, it should be taken as an average.

Common size statement analysis, ratio analysis (liquidity, solvency, profitability, efficiency, gearing ratios), and 13-week cash flow analysis are some of the techniques that can be used to gauge a firm's performance.

Concerning the point that "financial performance metrics are quantifiable,". Meaning you can measure them. But as your doctor can’t tell you "how healthy you are" by taking your temperature or blood pressure, there’s no single way you can measure financial performance.

For example, a firm may have a rapid increase in sales revenue. That does not necessarily mean that the financial operations are efficient and are producing fine results.

We have to dig deep into it and assess if the sales are on credit or cash. If the increase in sales does not have an increase in cash flows, it means that they are on credit, thus increasing Accounts Receivables balances. This might lead to a slower collection of cash receipts.

Another angle through which We can look at this example is if the cost of goods sold has increased with the increasing sales. Again, this will help Us understand the organization's efficiency in controlling costs.

What is Financial Statement Analysis?

It's the process conducted to gain a better understanding of the performance of the organization in financial aspects.

Carried out by internal and external investors to comprehend how effective and efficient the performance has been. The process includes a deep analysis of the financial statements of the organization.

Analysts use the production and productivity performance. This may include assessing profitability, liquidity, fixed assets efficiency, solvency, operational efficiency, funds flow, and social performance.

The financial performance analysis includes

• Working Capital Analysis

• Financial Structure Analysis

• Activity Analysis

• Profitability Analysis

Below we explore these analysis techniques in greater detail:

Working Capital Analysis

Working Capital (WC), or Net Working Capital, is a measure of a company’s liquidity and operational efficiency.

More importantly, financial health, since cash is the "magical" element that drives business operations. It represents a company’s ability to cover its short-term liabilities with its short-term assets.

Working Capital represents the company’s ability to cover its short-term obligations with its current assets, including cash and other liquid assets.

Working Capital = (cash + AR + Inventory) - (AP + accrued expenses) 

AR = Accounts Receivables

AP = Accounts Payables

As mentioned earlier, cash drives business operations. Because a firm may be profitable as shown on the income statements. But, if it doesn't have ample cash to fund its regular operations, it will go down.

Excess of current assets over current liabilities means the firm has a positive WC. And, if the current assets are short against the current liabilities, it has a negative WC.

Even excess WC doesn't mean the organization is doing well. It can also mean the amount of AR isn't received or the cash tied up in the inventory.

An optimal level of WC levels should be established. Policies should be formed accordingly and implemented as well to pump the business's regular needs.

Financial Structure Analysis

It's the way a firm has financed its assets by using long and short-term capital sources. It can also be said that it's the right mix of debt and equity that the firm uses for operating.

The financial managers have the responsibility of deciding the right mix to optimize the financial structure. Financial structure is also known as Capital structure. The capital structure mix may also depend if the organization is private or public.

Other considerations are also dependent on the requirements, expenses, expected revenues, and investor demands. Some important metrics used when analyzing financial structures are but are not limited to: 

Debt to Equity Ratio = Total Debt/Total Equity

Equity Ratio = Equity/Assets

Debt Ratio = Total Debt/Total Assets

Leverage Ratio = Total Assets/Total Equity

The Debt-equity ratio is predominantly used to understand the capital structure, the kind of financing of assets (via equity or debt), and leverage is understood. It's mostly interpreted as the lower, the better. Preferred in the range of 0.1 to 0.9.

Activity Analysis

Activity analysis is also known as Management Efficiency Analysis, also Economic Activity Analysis. The analysis circles around the assessment of the productivity of assets ( AKA Turnover ) and capital utilized by the firm.

Activity analysis is used to understand how the desired levels of sales could be achieved and the costs associated with achieving them. Activity ratios are ratios related to desired levels of sales to be achieved or costs associated with the levels of assets/capital used in the company.

Activity analysis and ratios help to gauge the performance of the firm in the area of sales, cost of sales, and assets utilized for generating sales. It assesses the ability of the firm to convert assets, liabilities, and capital into cash.

Activities can be analyzed with the following ratios:

Total Assets Turnover Ratio = Sales/Total Assets

Fixed Assets Turnover Ratio = Sales/Total Fixed Assets

Inventory Turnover Ratio = Cost Of Goods Sold/Average Inventory

Inventory Turnover Period = Inventory/365 x Inventory TO

Accounts Receivable Turnover Ratio = Net Credit Sales/Average AR

Accounts Receivable Turnover Period= Sales/365 x AR TO

Profitability Analysis

It helps businessmen identify ways to optimize profitability related to various projects, plans, or products. It is the process of analyzing profits derived from the various revenue streams of the business.

While profitability analysis does answer many quantitative questions, it's unique that it can also help managers identify which sources of information are most factual and reliable. It helps identify ways to maximize profits in the near and short term.

Also points at the costs related to these profits and understands the cost behavior concerning the profits. Understanding the quality of a business’s earnings is important for many reasons.

However, to maximize profits, business leaders first need to understand the drivers behind their profits. This helps to create efficiencies in the processes and activities that generate revenue. So, it forces leaders to find ways to reduce overhead and other costs that impact profitability.

Some of the profitability ratios that are used to analyze profitability analysis are as follows: 

Gross Profit Ratio = Gross Profit/Net Sales x 100

Operating Profit Ratio = Operating Profit/Net Sales x 100

Net Profit Ratio = Net Profit/Net Sales x 100

Return on Investment = Income of the business unit/assets of the business unit

Earnings Per Share(EPS) = Net Income/ No of shares outstanding

Measuring Financial Performance

Financial performance analysis involves calculating specific financial formulas and ratios to assess a company's financial condition and performance.

These ratios are compared to historical data and industry benchmarks to gain insights. Seven key ratios are commonly used in business to evaluate overall performance. Some of the metrics are as follows: 

1. Gross Profit Margin
Indicates the percentage of revenue left after deducting the cost of sales, providing insight into operational efficiency. Formula: 

Gross Profit Margin = Gross Profit​/Revenue

Where, 

• Gross Profit = difference between revenue and the cost of goods sold (COGS)
• Revenue = total sales generated by the company

2. Working Capital
Measures liquid net assets available to fund day-to-day operations, crucial for assessing liquidity. Formula:

Working Capital = Current Assets − Current Liabilities

Where, 

• Current Assets =  include cash, accounts receivable, and inventory
• Current Liabilities = include accounts payable and short-term debts

3. Current Ratio

Determines if a company owns enough current assets to cover its current liabilities, providing a measure of liquidity. Formula: 

Current Ratio = Current Assets​/Current Liabilities

4. Inventory Turnover Ratio
Measures how efficiently a company sells its average inventory, indicating demand and inventory management effectiveness. Formula:

Inventory Turnover Ratio = Cost of Goods Sold​/Average Inventory

Where, 

• COGG = refers to the direct costs associated with producing goods sold
• Average Inventory = represents the average value of inventory held during the period

5. Leverage 
Illustrates the proportion of debt used to purchase assets, with higher leverage indicating increased debt usage. Formula: 

Leverage = Total Assets​/Total Equity

Where,

• Total Assets = sum of all resources including tangible and intangible assets
• Total Equity = residual interest in a company's assets after deducting liabilities

6. Return on Assets (ROA)|
Evaluates how effectively assets are utilized to generate profits, with lower ROA indicating less efficient asset utilization.

ROA = Net Income​/Total Assets

Where,

• Net Income = total earnings of a company after subtracting all expenses and taxes from its revenue

7. Return on Equity (ROE)
Measures the profitability of shareholder equity, indicating how efficiently investors' equity is utilized to generate profits.

ROE = Net Income​/Shareholders Equity

Where, 

• Shareholders Equity = value of shareholders ownership in a company, calculated as total assets minus total liabilities

Financial Performance Analysis Information Sources

The performance analysis just doesn’t come out of nowhere. It starts with the primary sources of financial information, as stated earlier. To conclude and make informed decisions, an analyst must have fundamental and in-depth knowledge of the financial statements and their preparations.

It’s just not the ability to prepare financial statements. It’s also the ability to interpret them, which will add value to the organization.

Here is the WSO’s offering to gain fundamental accounting knowledge right from scratch to better understand financial statements.

Income Statement

The Income statement starts with the direct sources of revenue (sales or services), then proceeds on to the costs expended to obtain the sales/revenue, termed Cost Of Goods Sold (COGS). Finally, deducting COGS from the sales revenues gives us the gross profit.

Operating expenses (Selling and administrative expenses) are deducted from the gross profit to obtain operating income. Operating income is also known as Earnings before interests and taxes (EBIT). Step by step, deducting interests and then taxes will give us the net income.

Periodically, comparing these metrics will provide the management with the perspective that these numbers are favorable to the organization. If they aren’t favorable, which steps should be taken to improve these numbers? Past and present profitability can be understood.

With the help of historical data and proper assumptions, analysts can prepare Financial Models to project and predict future incomes.

Also known as a profit and loss (P&L) statement, an income statement shows you a company’s revenue for the reporting period, along with its costs and expenses for the same period. The bottom line typically shows you the company’s net profit or loss.

Balance Sheet

The balance sheet provides a comprehensive snapshot of a company's financial position by summarizing its assets, liabilities, and equity. It serves as a vital tool for assessing both the liquidity and solvency of the firm.

Assets represent the resources owned by the organization, which can be categorized into current assets and fixed assets.

Current assets are those expected to be converted into cash or consumed within the operating cycle, typically within a year. Fixed assets, on the other hand, are resources held for long-term use, with benefits expected to be derived for more than a year.

Liabilities represent the obligations that the company owes to external parties, and they are divided into current liabilities and long-term liabilities.

Current liabilities are obligations expected to be settled within the operating cycle or within a year, while long-term liabilities are due beyond that timeframe, typically payable after a year or the operating cycle.

The balance sheet provides a detailed breakdown of what the company owns and owes, offering insights into its liquidity (ability to meet short-term obligations) and solvency (ability to meet long-term obligations), as well as the composition of its capital structure. 

Cash Flows Statement

Arguably, the most important financial statement. Discloses the cash and liquid position of the Organization. It's the summary of the cash generated by the organization through the activities.

These activities can be divided into three types: 

• Operating Activities: Starts with net income and adds the non-cash expenses (depreciation and amortization). Then proceeds to add/deduct the changes in the current assets and the current liabilities. 

• Investing Activities: Summary of the cash generated through the sales of fixed assets and the amount of cash invested in acquiring them. The changes in the long-term assets accounts are instituted here.

• Financing activities: The changes in the long-term liabilities/equity accounts. Events related to the issuance, settlement, or reacquisition of debt bonds/notes. It includes the sale/purchase of an entity's equity securities or the issuance of debt.

To obtain a detailed and better understanding of the cash flows and how to interpret them, a person should be able to understand the capability and limitations of the business first. 

Statement of Changes in the Equity

Intended to help external users assess how changes in the company's financial structure may affect financial flexibility. It presents a reconciliation of the accounting period of each component of the beginning balance with the ending balance.

The FASB disclosure requires recording of the changes in each separate shareholder’s equity account when a balance sheet is issued. The requirement satisfies the FASB’s suggestion that complete financial statements should include investments by and distributions to owners during the period. Common changes include changes in:

• Net income/loss

• Dividends paid

• Issuance of common stock

• Total changes in the other comprehensive income

• Treasury stock

conclusion

Financial performance analysis is essential for evaluating an organization's health and effectiveness in managing its resources.

Understanding financial statement analysis involves delving into various aspects such as working capital, financial structure, activity, and profitability.

Through careful examination of financial statements and ratios, stakeholders can gauge profitability, liquidity, solvency, and efficiency, enabling informed decision-making and strategic planning.

These analyses provide insights into a company's operational efficiency, capital utilization, and overall financial health, guiding stakeholders in identifying areas for improvement and opportunities for growth.

By utilizing financial performance analysis techniques, stakeholders can assess the past, present, and projected future performance of an organization. This process not only aids in risk management but also helps in setting realistic financial goals and enhancing shareholder value.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Account Statement
• Capital Asset Pricing Model (CAPM)
• EBIT
• Return on Assets & ROA Formula
• Taxation