Financial Performance

It's the process of measuring a firm's decisions related to the policies and processes in quantitative terms

Andy Yan

Reviewed by

Andy Yan

Expertise: Investment Banking | Corporate Development


August 16, 2023

The organization's financial statements include the income statement, the balance sheet, the statement of cash flow, the statement of retained earnings, and the statement of changes in equity.

These statements are historical, subjective, and 100% quantitative in nature. But, with this historical information, using the right techniques, these statements could be projected.

These projections provide an insight into what future performances could look like.

Once the statements are prepared and ready to be used by external and internal stakeholders, we must understand that we are at the end.

We have used all the tools and rules that are used to prepare the statements. Now, it's the time when we understand and study the statement to assess performance.

Understanding Financial Performance

The performances are analyzed to answer some key questions.

Such as:

  • 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's insight into the well-being of the organizations.

What is Financial Performance?

The 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.

In a nutshell, it's 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

  • 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 analysisratio analysis (liquidity, solvency, profitability, efficiency, gearing ratios), and 13-week cash flow analysis WSO course are some of the techniques 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.

Financial Performance Analysis helps in understanding the reasons behind such phenomena.

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

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 Recievables

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 to 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

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.

The analysis 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.

There are many profitability ratios that are used to analyze profitability analysis, some are:

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

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 & Administrative expense) 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

Summary of what the firm owns and owes. A detailed explanation of the liquidity and solvency position of the firm. Also known as Financial Position Statement.

Assets are the resources that the organization owns. It can be further divided into current assets and fixed assets.

Current assets are those which can be converted into readily acceptable cash within the operating cycle.

Fixed assets are resources that the company owns and expects to reap the benefits of this expenditure for more than a year.

On the other side of the balance sheet are items that the organization has to pay, which they have lent.

These are current liabilities and long-term liabilities. These are debt obligations the organization has to pay.

Current liabilities are to be paid under the operating cycle. And long-term liabilities are due when specified, mostly payable after a year/operating cycle.

In the final segment, the Equity/Capital resources of the organization. Raised internally or externally through offerings.

Statement of Cash Flows

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. 

It converts the income from an accrual basis to a cash basis income. Net cash provided by operating activities shows the cash generated by regular business activities.

  • 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 issuance, settlement, or reacquisition of debt bonds/notes. It includes the sale/purchase of an entity's equity securities or the issuance of debt.

For obtaining 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:

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Researched and authored by Farooq Azam Khan, CMALinkedIn

Reviewed and Edited by Aditya Salunke I LinkedIn

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