What's financial performance and why is it important?
What is financial performance?
Financial performance means a complete evaluation of your company's assets, liabilities, equity, expenses, revenue and profitability. This evaluation gives you a snapshot of how well your business is using its assets to generate income and, more generally, a sense of the overall financial health of your business over a given period.
What's the purpose of evaluating financial performance?
Understanding your financial performance helps you determine your business's financial strength and spot opportunities to become more profitable and efficient.
If you're thinking about expanding, acquiring or selling, you’ll look at financial performance to decide what you want to do.
Why is it important to measure financial performance?
It's important to measure financial performance because the analysis will allow you to:
Assess the financial health of your business
Determine whether your operations, revenue and profits are on track to grow.
Identify areas for improvement
If you're experiencing low profitability or cash flow problems, analysing financial performance can help you pinpoint the causes.
Monitor performance
You can identify trends and potential problems before they happen.
Communicate financial information to stakeholders
Your financial performance lets you and external parties make intentional, well-informed decisions.
How to record financial performance using financial statements
To record financial performance, you'll need three financial statements and reports: a balance sheet, an income statement and a cash flow statement.
Here's a breakdown of each statement — and the information you can extract from each.
Income statement
Also known as a profit and loss (P&L) statement, an income statement shows revenue and expenses over a period. When people talk about the ‘bottom line’ they're referring to net income or net profit, as it's the last line on an income statement and reflects your income after all expenses have been deducted. You can use your income statement to assess current and future profitability and see how any changes you made at the beginning of a financial period have affected your bottom line.
Balance sheet
A balance sheet (or statement of financial position) measures the operational efficiency of your business. It can help you avoid financial trouble from business finance or shrinking assets. A balance sheet shows assets, liabilities and owner's equity up to a certain date. It's always balanced using the following accounting equation:
Assets = Liabilities + Owner Equity
Separate assets into current assets and non-current assets, and liabilities into short-term and long-term liabilities. Owner equity is also known as stakeholder or shareholder equity.
By comparing current assets and short-term liabilities, you can determine the liquidity of your business — in other words, whether you could pay back your short-term liabilities if required.
Owner equity includes retained earnings (net profit) and shareholders’ capital (assets after accounting for liabilities) – both metrics which assess the valuation of your business. If owner equity is positive, your business is worth more than it owes.
Cash flow statement
A cash flow statement shows all the money moving in and out of your business over a financial period. It has three main sections: operating, investing and financing activities. Together, these show whether your business is making enough cash to cover your operating expenses.
What are some of the common measures of financial performance?
The most common measures of financial performance use financial key performance indicators (KPIs) to track, measure and analyse financial health. When you compare your current numbers to your historical calculations, you get an insight into your business's long-term performance.
When calculating financial performance, there are 11 critical ratios you should monitor:
1. Working capital
Working capital uses current assets and liabilities to see if you'll have enough cash from invoices or finance to cover operating costs or pay back debt within one financial year.
Working capital = Current assets - Current liabilities
2. Current ratio
The current ratio helps you see if your business has enough current assets to pay its short-term liabilities.
Current Ratio = Current assets ÷ Current liabilities
3. Quick ratio
This ratio measures whether your business can pay its current liabilities without having to sell inventory or get additional financing.
Quick Ratio = Quick assets ÷ Current liabilities
Key:
Quick assets are current assets that are in cash form or can be exchanged for cash quickly like cash, cash equivalents and accounts receivable.
4. Cash ratio
Also called the cash asset ratio, this formula indicates your capacity to repay short-term debt with cash or cash equivalents.
Cash Ratio = (Cash + Cash equivalents) ÷ Current liabilities
5. Gross profit margin
Gross profit margin measures the revenue you have once you subtract the cost of sales. This percentage ratio indicates how much of each individual sale you can use to cover operating expenses.
Gross Profit Margin = (Revenue - Cost of sales) ÷ Revenue
6. Net profit
Net profit is the amount your business earns from sales after deducting all business-related expenses and taxes, including cost of goods sold, operating costs and interest. To calculate this number, you must also calculate your gross profit margin.
Net Profit = Gross profit - Operating expenses - Tax
7. Inventory turnover
Inventory turnover measures how many times your business sells its average inventory in a financial year. While economic order quantity (EOQ) tells you how much inventory to order, and inventory days predict how long that stock will last, inventory turnover shows if your inventory is in demand or if your carrying/holding costs are high.
Inventory Turnover = (Cost of sales) ÷ ((Beginning inventory + Ending inventory) ÷ 2)
8. Operating cash flow
Operating cash flow is how much cash your business brings in through its core business activities. There are two ways to calculate operating cash flow: indirect and direct. The direct method is more common because it clearly shows what cash is coming in and out.
To calculate operating cash flow using the direct method, follow this formula:
Operating Cash Flow = Total Cash Inflows – Total Cash Outflows
9. Return on assets
The return on assets (ROA) ratio indicates how well your business manages its available resources and assets to increase profitability. If you’re not using your assets effectively, your return on assets sum will be low.
Return on Assets = Net profit ÷ ((Beginning assets + Ending assets) ÷ 2)
10. Return on equity
The return on equity ratio shows how efficiently your business handles its shareholder contributions. A higher return on equity suggests that investors are earning returns at a more efficient rate.
Return on Equity = Net profit ÷ ((Beginning equity + Ending equity) ÷ 2)
11. Debt-to-equity ratio
A solvency ratio, the debt-to-equity ratio indicates how much debt versus equity your business uses to finance its operations. It shows whether you’ve got enough equity to cover all debts during a business downturn.
Debt-to-Equity Ratio = Total Debt + Total Equity
12. Financial leverage ratio
Also known as equity multiplier, financial leverage shows how much debt you use to purchase assets. If you finance all business assets using equity, the multiplier is one. As debt increases, the multiplier increases, and so does your financial risk, demonstrating the leverage impact of the debt.
Leverage = Total assets ÷ Total shareholders’ equity
Key:
Total assets = current and non-current assets
Total shareholders’ equity = total assets - total liabilities
13. Total asset turnover
This ratio measures how efficiently your business uses its assets to generate revenue. The lower the turnover ratio, the worse the performance of your business.
Total Asset Turnover = Revenue ÷ ((Beginning total assets + Ending total assets) ÷ 2)
Ways to improve financial performance
There are many ways you can improve the financial performance of your business.
Here are some examples:
Improve cash flow
You likely have many unpaid accounts receivable invoices if your business exhibits negative cash flow. Chase up those outstanding payments. Then, analyse cash flow from all business activities to identify areas where you might be spending unnecessarily.
Sell unwanted or unused assets
It’s essential to keep clear and accurate records of your business assets so you can quickly analyse which assets are performing and which ones are generating less value. Disposing of assets that aren’t serving you well can be a good way to inject cash into your business.
Control or reduce business expenses
If you can cut costs while keeping revenue the same, you’ll increase profitability. Use net profit margin to analyse how expenses affect financial performance. For example, if your net profit margin starts dropping, it might signal a need to reduce the cost of goods sold.
Consolidate or refinance current debt
Debt consolidation is rolling all your outstanding debts into a single loan with one monthly repayment. Refinancing is also an option and could mean you end up paying less interest and fees over the term of the new loan.
Financial performance FAQs
What’s an example of poor financial performance?
These are some warning signs that your business may be displaying poor financial performance:
You’re experiencing significant negative cash flow issues.
Your business debt levels are increasing without an increase in equity.
Your profit margins are falling.
You’ve got high levels of unsold inventory.
Your revenue relies on only a few customers.
What’s the best financial performance measure to use?
There isn’t a single best financial performance measure – assessing multiple metrics provides a complete overview of financial health. The following ratios examine business liquidity, solvency, profitability and operating efficiency to give you a good overview:
Liquidity – current ratio and quick ratio
Solvency – debt-to-equity ratio
Profitability – net profit margin
Operating efficiency – operating cash flow
What’s the best measure to show financial strength?
The best measures of financial strength are analysis of your cash flow statement and current ratio. At its most basic level, a financially strong business can generate profits and sufficient cash flow to pay bills and repay debt. Other measures used to assess financial strength include ratios of debt to equity, interest coverage, current and quick ratios and your cash ratio.
What are the key factors influencing financial performance?
The key factors that influence financial performance are:
Profitability
Liquidity
Cash flow
Debt-to-equity ratio
Return on assets
When considered alongside your financial statements, balance sheets and other standard measures of financial performance, and compared with historical data and industry benchmarks, you’ll get a comprehensive understanding of how your business is truly performing.
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