Financial performance refers to the overall financial health of the business. All businesses take financial assets, which come in many forms, and use them to support business activity, which generates revenue and ultimately, profits.
In its simplest definition, financial performance can refer to the effectiveness in which the business generates profits, but it also refers to much more. It is a reflection of all the elements that contribute to profitability, separately as line items, and holistically as a collective dynamic.
Different stakeholders, such as management, investors, and lenders, will assess the financial performance of a business from varying vantage points and with distinct objectives. For this reason, no single measure can be taken of a business’s financial performance. A variety of metrics are used, individually and collectively, to make this assessment.
Businesses produce various financial statements which can be used to assess financial performance. Because there are many different facets to a business’s financial operations, there are also several different types of financial statements. Each type presents the details for a specific aspect of the business and its finances:
Balance sheet—shows what a company owns and what it owes, both at a specific point in time. In accounting terms, this is expressed as equity, liability and assets. The terms themselves are arranged in the format of an equation. Specifically, it reads as equity = assets – liability. The balance sheet provides a snapshot of the company’s value or worth for the point in time at which it is produced. Generally, that is either monthly, quarterly, or annually.
Income statement—focuses on how much revenue was earned by the business for a particular point in time. In simple terms, they list the total amount of sales revenue generated by the business for the period. From this total, the statement will subtract the costs associated with those earnings to arrive at the gross profit. From the gross profit, the income statement will then subtract operating costs, such as rent, equipment, marketing and supplies. It will also subtract other expenses, such as taxes and interest, to arrive at the net profit.
Cash flow statement—focuses on the exchange of money between the business, its customers and vendors. The statement does not look at assets and liabilities or profit and loss. It only examines the ability of the business to generate cash. Cash flow is an important detail because every business needs cash to operate. Cash is used to pay bills, payroll, vendors, and other expenses. A business’s ability to generate cash is a reflection of its overall health and viability. It is one of many barometers of the business’s financial performance. Cash flow statements will list all manner of financial activities that impact cash, such as accounts receivable, accounts payable, inventory, unearned revenue and net income.
Many metrics are extracted from the financial statements to assess financial performance. These metrics are also referred to as key performance indicators, or KPIs. Some of the most common include:
Gross profit margin measures revenue minus COGS in proportion to total revenue.
Net profit margin calculates revenue after subtracting all costs for the business, including COGS, plus operating expenses, interest, and taxes, in proportion to total revenue.
Working capital measures the business’s available liquidity, or assets that can be easily converted to cash. It is derived by subtracting current liabilities from current assets.
The current ratio measures assets in proportion to liabilities. This helps measure the business’s solvency, or its ability to repay debts. It is instead expressed as a fraction, with current assets divided by current liabilities.
The quick ratio is also known as an acid test ratio. It also measures liquidity, but only considers highly liquid current assets, such as cash, marketable securities, and accounts receivables. This calculation filters out some current assets, like inventory, which are not as easily converted to cash.
Inventory turnover measures how frequently the business sells its inventory. It is expressed mathematically by subtracting the average inventory for the reporting period from the total cost of sales.
Total asset turnover measures how efficiently a company uses its assets to generate revenue. It is calculated as a fraction, by dividing total revenue by the average total value of assets for the period.
Return on equity (ROE) measures how well the business is converting shareholder’s equity into profits. It is calculated by dividing net profit by average equity.
Similarly, return on assets (ROA) assesses how well the company is converting its assets into profits. It is calculated by dividing net profits by average assets instead of average equity.
Operating cash flow measures how much cash the business has as a result of its operations. It is calculated using one of two ways: the indirect method and the direct method.
There are many other metrics that can be used to assess financial performance. They vary depending on the type of business and the industry in which it operates.
Financial performance is an important metric to various stakeholders in the business. For investors and shareholders, it provides an indicator of how well the business will be able to generate a return on their investment.
For lenders, it lets them know how well the business will be able to repay its loans. Financial performance tells regulators how well the business is complying with certain regulatory requirements.
Finally, it provides overall insight to management about how well the business is operating and meetings various objectives.