Financial Performance Analysis

Financial performance analysis describes the methods that those examining the affairs of a business use to evaluate and assess its financial activity.

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.

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. Information is extracted from these statements to conduct a financial performance analysis:

• 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 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 in a given period. Statements list the total amount of sales revenue generated by the business for the period minus the costs associated with those earnings.

• Cash flow statement—focuses on the exchange of money between the business, its customers, and its vendors. The statement only examines the ability of the business to generate cash. 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.

A financial performance analysis is an evaluation of one or more aspects of the business’s finances. Different stakeholders, such as management, investors, regulators, and lenders, will assess the financial performance of a business from varying vantage points and with distinct objectives.

There is no one measure of financial performance. Generally, a financial performance analysis looks at one or more of several distinct aspects of the business’s finances:

Liquidity refers to cash and other assets that the business can easily convert to cash in order to meet its day-to-day obligations, such as purchasing, salaries, and utilities.

Similar to liquidity, solvency refers to the business’s ability to meet its debt obligations over time.

Operating efficiency is an indicator of the business’s ability to manage the costs of running the business in relation to the sales and profits that it generates.

Profitability, otherwise known as the bottom line, refers to the business’s ability to generate a profit on its business activity.

Financial performance analysis can be conducted in different ways:

Horizontal Analysis

A horizontal analysis examines the same elements of the business’s finances—such as subsidiary ledgers or statements (or specific items within either)—across two or more time periods. The horizontal analysis is intended to identify significant changes, patterns, or trends across time.

For example, a horizontal analysis of the costs of goods sold (COGS) may help a business identify if patterns in the price of goods is affecting its profits. Similarly, a horizontal analysis of payroll costs may determine if the business is paying too much, or too little, to support its workforce.

Vertical Analysis

In contrast, a vertical analysis looks at multiple items in the same statement or ledger for one reporting period, to identify correlations between one aspect of the business and another. These are often calculated as ratios or percentages, which illustrate proportionality of one financial activity to another.

For example, a vertical analysis might calculate COGS as a percentage of total sales revenue, to determine if costs are having a significant effect on profit. A business might also calculate the sales of various items as a percentage of total sales to determine which products are driving revenue.

A horizontal or vertical analysis can employ either a ratio analysis or a trend analysis. A ratio analysis compares one item in a statement to another in the form of a fraction. The fraction reveals a proportion or percentage, which can be analyzed on its own or compared against other similar ratios to reveal further insight. The ratio can be compared to the same ratio for a different reporting period, or it can be compared to the ratio for other businesses or an industry standard.

A trend analysis compares information, including ratios or individual line items, over a period of time. This reveals trend lines in the business.

All of the above financial performance analyses utilize various metrics to make their assessment. These metrics are also referred to as key performance indicators (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.