Financial Performance Defined (2024)

Just how financially healthy is your company? The answer to that question isn’t alwaysclear. Maybe the business recently had great revenue growth or paid off a large portion ofits debt. But hidden under those positive signs could be cash flow problems and workingcapital inefficiencies. To get a full picture of a company’s overall financial health,business managers must analyze the company’s entire financial performance.

What Is Financial Performance?

Financial performance takes a broad look at a company’s standing through analysis ofits assets, liabilities, revenue, expenses, profit and more. Generally, financialperformance analysis is based on four sources: the balance sheet, cash flow statement,income statement and, for publicly traded companies, 10-K or annual report. Whetheryou’re doing in-house financial analysis or trying to show the value of your companyto external investors or lenders, having a detailed understanding of the business’sfinancial performance can help ensure that every stakeholder gets an accurate and in-depthpicture.

Key Takeaways

• Analyzing financial performance should create an in-depth picture of a company’sgeneral health and financial strength.
• The foundation of financial performance analysis comes from the balance sheet, cash flowstatement, income statement and annual report.
• Various KPIs (key performance indicators), financial ratios and other metrics are usedto give internal analysts or external investors a detailed look at companies’financial performance.

Financial Performance Explained

When a business examines its financial performance, many factors come into play, includingmeasures like profitability, liquidity and efficiency. Thebusiness may be profitable, but inefficient accounts receivable processes could leave itwithout the cash to pay bills on time. So, for example, even with strong growth in sales, acompany that lacks efficient cash management may not have the cash on hand to pay employees,restock inventory or pay suppliers. Financial performance takes all these aspects intoaccount when determining a company’s financial strength by analyzing thebusiness’s financial statements and other data.

A company in good financial health will pay its bills on time and maintain good businesscredit. Analysis of financial performance metrics can be used to identify internalinvestment opportunities, like automatingrepetitive processes to increase productivity, and can help maintain positive cashflow. In other words, it can keep the business’s operational and financial aspects insync.

Why Measuring Financial Performance Matters

The primary reasons to measure financial performance are to show external investors and/orlenders why a company would be a good investment and for internal analysis to betterunderstand a business’s strengths and weaknesses. While external and internalstakeholders may have different objectives, both examine a company’s past financialperformance metrics and compare them to relevant industry metrics and competitors’financial performance to glean insight into a business’s financial strength.

What emerges from that analysis are patterns in cash flow,profitability, liquidity, growth and other critical metrics. External investors and lenderscan use these patterns to set expectations for potential return on investment orcreditworthiness. For internal analysts and managers, financial performance can helpillustrate what went wrong and what went right over a specific time period. A small businessmay find that “back-of-the-envelope” calculations are more than enough tomaintain successbut, as a company grows, it requires more sophisticated analysis — with more data thancanfit on an envelope — to take them to the next level. Financial performance givesdecision-makers the information they need to implement intentional and focused improvementsand grow their business.

For example, two local hardware stores may both have a year of increased sales and profits,but without detailed financial performance measures the owners might have difficultymaintaining their success going forward. With detailed analysis of monthly financialperformance, however, owner A can see the effects of seasonality on demand and adjustinventory levels to avoid stockouts during peak seasons while reducing overall carryingcosts, resulting in higher revenue and improved profitability. But owner B lacks thatin-depth information, so chooses to increase inventory, keeping stock at a consistent levelthroughout the year. This not only results in higher carrying costs and less profit, butneedlessly ties up cash.

How to Record Financial Performance

For a business to assess its financial performance, it first must record its finances tocreate a baseline for comparison and analysis. Publicly traded companies are required tosubmit financial statements to the Securities and Exchange Commission (SEC) each quarter andannually, using Form 10-Q(opens in a new tab)and Form 10-K(opens in a new tab),respectively. Once received, the forms are added to the SEC’s EDGARdatabase(opens in a new tab) and can beaccessed by thepublic. While private companies generally aren’t required to publish financialstatements, most prepare monthly reports to help internal stakeholders and others analyzefinancial performance. Private companies can use many of the same financial metrics aspublic companies to track their results, provide to potential investors and lenders, and fortax purposes.

Form 10-K is made up of five sections — business, risk factors, selected financialdata,management’s discussion and analysis (MD&A), and financial statements andsupplementaldata. Each section provides a foundation for comparison with other businesses in the sameindustry or can establish how a business’s financial performance has changed overtime.

• Business. This section is an overview of a company’s primaryoperations, such as the business’s main products and services, the markets inwhich it participates and any subsidiaries. It may also include competitors, recentevents, regulations and more “big picture” information on a business. Thiscan helpdetermine how well a business’s finances can be used in a comparison with anothercompany’s performance.
• Risk factors. The list of risk factors usually includesindustry-specific, geographical and economy-wide risks the company currently faces orexpects to face in the foreseeable future. This information will inform the MD&Asection, where a company makes its case about how well it believes it can handle theserisks.
• Selected financial data. This section includes the company’sfinancial information from the previous five years, detailing items like ownedproperties, equity securities, dividends and legal proceedings. More detailed financialrecords are found in the “Financial Statements and Supplementary Data”section.
• MD&A. This section is management’s perspective on thebusiness’s most recent year’s financial results. It lays out assumptions andestimates, and explains any major changes in financial performance. This sectionprovides context for the other sections when the numbers can’t speak forthemselves. When comparing two businesses’ performance, the MD&A section cangivevaluable insight into why and how they differ.
• Financial statements and supplementary data. Form 10-K requires publiccompanies to include their balance sheet, cash flow statement, income statement and astatement of stockholder’s equity. Also included are financial notes that provideadditional context for the statements through annotations and explanations, likeaccounting methods used (when multiple options are allowed) and supporting details.Collectively, these statements serve as the foundation for financial performanceanalysis, both through historical internal data and industry comparisons.

Once a company has its financial statements and notes prepared, analysts can begin looking atthe business’s performance and then layer their findings throughout these documents.Remember, financial performance paints a picture of a company over time, typically comparingit to other businesses in the same industry. For example, a law firm wouldn’t careabout “inventory turnover,” while a retailer would, so a side-by-side comparisonof the twobusinesses is unlikely to provide useful insights. But comparing the financial performanceof a chain of grocery stores with a similar chain in the same region could give valuableinsight into financial efficiency.

Financial Statements

Financial statementsare valuable not just for the data they contain, but for how they’re organized. Theyhave a similar structure and provide the same data elements for every company, makingside-by-side comparisons easier. While private companies don’t necessarily need toadhere to U.S. Generally Accepted Accounting Principles(GAAP), doing so is considered a best practice, as lenders and potential investorswho review financial statements expect companies to comply.

Internally, managers and decision-makers use financial statements for analysis and budgetplanning. Many companies use automated systems to help generate their financial statements.Manually entering and formatting data is time-consuming, and delays make it difficult formanagers to quickly identify trends and potential problems, resulting in lost revenue orunnecessary expense. Additionally, manual data entry is less accurate, and errors can leadto managerial “fixes” that don’t address a problem’s root cause— or may evenmake it worse.

The four main statements used for financial performance are:

Balance Sheet

The balance sheet shows assets, liabilities andowner’s equity as of a certain date. The balance sheet will always balance using thefollowing “accounting equation”: Assets = Liabilities + Owner Equity. Thisstatementtypically separates liabilities into those that will be paid within a year, like vendorbills, and those to be paid long-term, like mortgages. Differentiating between short-termand long-term liabilities helps with cash flow forecasts and can indicate whether thebusiness will need additional working capital, such as a loan or line of credit. Assets aresimilarly compartmentalized into current and long term and, by comparing short-term assetsto short-term liabilities, potential creditors or investors can see how liquid a business isand whether it’s a good risk. The listed equity includes measures like retainedearnings and share capital, which can be used to assess the valuation of a business. Ahealthy company usually has positive equity, demonstrating that it’s worth more thanit owes. Careful study of the balance sheet over time can help a business avoid long-termfinancial struggles by identifying growing liabilities or shrinking assets.

Cash Flow Statement

The cash flow statementshows all the funds coming in to and going out of a business over a given period, withbeginning and ending cash balances. This statement can yield valuable information on acompany’s sources of cash, whether it generates enough cash to cover operating costsand how much cash it has on hand. It’s important to note that cash flow is differentfrom profit. If a business makes a sale, but has not been paid for it, that sale will showas revenue and affect profitability but won’t increase the company’s availablecash until payment is received from the customer.

There are three primary sections in the cash flow statement:

• Cash flow from operating activities captures cash inflows and outflowsfrom a company’s core business, changes in current assets and liabilities, andtotal depreciation/amortization expense during the period.
• Cash flow from investing activities includes gains and losses from thepurchase and/or sale of capital equipment and securities, and from mergers andacquisitions.
• Cash flow from financing activities shows transfer of cash between acompany and its owners, investors and creditors. Sale of stock, debt issuance and anydividend payments appear in this section.

Taken as a whole, the sum of the three sections of the cash flow statement show thebusiness’s net increase or decrease in cash for that period.

Income Statement

The income statement, commonlycalled the profit and loss (P&L) statement, records the financial results of allbusinessactivity over a given period, including all revenue and expenses as well as any gains orlosses. This is where the “bottom line” for a business comes from, as net incomeisliterally the last line on the income statement. The income statement shows acompany’s total revenue, operating costs, margins, non-operating expenses andprofitability for a given period, and will usually show comparisons with previous periods,like the previous year or quarter. Businesses can use the income statement to see howchanges implemented at the beginning of a measured financial period affected the bottomline, thus informing future decisions and forecasting future income.

Annual Report

Annual reports are less standardized than other financial documents butare a common way for a business to give external stakeholders a more accessible look at thepast year’s financial performance, along with a glimpse into future performance.Annual reports usually include the balance sheet, cash flow statement and income statements,but can also have charts or graphs to make the data more understandable for non-accountantsthan typical numbers-heavy statements. Plus, their production values are usually closer towhat might be seen in a glossy magazine. Annual reports also usually include qualitativestatements to showcase a company’s values, future plans, noteworthy achievements fromthe previous year and anything else the company’s management wants to spotlight. Whilepublic companies must follow SEC guidelines for their annual reports, private companies cantake liberties with what they include — if they produce an annual report at all.Typically,smaller private businesses don’t create annual reports. But large private companiesmay do so to showcase their activities and future plans for existing or prospectivecustomers, suppliers or the community in which they operate — anyone they want toinformabout what and how the business is doing.

12 Measures of Financial Performance

Financial statements are packed with information. Here’s a look at a dozen of themetrics and KPIs shown in financial statements and the helpful clues they can give into abusiness’s financial performance. When reviewing these, keep in mind thatthey’re generally used to measure and report performance over the short or medium term— but companies also have long-term strategies and initiatives that can throwshort-termviews out of kilter. For example, a company may have R&D or marketing expenses thatreduceprofits in the current period but are expected to improve future profits. So it’simportant to consider long-term strategy when evaluating the true meaning conveyed by thesemetrics.

• Working Capital

  Working capital isall the funds available to support day-to-day operations. It’s used to payimmediate bills and obligations and can be calculated by subtracting currentliabilities from current assets. While positive working capital covers abusiness’s liabilities, and then some, a large excess of working capital mayindicate that a business is not effectively reinvesting its resources. A workingcapital deficit suggests that a company may not be able to meet its currentobligations. Companies can juggle such imbalances over the short term, but arecurring working capital deficit is not sustainable over the long run as theorganization will eventually run out of money to pay its bills.

• Gross Profit Margin

  Gross profitmargin is a crucial measure of the percentage of direct profit a companyobtains from the sale of its products. To calculate gross profit margin, first workout gross profit — the direct cost of goods/services sold (COGS) subtractedfrom thenet sales produced by those goods or services — and divide the result by netsales.To illustrate, if a company sells $1 million worth of widgets, whose COGS is$500,000 (including direct manufacturing, selling, marketing and delivery expenses),it has a 50% gross margin ($1,000,000 – $500,000 = $500,000, and$500,000/$1,000,000= 0.5, or 50%). Companies with higher gross profit margins than their directcompetitors would be more profitable, all other factors being equal, and have ahigher return on assets.

• Net Profit Margin

  Net profit margin is part of a company’s bottom line: net income divided byrevenue. Since net income is the result of subtracting all company expenses from itstop-line revenue, comparing the net profit margins of similar businessesdifferentiates which have the most efficient operations.

• Current Ratio

  Current ratio, also called working capital ratio, is a measure of liquidity similarto working capital (No. 1, above). Both are determined using current assets andcurrent liabilities, but where working capital is calculated by subtractingliabilities from assets, current ratio results from dividing assets by liabilities.For example, a business with $1 million in current assets and $1 million in currentliabilities has a current ratio of 1. A ratio above 1 shows that a company has morethan enough assets to cover its liabilities; if the ratio is below 1, there are notenough assets to cover liabilities.

• Quick Ratio

  The quick ratio, also knownas the acid test ratio, deals only with assets that can be quickly converted to cashwithout reducing their value, usually in less than 90 days. They’re thereforeknown as quick assets, and they typically include current assets like cash, accountsreceivable and marketable securities (but not inventory, even though it is a currentasset). Dividing quick assets by current liabilities shows the quick ratio, ameasure of solvency for a company. The quick ratio is most useful when looked atnext to the current ratio, as together they will show how liquid a company is andattest to the “quality” of its liquidity. Two grocery stores, forexample, mighthave similar current ratios but different quick ratios. The one with the lower quickratio would typically have higher inventory, which ties up cash and lowers thequality of its liquidity.

• Inventory Turnover Ratio

  Inventory turnover shows how often a business sells its entire inventory over a givenperiod, an important measure of efficiency. Inventoryturnover ratio (ITR) can be used to determine the average time, in days, ittakes for inventory to sell. ITR is calculated by dividing COGS by the averageinventory balance. For example, if the COGS for a given period is $28,000 and theaverage inventory balance is $14,000, ITR would be 2. Divide ITR into 365 days peryear to get an expected average inventory period of 182.5 days. A high ratio showsstrong sales but could also show that demand exceeds supply, while a low ratioimplies excess inventory and potentially wasted supply. Studying the inventoryturnover ratio over time can help managers plan inventory allocation because adecreasing ratio points to a lower turnover rate — either from overproductionordecreasing sales. By identifying changes in ITR and comparing it withcompetitors’ ITRs, a business can adjust its production and keep inventory insync with sales patterns.

• Return on Assets

  Another profitability ratio, return on assets (ROA) shows how well a business isutilizing its assets to earn a profit. To calculate ROA, first find thebusiness’s average total assets by adding the beginning and ending assetvalues over a given time period and dividing by 2. Then, divide the result into netincome for the same period. For example, if a company begins the year with $750,000in assets and ends the year with $850,000, its average total assets for the periodis $800,000. If, during that same period, the business had a net income of $250,000,ROA would be calculated by dividing $250,000 by $800,000 to get a ROA of 0.3125 or31.25%. Analysts use ROAs to compare how businesses are using their assets to makemoney. If a business has a lower ROA than its competitors, it could signal thattheir assets are not generating the profits that they should, given their value, andefficiency fixes should be implemented. Every industry is different, as some requireheavy assets, like transportation companies, while others, like financialconsultancy firms, may expect a higher ROA due to lower asset costs. So be sure toonly compare companies in similar industries when analyzing ROA.

• Leverage

  When debt is used to finance assets, it increases a business’s financialleverage, also called the equity multiplier. Leverage is usually measured as totalassets divided by total equity. If the resulting ratio is above one, investors cansee that the company is financing assets with debt. Higher leverage implies higherrisk. If a business wants to increase its creditworthiness or woo investors, it mayneed to reduce leverage by paying down debt.

• Return on Equity

  Return on equity (ROE) is a way to measure the business’s return on net assets(which is assets minus liabilities). ROE is found by dividing net income by totalequity. ROE shows how effectively a company is using equity and generating incomeover a given period of time. For example, if a business generated net income of$600,000 and had total equity of $4.8 million for the fiscal year, dividing theformer by the latter would give a ROE of 0.125 or 12.5%. That means that for everydollar of equity in the business, the company has generated 12.5 cents. Manyinvestors look at ROE compared both to that of similar companies and to an industryaverage when choosing where to invest, so ROE can be a valuable measure for abusiness to consider when seeking external investors.

• Earnings Per Share

  Earnings per share (EPS) shows the relationship between income over a period of timeand shares of outstanding stock. Often calculated quarterly and yearly, EPS issimply net income divided by the number of shares outstanding. It shows the amountof income that could theoretically be attributed to each share, if all the incomewere to be distributed as dividends, and is therefore seen as a proxy for companyvalue.

• Price-to-Earnings Ratio

  The price-to-earnings ratio, typically written as P/E, is an investment ratio foundby dividing earnings per share into a single share’s market price — so,bydefinition, it applies only to public companies. Many investors look for stocks thatare priced low relative to their earnings and use P/E ratio to tell whether a stockis a good deal. For example, if a stock’s EPS is $1.50, and a share costs $10,the P/E ratio would be 10/1.5, or 6.7. On its own, P/E is not very useful, but, whencompared to other companies in an industry, it helps investors decide where toinvest.

  See Also

  The Four Pillars of Financial Health

• Free Cash Flow

  Free cash flow (FCF)is the remaining cash after short-term liabilities and capital expenses are paid.FCF is calculated by subtracting capital expenditure from operating cash flow. FCFis an important measure of liquidity, as it shows how much cash a business has leftafter operating expenses, like payroll, and capital expenses, like new equipmentacquisition, are paid. The higher the FCF, the more money decision-makers have forthings like expansion projects, paying debt and dividends, or share buybacks. Forthese reasons, a high FCF can make the business more enticing to investors.

Examples of Financial Performance

Financial statements are too detailed for readers to quickly extract meaningful insights, soa good financial performance analysis typically distills key metrics from the statements forcloser scrutiny. The example shown in the table below looks at the 12 financial performancemetrics just discussed, from two companies in the same industry, using a side-by-sideformat.

Example of Financial Performance Analysis

For these two companies, the performances vary depending on which measures are beingevaluated. Company A has lower overall working capital but also a current ratio closer to 1,showing that it is more effectively utilizing its working capital. Company A also has ahigher net profit margin, higher return on assets and a higher P/E, showing that it may be abetter value for an interested investor. But Company B has a higher gross profit margin, ahigher inventory turnover rate and higher free cash flow — all of which point tostrongsales. Coupled with higher earnings per share and less leverage, some investors may thinkCompany B is a better investment.

What Financial Performance Means for Investors

All investments bear some level of risk. A good analysis of a business’s financialperformance helps investors get a sense of how much risk they would be buying into if theyinvested in the business. Different investors may weigh the importance of the variousfinancial metrics differently, and all investors generally take more than one measure offinancial performance into account when evaluating a business. So, investors typically lookfor a fuller picture, often gained through side-by-side comparisons of information frommultiple companies’ financial statements — the balance sheet, income statement,cashflow statement — and annual reports. While past performance is not a guarantee offutureearnings, trends and historical data from recurring financial statements can show howeffectively a business has utilized its assets to gain ROIs of its own, which can go a longway toward convincing investors of a given business’s value.

Financial Performance Analysis

Businesses use all these reports and data about financial performance to continually analyzehow to strengthen the company. Analyses of financial performancedata can answer questions like, “How efficiently does the business use itsassets?”“How profitable is product A versus product B?” “Is our capital structuresufficient to fundour growth plans?” and many others. The following four forms of financial performanceanalysis are often used to help internal business managers and external investors makestrategic business and investment decisions.

Working Capital Analysis

Working capital is a simplemetric, in theory (current assets minus current liabilities), but analysis of workingcapital can yield essential details. Working capital analysis can help managers andinvestors understand a business’s liquidity, its ability to pay its bills, and cancontribute to other valuable KPIs, like the working capital/current ratio. A working capitalratio below 1 suggests that a company may struggle to cover its debts and obligations, whilea ratio above 2 might indicate that assets are not being used to their full potential.

Financial Structure Analysis

The term “financial structure,” also called capital structure, refers to how abusiness isfinanced, specifically through its mix of equity and debt. Financial structure analysis canshow a business’s value and its risk. For example, a business that funds all itsgrowth with the profit it generates is growing via all equity and no debt; it is financiallystrong and carries inherently low risk. Businesses that use a high level of debt financingcould raise a red flag for potential investors, depending on the nature of the business andthe mix of equity and debt financing that is typical for their industry.

Activity Analysis

Activity analysis breaks down all the direct and indirect input costs that go into eachproduct/service that the business offers. During activity analysis, a share of overheadcosts is allocated to products to show the actual, “all-in” costs of producingthem,relative to their respective prices. If a business bundles multiple products or servicesinto a single customer sale, its activity analysis may need to start by allocating a portionof the sale price to each element in the bundle. Activity analysis can help internalmanagement make determinations on efficiency, and can help show the team where costs can betrimmed or which products are accruing the highest costs. How useful an activity analysis ismay depend on the organization’s ability to scale its shared costs up or down —someshared costs may be fixed and therefore difficult to change, while others may be variableand easy to adjust.

Profitability Analysis

Profit is usually at the forefront of performance analysis. Profitabilityanalysis shows which product- or service-specific revenue streams are mostprofitable, which assists managers who forecast future profit levels and predict how toutilize assets more effectively. A business can use profitability analysis to decide whetherto increase or decrease investment in a particular product or service, but it must also takemarket potential into account when doing so. For example, if the most profitable product ina company’s portfolio has 90% market share, there will be little room for growth evenwith higher investment; but if a highly profitable product has low market share, it may beripe for that investment.

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Analyzing a business’s financial performance answers the question, “Is thisbusinessfinancially healthy?” Financial performance analysis uses many metrics, most based oncorefinancial statements. Whether it’s for an internal manager, a potential investorassessing your company or a lender deciding whether to approve a loan application, strongfinancial performance analysis can show detailed information on where a business’sstrengths and weaknesses lie and give a good sense of where it’s headed. Unlike publiccompanies, private businesses are not legally obligated to report financial performanceinformation. But they can use the same accounting practices to create a stronger,financially healthier company.

Financial Performance FAQs

Why is financial performance important?

Financial performance tells a company’s senior managers how well the company is doing.Without proper understanding of its financial performance, the business will struggle toidentify how to improve operations. Investors also want to see strong financial performanceto justify their investment in the company, and lenders use it to assess the risk of loaningmoney to the company.

What is meant by financial performance?

Financial performance is the overall health and strength of a company’s finances.Financial performance looks at data from financial statements and other reports to assistinternal company managers whose goal is to strengthen the business, or to inform externalinvestors and lenders. A typical financial performance analysis will compare financial datafrom a company’s current fiscal period (perhaps a month, quarter or year) to previousperiods and/or to competitors’ data.

What measures financial performance?

Financial performance is measured by many KPIs, but the main financial sources are thebalance sheet, income statement and cash flow statement. The data found on these statementscan be compared against competitors’ statements to assess a company’s financialstrength relative to its peers.

What is a financial performance example?

Financial performance can take many forms but tends to show quarterly or yearly metrics andhow they’ve changed. For example, Meta’s second quarterly report of 2022 showeda revenue drop of 1% and an expense increase of 22%, contributing to a 32% decrease indiluted earnings per share.

What are the three elements of financial performance?

When business managers or investors think about the three main elements used to measurefinancial performance, they’re usually thinking of the primary financial statements:the income statement, which is the one with the top and bottom lines; the cash flowstatement, which illuminates the business’s sources of cash coming in and going out;and the balance sheet, which lists the business’s assets, liabilities and equity.

What are financial performance indicators?

There are many effective financial performance indicators, but some of the most importantKPIs are working capital, gross and net profit margins, current ratio, quick ratio,inventory turnover ratio, return on assets, return on equity, leverage, earnings per share,price-to-earnings ratio and free cash flow.

How can a business improve its financial importance?

By studying core KPIs like net profit margin and return on assets, a business can focus onwhere it is most efficient and where it needs improvement. With proper management, financialperformance analysis can help create a roadmap to ways a company can strengthen and grow.