A company’s financial well-being is like a compass, guiding its direction and future success. As an accountant, it’s one of your key responsibilities to keep a pulse on the financial health of companies that you manage.
This blog article dives into key metrics, analysis steps, and strategies to improve financial performance, ensuring your company thrives in the ever-competitive business landscape.
What is financial performance?
Financial performance is a multi-faceted way to measure a company’s overall financial health and ability to make a profit. Think of it as a scoreboard that keeps track of your runs (profits), wickets (expenses), and overall game position (financial health). This analysis helps assess the company’s overall economic well-being over a specific period.
Analysing financial health can help you assess more than just profitability. It can help you gain insights into a company’s ability to meet financial obligations and manage its resources to make revenue.
Financial performance is relevant for the most important business stakeholders, such as management, investors, and creditors. Knowing how to measure financial performance is a valued skill among accountants and bookkeepers.
When would you need to measure financial performance?
Measuring financial performance is an ongoing process with key milestones. Accountants and bookkeepers will typically need to evaluate financial performance in the following situations:
- Regular reporting: This can be done every month, quarter, and year to identify trends and inefficiencies in relation to the business’s goals.
- Strategic planning: When mapping out future plans and goals, financial performance analysis allows you to make informed decisions on different investments.
- Performance reviews: Analysing financial health can give insights into past strategies’ effectiveness and highlight improvement areas.
- Mergers and acquisitions: Financial performance analysis lets all parties assess potential risks and opportunities when joining forces with another company.
- Regulatory compliance: Publicly traded companies must report financial performance to the Australian Securities and Investments Commission (ASIC). This ensures transparency and protects investors’ interests.
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The importance of knowing a company’s financial performance
The importance of knowing a company’s financial performance boils down to informed decision-making. It’s like having a business compass that steers you in the right direction. Here are a few examples of why it matters:
Reduced risks
Financial performance reveals a company’s profitability, liquidity, and solvency. This helps investors assess potential risks and make informed investment decisions, avoiding companies with shaky financial ground.
Performance tracking
Regularly measuring financial performance allows management to track progress towards goals, identify areas that need improvement, and course-correct strategies as needed.
Identifying growth potential
By analysing trends in financial performance, investors can identify companies with strong growth patterns, leading to potentially higher returns.
Loan security
Creditors rely on financial performance to assess a company’s ability to repay business loans. Strong financial performance translates to a lower risk of default, allowing creditors to offer better loan terms and interest rates.
Investor confidence
When investors have access to transparent financial data, it fosters trust in the market. This leads to more informed investment decisions and promotes overall market stability.
Company accountability
Financial reporting holds companies accountable for their financial health. This incentivises companies to manage their resources effectively and operate ethically.
3 signs that a company has poor financial performance
Declining profits
Consistently falling profits can be a sign of several underlying issues. The company might be spending more than necessary on production, administration, or marketing. If these investments don’t return the best outcomes, it could be a sign that the products or services are becoming less popular due to market changes or competition. Effective leadership decisions are crucial to avoiding wasted resources and opportunities.
Liquidity issues
Difficulty meeting short-term obligations due to a lack of readily available cash is a major red flag. The company might be slow or ineffective at collecting payments from customers, leading to cash flow problems. On the other hand, holding onto too much inventory ties up cash that could be used for other purposes. Companies with these issues tend to face factors like slow sales, high volume of returns or refunds, or offering extended credit terms without risk assessment.
High debt levels
Excessive debt can limit a company’s ability to invest in growth and make it vulnerable to economic downturns. A higher debt burden means more money needs to be allocated towards servicing the debt, leaving less for other critical areas. Companies with this financial risk may find it difficult to secure additional loans in the future, hindering their ability to respond to emergencies or pursue growth opportunities.
Key statements to measure financial performance
To effectively measure financial performance, accountants rely on three key financial statements: the balance sheet, income statement, and cash flow statement. Each statement provides a unique perspective on a company’s financial health.
Balance sheet
The balance sheet provides a picture of a company’s financial position at a specific point in time, typically at the end of a quarter or year. It follows the fundamental accounting equation:
Assets = Liabilities + Shareholders’ Equity
This equation indicates that everything a company owns must be financed by its financial obligations and/or its net worth based on the investment of shareholders and retained earnings. By analysing the balance sheet, you can assess a company’s ability to answer short-term and long-term obligations through the current ratio, where a value below 1 indicates liquidity issues, or the debt-to-equity ratio, where a higher ratio suggests higher risks.
Income statement
Unlike the balance sheet’s snapshot, the income statement reports on a company’s financial performance over a specific period, typically a quarter or year. It details the following aspects:
- Revenue: Income generated from selling goods or services.
- Expenses: Costs incurred in running the business, including cost of goods sold, operating expenses, and interest expenses.
- Net income: The difference between revenue and expenses, representing the company’s profit or loss for the period.
Through income statements, you can assess a company’s profitability through the net profit margin, where a higher margin indicates better profitability. You can also use the return on equity (ROE), which measures how effectively a company is using its shareholder investments.
Cash flow statement
The cash flow statement bridges the gap between the balance sheet and the income statement. While the balance sheet shows what a company owns and owes at a specific point, and the income statement shows its profit or loss over a period, the cash flow statement reveals where cash comes from and goes during that period.
With a cash flow statement, you can assess a company’s ability to generate revenue from its operations and manage its short-term financial needs. To avoid negative financial performance, a company would need to maintain a positive operating cash flow and free cash flow.
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Key financial performance indicators & metrics
Financial performance indicators and metrics are like gauges on a car dashboard – they provide insights into a company’s financial health and its ability to generate profits. Here’s a breakdown of the most important KPIs and metrics:
Profitability ratios
- Net profit margin: This metric shows what percentage of each dollar of revenue remains as profit after accounting for all expenses. A higher margin indicates better profitability.
- Return on equity (ROE): This ratio measures how much profit the company generates relative to shareholders’ equity. A higher ROE indicates the company is effectively using shareholder investment to generate profit.
- Return on assets (ROA): Similar to ROE, but instead of shareholder equity, ROA considers total assets. It measures how efficiently a company uses its assets to generate profit.
- Earnings per share (EPS): This metric shows a company’s profit attributable to each common share outstanding. It’s a key measure of profitability for shareholders.
Liquidity ratios
- Current ratio: This ratio assesses a company’s ability to meet its short-term obligations (due within a year) using its current assets (easily convertible to cash). A ratio below 1 indicates potential liquidity issues.
- Quick ratio: A more stringent measure of liquidity, the quick ratio excludes inventory (as it may take longer to sell) from current assets. It provides a clearer picture of a company’s ability to meet immediate obligations.
- Free cash flow: This metric represents the cash available for dividends, debt repayment, or stock buybacks after accounting for operating expenses and capital expenditures.
Solvency ratios
- Debt-to-equity ratio: This ratio indicates how much a company finances its operations with debt compared to shareholder investment. A high ratio suggests higher risk, as the company relies heavily on borrowed funds.
- Times interest earned ratio: This ratio measures a company’s ability to cover its interest expenses on debt. A lower ratio indicates potential difficulty meeting debt obligations.
Efficiency ratios
- Inventory turnover ratio: This metric measures how many times a company sells and replaces its inventory over a period. A higher ratio suggests efficient inventory management, while a lower ratio could indicate overstocking or slow-moving inventory.
- Receivables turnover ratio: This ratio measures how effectively a company collects payments from customers on credit. A higher ratio indicates faster collection of receivables, while a lower ratio could suggest issues with customer credibility or collection processes.
Remember, there’s no single “perfect” ratio or metric. The best approach is to analyse a combination of these indicators while considering the company’s industry, size, and stage of growth. By understanding these key financial performance indicators, you can gain valuable insights into a company’s financial health and make informed investment or business decisions.
How to analyse financial performance
1. Gather the financial performance statements
Obtain the company’s balance sheet, income statement, and cash flow statement for the most recent period (usually annual) and potentially prior periods for comparison. These can be found in the company’s annual report or on the accounting platform used.
2. Calculate the key ratios
Financial ratios should be compared across periods and against competitors to see whether your company is improving or declining and how it’s faring against direct and indirect competitors in the industry. No single ratio or statement is sufficient to analyse the overall financial health of your organisation. Instead, a combination of ratio analyses across all statements should be used.
3. Analyse trends and compare ratios
Compare the calculated ratios for the current period with those from previous periods to identify profitability, liquidity, solvency, and efficiency trends. Benchmark the ratios against industry averages or competitors to understand the company’s relative performance within its sector.
4. Consider qualitative factors
Don’t rely solely on financial ratios; consider qualitative factors like management strength, market position, and future growth opportunities. Aspects like industry and company growth stage can also explain the current financial performance and help you evaluate the risks of pursuing certain business goals.
5. Draw conclusions and make informed financial decisions
Based on your analysis, form an opinion on the company’s financial health, profitability, and future prospects. Package these insights with recommendations for moving forward and advise the company on its investment decisions and credibility.
How to help improve a company’s financial performance
Find strategies that boost profitability
Explore ways to grow sales through effective marketing campaigns, new pricing strategies, or the launch of innovative products or services. In times of negative financial performance, businesses must find ways to reduce costs, whether by renegotiating with suppliers or streamlining operations.
Focus on improving cash flow
Implement stricter credit policies, offer early payment discounts, and improve collection processes to ensure timely customer payments. Maintain optimal inventory levels to avoid overstocking and reduce carrying costs. Implement just-in-time inventory management practices, if applicable.
Restructure any existing debts
Develop a plan to pay down existing debt or avoid excessive borrowing. Consider using profits or selling off non-core assets to reduce debt burden. Negotiate with lenders to extend repayment terms for existing debt, providing more breathing room for managing cash flow. These strategies should work hand-in-hand with profitability initiatives to generate more cash flow.
Improve operational efficiency
If the financial performance analysis revealed issues with internal processes, focus on fixing anything that eats up too many resources without a positive impact. Consider investing in automation to save money on labour costs or employee training for staff to improve their productivity.
Support financial performance with the right tools and resources
In conclusion, financial performance analysis is a powerful tool for understanding a company’s health and navigating the complexities of the business world. You can make informed decisions that propel your company towards sustainable success by wielding the insights gleaned from financial statements, key ratios, and strategic planning.
Consider utilising the best available software and resources to maximise the effectiveness of your analysis. Financial performance analysis is a continuous journey, and by leveraging the latest tools and expertise, you can ensure your clients stay on the path to financial well-being.
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