Financial performance is a broad term that describes a company’s overall fiscal health. When you hear that a business has strong financial performance, that often means it has growing revenues, manageable debt, and a healthy amount of free cash flow. However, financial performance is subjective, and it can’t be gauged with a single metric.
In this article, we’ll explain how financial performance works. We’ll discuss some common ways of measuring financial performance, and where you can find this information. Finally, we’ll explain how you can apply financial performance concepts to your investment decisions.
Definition and Examples of Financial Performance
Financial performance is a general term that describes the overall financial health of an organization.
Financial performance metrics are quantifiable, meaning you can measure. But just as your doctor can’t tell you how healthy you are just by taking your temperature or blood pressure, there’s no single way you can measure financial performance.
Any financial performance metric should be considered in a broader context, such as the company’s business model or even the industry it operates in.
For example, a firm may be rapidly increasing its revenues, but that doesn’t mean its financial performance is strong. To assess its financial performance, you’d also need to look at its expenses, its liabilities, and how much free cash it has available.
How Does Financial Performance Work?
Financial performance matters to investors, who make decisions about whether to buy or sell a company’s stocks and bonds based on this information. But investors aren’t the only ones who care about financial performance. Managers use this information to determine how to allocate company resources. Analysts use financial performance data to make forecasts about future earnings and growth. Lenders use this information to assess whether a company is creditworthy.
A company’s financial performance doesn’t always align with whether its shares gain or lose value. Sometimes, a company’s share prices will tank even after a strong earnings report. Or a company’s share prices will soar, even though it has yet to actually earn profits.
For example, Tesla went public with an IPO in 2010, but it only achieved a full year of profitability in 2020. However, its shares rose from $4.7 at the end of June 2010 to a high of $87 in December 2019, despite Tesla reporting an annual loss of $862 million in 2019.
The U.S. Securities and Exchange Commission (SEC) requires publicly traded companies to provide detailed financial information by filing Form 10-K annually. Companies are also required to provide an annual report to shareholders when they hold annual meetings to elect their boards of directors. You can access a company’s 10-K statement using the SEC’s EDGAR database.
You can find the information you need to assess a company’s financial performance by examining its financial statements. The three most common types of financial statements are the balance sheet, income statement, and cash flow statement, which are explained in greater detail below.
Investors can find important context for analyzing financial performance in the Management’s Discussion and Analysis of Financial Condition and Results of Operations, or MD&A, which accompanies annual and quarterly reports. The MD&A includes insight from management about the financial statements, as well as trends and risks.
The balance sheet provides an overview of a company’s assets, liabilities, and shareholder equity for a reporting period. It doesn’t show cash inflows and outflows.
- Assets: This is property the company owns. This includes cash; physical property such as real estate, buildings, and equipment; and intangible assets, i.e., assets that can’t be touched, like patents or trademarks.
- Liabilities: This is money the company owes. Examples include a mortgage or rent, bank loans, money owed to suppliers, taxes due to the government, and employee payroll obligations. Current liabilities are obligations due within a year, while long-term liabilities are due more than one year out.
- Shareholder equity: This is how much shareholders have invested. If a company sold all assets and paid off all liabilities, only shareholder equity would remain.
Also known as a profit and loss (P&L) statement, an income statement shows you a company’s revenue for the reporting period, along with its costs and expenses for the same period. The bottom line typically shows you the company’s net profit or loss. The statement also usually includes the company’s earnings per share.
Cash Flow Statement
A cash flow statement includes information from both the balance sheet and income statement. It shows cash inflows and outflows from operations, investment activity, and financing. The bottom line of the statement shows you the net increase or decrease in cash for the reporting period.
Types of Financial Performance Metrics
Financial performance metrics or key performance indicators (KPI) will vary by industry, but here are some important metrics both investors and managers often consider.
Net Profit Margin
This type of profit margin shows the percentage of revenue that’s left after accounting for all costs, including operating costs, taxes, amortization, and depreciation.
Net-profit margins vary widely by industry, but a company with higher net margins compared to its peers is usually more competitive.
Net profit margin = Net profit / revenue x 100
Liquidity ratios measure a company’s level of cash and assets that can easily be converted to cash that a company has on hand to meet its obligations.
- Current ratio: Measures a company’s ability to pay its current debt (i.e., obligations due within a year) with current assets (i.e., cash and assets that will be converted to cash within a year).
Current ratio = Current assets / Current liabilities
- Quick ratio: Also known as the acid test, the quick ratio excludes inventory from current assets and the current portion of long-term debts to show a company’s ability to meet its short-term obligations.
Quick ratio = [Current assets - inventory] / [Current debt - current long-term debt]
A company’s financial leverage ratio, or equity multiplier, shows how much of its assets are financed by shareholder equity versus debt. A company with a higher equity multiplier is more reliant on debt—therefore, it’s typically seen as a greater risk.
Leverage = Total assets / Total equity
Earnings Per Share
Earnings per share, or EPS, tells you how much profit a company is earning per share of outstanding stock. Examining a company’s earnings per share over time can show investors how its profits are trending, providing that a company isn’t issuing new shares or repurchasing large numbers of existing shares.
Earnings per share = Net earnings / Outstanding shares
The price-to-earnings ratio, or P/E ratio, divides the current share price by earnings to share. Value investors often look for companies with a low P/E ratio compared to their peers. However, growth investors are often less concerned with P/E ratios because they believe the rapid growth potential justifies a higher price.
P/E ratio = Market price / Earnings per share
Operating Cash Flow
Operating cash flow refers to the amount of cash a company has from its operations. If the number is positive, it can maintain and expand operations. If it’s negative, additional financing is needed to continue operating at current levels.
Example of Financial Performance: Home Depot vs. Lowe’s
To understand how financial performance works, let’s compare the financial performance for home improvement rivals Home Depot and Lowe’s. This comparison is based on quarterly financial statements for the fiscal quarter that ended April 30, 2021, for Lowe’s and May 2, 2021, for Home Depot, and historic stock prices.
|Net margin (TTM, or trailing 12 months)||10.45%||7.23%|
|Earnings per share (diluted)||3.86||3.21|
|Trailing P/E ratio (based on the past year’s earnings) as of April 30||27.11||25.32|
|Operating cash flow (TTM)||$19.41 billion||$11.09 billion|
Based on Home Depot’s and Lowe’s recent financial performances, Home Depot has a higher profit margin and superior earnings per share. However, Lowe’s has a slightly lower P/E ratio, indicating it could be a better value. The companies are fairly similar in terms of liquidity, but Lowe’s is more leveraged, suggesting that it’s relying more on debt for financing compared to Home Depot.
What It Means for Individual Investors
Individual investors should be careful not to rely on any single metric in evaluating financial performance.
Financial performance analysis is most effective when it’s used to compare companies in similar industries. Otherwise, you risk apples-to-oranges comparisons.
Using a company’s recent financial performance and comparing it against past performance can help you spot important trends. But it’s also important to remember that past performance doesn’t indicate future results. Even if a company has a record of good financial performance, that’s no guarantee it will perform well moving forward.
- Financial performance refers to a company’s overall fiscal health, but there’s no single metric that measures it.
- Publicly traded companies are required to provide detailed financial information by filing Form 10-K annually with the SEC.
- Financial performance analysis is most effective when investors compare companies in similar industries.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.