How To Measure Financial Performance Effectively

Learn why measuring financial performance is important and which factors you should consider as your financial metrics or key performance indicators. RELATED: How To Prepare Organized Financial Reporting In this article:

1. Understanding Financial Performance
2. The Role of Measuring Financial Performance in a Business
3. Factors to Consider When Doing a Financial Performance Evaluation
4. Financial Performance Metrics
5. Standard Financial Ratios

Financial Performance Measures and Metrics

Understanding Financial Performance

What Is Financial Performance? This is a subjective measure of how effectively a firm can use its business assets to produce revenues. It also refers to the general measure of a firm’s overall financial health within a certain period.

What Is Revenue? This refers to the total amount of income made from selling goods or services in relation to the firm’s operations. This is the income before deducting operating costs, expenses, and debts.

Aside from reflecting how well they produce revenue, a firm’s financial performance also shows how they manage their assets, liabilities, and their stakeholders’ financial interests. There are a lot of ways to measure financial performance, yet remember that all measures must be in aggregate. It’s not advisable to limit the metrics to just one. The financial metrics you choose to focus on should cover the parts of your business where you want to monitor your performance.

The Role of Measuring Financial Performance in a Business

Measuring financial performance is an essential practice when you’re running a business. Some businesses failed to grow because the owners weren’t able to properly plan for and manage their finances. A review of your business’ financial performance can help you determine the feasibility of your business goals. In turn, you can implement effective plans to improve and grow your business. Financial performance is also important to investors and analysts as they use it to compare the following:

• Similar firms across one industry
• Sectors or industries in aggregate

Public companies publish the Form 10-K from the SEC, which includes three financial statements:

• Balance Sheet
• Income Statement
• Cash Flow Statement

Investors and analysts get financial data from Form 10-K to determine the financial performance of a company.

Factors to Consider When Doing a Financial Performance Evaluation

Here are the factors you should consider when you’re reviewing your business’ finances:

• Cash flow — Check the balance of all the money that flows in and out of your business. It’s important to regularly review your cash flow forecast and keep it up-to-date.
• Borrowing — Check the status of your other financing sources such as loans or overdrafts (credit extensions that go beyond the fund limit). Can you switch to more appropriate or cheaper financing options?
• Working Capital — This is the difference between your company’s current assets (e.g. cash, inventories, and accounts receivable) and current liabilities (e.g. accounts payable). The working capital formula is: Current Assets – Current Liabilities.
• Cost Base — Make sure you cover your operating costs in your pricing. However, be careful to not pass the burden of business inefficiencies to your customers.
• Growth — Evaluate your plans for your finances to adapt to the growth and changing needs of your business.

Financial Performance Metrics

Here are four metrics you can use to effectively measure your business’ financial performance:

1. Profitability

An important area of your finances you should review is the profitability of your business. A profitable business has the capacity to produce revenue that exceeds all expenditures. Businesses that focus on growth normally aim for increased profits. This makes it important to know how to analyze your business’ profitability ratios. There are two general categories under profitability ratios, namely, margins and returns. The most common of these are:

• Gross Profit Margin — The amount of money made after taking into account the direct cost of sales, also known as the “contribution.”

• Net Profit Margin — Here, you take into account all costs, not only the direct ones. When calculating for the profit, you include all overheads plus the tax payments and interest.

• Operating Expenses Margin  — This is in between the gross and net measures of profitability. Here, you take overheads into account, but not tax payments and interest — that’s why it’s called the EBIT (earnings before interest and taxes) margin.

• Return on Capital Employed — Here you calculate net profit as a percentage of the total capital you employed in your business. By doing so, you’ll be able to see how well the money you invested in your business is doing as compared to other investments available to you.

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2. Net Income

Net income is the most traditional financial performance metric, but it can also be the most misleading. It’s important to know whether your business made a profit or incurred loss over the previous financial period. Yet focusing too much on net income can lead you to prioritize short-term profits over long-term success. Accounting software automatically renders output figures for net income. However, you should carefully interpret the number, as net income trends often hold more meaning than a single figure.

3. Sales Growth

Sales growth is a common financial performance measure among small businesses that earn their revenue through sales. This metric presents a rough estimate of the business trend over a certain period. Often, you measure sales growth as a percentage of growth over the previous year. The financial performance indicators are:

• Positive sales growth = Growing business
• Negative sales growth = Decreased sales

Sometimes, though, sales growth can also deceive you. For instance, a 5% growth over the past year can mean good company performance. If you find the economy growing by 15% in your particular industry, this may mean you need to undergo changes so you can go toe-to-toe with your competition.

4. Expense Reduction

Expense reduction is an important metric for a slowing business or within a declining economy. You can conduct your analysis in two ways. If you only want to check your business expenses, you can examine your revenue from year to year. Ideally, it should be this way:

• Decreased revenue = Decreased expenses
• Increased revenue = Increased or no change in the amount of expenses

You can employ a more useful way to measure changes in your expenses by examining them as a percentage of revenue from year to year. This number should either stay as-is or decrease every year.

Standard Financial Ratios

To help you analyze your business’ performance further, you should also consider standard financial ratios. These examine the following:

• Efficiency — This determines how well your business is using its assets.
• Liquidity — This assesses your business’ ability to meet short-term financial obligations.
• Solvency — This measures long-term debt against equity and assets to determine the stability of your business financially.

Utilizing your financial statements to determine financial ratios is one of the simple and effective ways to assess your business’ performance. When you measure standard financial ratios against industry averages, competitors, and the past years, you’ll be able to identify which business issues you need to resolve. You can use financial ratio analysis to gather useful information in a short amount of time. Keep your business healthy by regularly checking your financial performance. When you use these financial performance measures, you’ll be able to determine the problems you need to tackle and properly plan for the growth of your business. Always remember that being proactive when it comes to your finances will help your business succeed in the long run. Do you regularly measure your business’ financial performance? Why or why not? Share your thoughts with us in the comments section below. Up Next: 

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