Understanding financial performance is essential for every organization because most of the organization’s crucial decisions depend on the financials. Understanding financial performance is necessary because they help in the decision-making process of the company.
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What are the financial key performance indicators?
These are the indicators that the organization tracks to analyze its financial health. Different categories such as liquidity, profitability, efficiency, solvency, and valuation are few of which fall under these KPIs.
Understanding these KPIs will help you to understand where your business is currently and what the prospects are looking like. Once you understand these KPIs, you can use that knowledge to adjust your strategies accordingly. This is important because you cannot run any significant strategy in the company without having stable financials.
Usually, companies ensure that the KPIs are available internally, and every employee receives it every week. This will give a reflection of the organization’s profitability to every employee. It will also provide the employee with a picture of what is expected on his behalf to match the company-wide goals.
The financial KPIs also allow you to make decisions about the required changes in the organization. These KPIs are also important when it comes to measuring the effectiveness of your organization’s policies.
In an ideal scenario, if everything is running smoothly and correctly, then all financial indicators will be green. Financial performance will also help to determine if the path and strategy that you have chosen for your department or organization are working or not. It acts as an indicator or correctness of processes in an organization.
Long term financial performance is essential to understand the future of the company, while short term financials is crucial to understand if an implemented policy is working or not. A company’s financial health is essential for all departments to function.
Financial statement analysis
It is the process of understanding and reviewing the financial statements to get a better understanding of the performance of the company. In simple words, it is the analysis of the financial statements of your company.
Although there are multiple financial statements available in every organization, the following are four commonly analyzed financial statements that give a brief picture of the company’s financial health:
The balance sheet is a statement that enlists assets and liabilities of the organization. A balance sheet of any organization is a primary but good indicator of the financial health of the organization.
2. Income statement
It is the summary of revenue, profits, and expenses of the company over a while. An income statement shows the financial performance in terms of sales and revenue generated over a specified period.
The statement which shows the activities of cash and its flow throughout the organization is called a cash flow statement. Usually, cash statements are categorized into investing, operating, and financing activities.
4. Annual report
The annual report is the document that explains the financial and operational conditions of the company. An annual report contains all the documents mentioned above and other essential insights and numbers from the organization.
Financial performance measures
Further are standard metrics that are typically present in every financial statement. They are also the parameters observed by stakeholders and investors to understand the organization’s financial position.
1. Gross profit margin
It is defined as the profitability ratio, which measures the percentage of revenue obtained after reducing the cost of goods sold. It can be said that the gross profit margin is the measure of profitability without considering the cost of overheads.
It is represented as:
Gross profit ratio = (Revenue – Cost of Goods sold) / Revenue x 100
Here, the cost of goods sold is the direct cost of production and usually does not include other operating expenses, taxes, and interest, which are applied later to the product price.
Working capital is the amount of capital that is available with business and is used to facilitate everyday operations. It is the required cash which is available with the business and can be used for everyday transactions.
It is obtained when the current liabilities or subtracted from the current assets. The value, which often gives net working capital, is available with the organization.
It is represented as:
Working capital = Current Assets – Current liabilities
3. Net profit margin
It is the profitability ratio that measures the percentage of income that is left after reducing all the costs of the business. When it is mentioned that all the cost is reduced, it should be done accordingly. Costs such as cost of goods sold, interest, operating expenses, and taxes are reduced.
It is represented as:
Net profit margin= Net Profit / Revenue x 100
The primary difference between gross profit margin and the actual of its margin is that net profit does not only consider the cost of goods sold but considers all the related expenses.
4. Quick Ratio
When the business wants to measure its short-term obligation handling ability, it resorts to what is known as the quick ratio. Liquid assets such as cash, accounts receivable, securities, etc. are used in case of a quick ratio.
It is represented as:
Quick ratio = ( Current Assets – Inventory ) / Current liabilities
In this ratio, an assumption is made that inventory can be turned into cash, but practically it is a challenging task to convert inventory into cash. It is also known as the acid test ratio.
5. Current ratio
The obligations that are due within one year are termed as short-term obligations, and the current ratio helps you understand if businesses can nullify its short-term obligations.
It is represented as:
Current ratio = Current Assets / Current liabilities
6. Debt – Equity ratio
It is known as the solvency ratio, which is the measurement of a company’s ability to finance itself with the help of equity versus debt. This ratio helps to provide an insight into the business solvency.
It is represented as:
Debt to equity ratio = Total debt / Total Equity
7. Leverage
Equity multiplier, which is also known as financial leverage, is the use of debt to purchase assets. As there is a rise in the debt, the multiplier also increases, which shows the impact of leverage of debt and finally increases the business’s risk.
It is represented as:
Leverage = Total Assets / Total Equity
8. Total Asset Turnover
The total asset turnover ratio is used to measure the efficiency in which a company uses its assets and generates revenue. The performance of the company depends on the turnover ratio. Therefore higher the ratio, the better is the performance of the company.
It is represented as:
Total asset turnover = Revenue / (Beginning Total Assets + Ending total assets / 2 )
9. Inventory Turnover
The inventory turnover ratio is the one that measures the number of times the company can sell the entire inventory during the accounting period. It helps to understand if a company has excessive inventory for its sales levels.
This also allows the company in sales forecasting and inventory management.
It is represented as:
Inventory turnover = Cost of Goods sold / ( Initial inventory + Ending inventory / 2 )
10. Return on Equity
Return on equity, also known as ROE ratio, indicates how efficiently a business can utilize its investments to profitability for its investors. It is calculated by dividing the net profit over the equity of shareholders.
It is represented as:
ROE = Net Profit / (Beginning equity + Ending Equity ) / 2
11. LOB revenue vs. Target
With this ratio’s help, you can compare your revenue for a particular line of business to your expected projected revenue. The difference between actual and your projection revenues will help you better understand if your department is performing financially correct.
This is an important ratio when it comes to calculating budget variance because The comparison of the difference between the expected budget and the actual budget is essential and relevant to understand your budgeting needs.
12. LOB expenses vs. budget
When you compare actual expenses to the budgeted amount, then this ratio is formed. This can help you to understand where you have been spending more than the expectation and helps you to budget accordingly.
One of the essential factors in budget variance is expense versus budget. Understanding the variance between the total actual ratio of revenues and total assumed ratio to expenses will help you become an expert on the relation between the business’s finance and operations.
13. Operating cash flow
This is the measure of the cash in the business, which is the result of its operations. When the operating cash flow is positive, that means the business has enough cash to expand its operations.
If the cash flow is negative, then it can be derived that the business requires additional financing to maintain its existing operations. Usually, the cash flow statement is the one that represents operating cash flow.
The customer satisfaction ratio is the ultimate indicator of the long-term success of the company. Although the financial indicators are important, this ratio will determine the company’s viability in the long run in the market.
Different companies calculate the net promoter score, which results from calculating the positive responses from different customers after a satisfaction survey.
The net promoter score gives an accurate measurement of likely customer retention rate in the future based on current customer satisfaction.
15. Seasonality
Many businesses are based on the season. They generate the business of the entire year in two or three months. For example, a business of half sleeve T-shirts will thrive in summer but will go down during the rest of the year.
If you are in such a business, then you will see the confounding variables for what indeed they are.
16. Trend analysis of financial statements
As the name suggests, trend analysis is an analysis of the financial statements over a specified set of times. For example, a side-by-side comparison of two financial statements from two different years. Or a comparison of financial statements of two different quarters.
This comparison will help to analyze the financial trend over the specified period. It also helps to understand where things changed, and the company can look into why they changed.
Conclusion
Financial analysis is essential for every company to understand its current financial position and its future financial goals. It is an indicator to determine if the company is going the right way and if there are any changes required.
Financial performance will be positive if all things and strategies are well in the organization, and it would be negative if things are not working in favor of the company. Multiple ratios can be used to analyze the financial performance of the company.
