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. 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. 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.
Balance Sheet
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.
Income Statements
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 margin = Net profit / revenue x 100
Liquidity Ratios
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]
Financial Leverage
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
Price-to-Earnings Ratio
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.
What It Means for Individual Investors
Individual investors should be careful not to rely on any single metric in evaluating financial performance. 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.
