Financial performance has always been a yardstick to measure how a business is performing in the broader sense and whether it is achieving the goals it sets for itself. Understanding financial performance requires financial analysis making financial analysts the cornerstone of any successful global organization.
Financial metrics provide very granular details regarding the financial health of a company. Revenue metrics are one of the most important measurements for financial analysts to consider when evaluating financial performance. In addition to revenue metrics, gross income, net income, and earnings per share are all key metrics used by financial analysts for financial health assessment.
Other metrics include customer acquisition cost, average order value and lifetime value, and gross margin which measures profitability on each sale.
Revenue metrics measure total revenue over time by comparing two different periods. By expressing revenue growth as a percentage, financial analysts can make meaningful comparisons between companies in the same industry.
Gross profit is another revenue metric that indicates the amount of money left after subtracting costs associated with producing goods or services from total sales revenue. Gross profit gives insight into the efficiency of business operations by reflecting on how well it manages its direct expenses relative to sales volume and pricing levels.
Revenue metrics supply a significant understanding of a company’s financial well-being and can be employed to detect areas for growth.
Profitability ratios are used to evaluate the financial health of a company and allow the investors to compare the enterprise’s financial performance within the industry and understand an organization’s capability to generate value and provide healthy ROI.
They are primarily divided into two margin ratios and return ratios.
The margin ratios include gross profit margin, operating profit margin, net profit margin, cash flow margin, EBIT, EBITDA, EBITDAR, NOPAT, operating expense ratio, and overhead ratio.
While the return ratios include return on invested capital, return on assets and return on equity.
Financial analysts use all these ratios or a combination of a few critical ones to assess the financial performance of an organization but the most frequent ratios include
Gross Profit Margin – It compares the gross profit with sales revenue, the higher this ratio is better the company’s financial performance.
EBITDA Margin – A company’s profitability should also take into account non-operating items like interest and taxes, as well as non-cash items like depreciation and amortization. EBITDA margin provides that information while excluding expenses that may be volatile or discretionary.
Operating Profit Margin – A company’s operating cost impacts its profitability, and this ratio looks at earnings as a percentage of sales before other expenses like interest and taxes are deducted.
Net Profit Margin – Net Income divided by net revenue and paints a picture of the company’s profitability after all the expenses have been accounted for.
Cash Flow Margin – This ratio expresses cash flows from operating activities and sales generated, basically a view of a company’s ability to turn sales into cash. And negative cash flows indicate despite profits, a company might be losing money.
Return on Assets – This ratio calculates the amount of profit after taxes the company generates for every dollar of the asset it owns. The asset-intensive companies that require big machinery and equipment usually have lower ratios.
Return on Equity measures net income relative to shareholder’s equity and a higher ROE makes a company attractive to investors.
Return on Invested Capital measures the return generated by all capital providers including shareholders and bondholders. It represents the earning available to all investors and not just shareholders.
Liquidity metrics are another measure of a firm’s financial health that evaluate a company’s ability to meet its short-term obligations through liquid assets. The two most commonly used liquidity metrics are the current ratio and quick ratio.
The current ratio is calculated by dividing a company’s total current assets by its total current liabilities. A higher figure implies the firm has more liquid assets than liabilities, suggesting it could easily cover short-term debt payments if necessary.
Generally speaking, investors prefer companies with a high current ratio as it suggests they have enough resources to remain solvent in the event of unexpected expenses or downturns in business activity.
The quick ratio is similar but excludes inventory from the calculation since it can take longer to convert into cash compared to other types of assets such as accounts receivable or cash equivalents like money market funds or government bonds. This metric provides a more conservative view of liquidity since it assumes all inventory must be sold before any debts can be paid off; therefore, investors usually look for higher numbers when evaluating this metric than they do for the current ratio.
While not always perfect indicators of success, liquidity metrics provide valuable insight into how well-prepared companies are financial should any unforeseen events arise that require additional funding or payment flexibility in order to stay afloat during difficult times.
CFOs and financial analysts and other corporate leaders can gain insight into the financial well-being of their company by utilizing liquidity metrics.
Efficiency metrics can help gauge the speed of transforming inventory into revenue or cash.
Inventory turnover and days sales outstanding (DSO) are two common efficiency metrics used to evaluate performance.
Inventory turnover measures how quickly a company can sell its products relative to their total inventory value. Investors can use this to determine whether the company has enough liquidity to cover expenses, or has too much stock on hand that could be tying up capital.
Day sale Outstanding metric provides a glimpse into customer payment behavior and allows companies to adjust their credit policies accordingly, such as extended terms for larger orders but requiring swift payments for smaller orders with shorter turnaround times before they become delinquent debts.
Metrics of effectiveness are a key instrument for CFOs and other financial chiefs to evaluate the accomplishment of their association.
Debt metrics measure the amount of debt an organization holds, relative to its assets and liabilities. Examples of debt metrics include DER, ICR, and TLAR.
DER or debt to equity ratio measures a company’s total debt with respect to total equity, a higher DER indicates greater reliance on debt financing and a lower ratio indicates a conservative approach to financing.
The ICR ratio sheds light on a company’s ability to meet the interest payments on its debt, a higher ICR indicates better capabilities in managing debt-related interest payments.
TLAR measures the total debt financing used by a company and compares total liabilities with total assets, a lower TLAR indicates better financial health and indicates the company relies less on debt financing.
Key Performance Indicators (KPIs)
KPIs are a critical resource for financial analysts to assess and observe the effectiveness of their organization. KPIs monitored over a period of time, divulge critical information regarding the financial health of the company, and can provide insights to drive growth through informed decision-making.
By monitoring these various KPIs over time, finance executives can gain a better understanding of how their company is performing financially. This knowledge can then be used to make informed decisions about future investments or strategies for success in today’s ever-changing business landscape. CFOs and other finance execs can analyze present financial circumstances and recognize where progressions may be necessary to guarantee long-term objectives are achieved by utilizing key performance indicators.
Financial goals when measured against KPIs, provide clear actionable insights which are based on a comparison of historic and current data and help organizations course correct in time.
In conclusion, financial analysts have to explore various metrics to measure different aspects of a business’s financial performance and to gauge the success and continuity of business operations. Investors use this information to make informed investment decisions and companies themselves can use these metrics to navigate the capital markets’ ups and downs.