Measurement of financial performance is an important part of running a growing business. Many businesses fail because of poor financial management or planning.
A financial performance review can help you examine your business goals and plan effectively for improving the business. When carrying out a financial review of your business, you should consider:
Cashflow - this is the balance of all of the money flowing in and out of your business. You should regularly review and update your forecast. See cashflow management.
Working capital - have your requirements changed? If so, try to determine why and assess how this compares to the industry standard.
Cost base - keep your costs under review. Make sure that your costs are covered in your sale price - but don't expect your customers to pay for any business inefficiencies. See how to price your product or service.
Growth - do you have plans in place to adapt your financing to accommodate your business' changing needs and growth? Read more onfinancing growth.
Financial performance measures
One of the most important financial areas you should review is your profitability. This is your capacity to make a profit, ie generate revenue that exceeds your overall expenditure (all costs, taxes and expenses). Most growing businesses ultimately target increased profits, so it's important to know how to analyse your profitability ratios.
Profitability ratios
Profitability ratios typically fall under two broad categories: margins and returns. Most common profitability ratios are:
Gross profit margin - how much money is made after direct costs of sales have been taken into account, or the contribution as it is also known.
Operating expenses margin - this lies between the gross and net measures of profitability. Overheads are taken into account, but interest and tax payments are not. For this reason, it is also known as the EBIT (earnings before interest and taxes) margin.
Net profit margin - this is a much narrower measure of profits, as it takes all costs into account, not just direct ones. All overheads, as well as interest and tax payments, are included in the profit calculation.
Return on capital employed - this calculates net profit as a percentage of the total capital employed in a business. This allows you to see how well the money invested in your business is performing compared with other investments you could make with it, like putting it in the bank.
Accounting ratios to measure performance
As well as measuring profit, you should consider other standard financial ratios to help you to analyse your business' performance. These ratios look at:
liquidity - assessing your ability to meet your short-term financial obligations
solvency - measuring long-term debt against assets and equity to determine financial stability
efficiency - measuring things like stock turnover to determine how well you are using your business assets
Measuring these ratios against industry averages, previous years and competitors can help you identify problems and issues within your business. See how to use accounting ratios to assess business performance.
The most widely used financial performance indicators include: Gross profit /gross profit margin: the amount of revenue made from sales after subtracting production costs, and the percentage amount a company earns per dollar of sales.
There are several ratios to measure the company's financial performance, among others; liquidity ratio, profitability ratio, solvency ratio, efficiency ratio, leverage ratio.
A company in good financial health will pay its bills on time and maintain good business credit. Analysis of financial performance metrics can be used to identify internal investment opportunities, like automating repetitive processes to increase productivity, and can help maintain positive cash flow.
One example of a financial analysis would be if a financial analyst calculated your company's profitability ratios, which assess your company's ability to make money, and leverage ratios, which measure your company's ability to pay off its debts.
A financially healthy company typically has sufficient cash flow to cover its expenses and debts, generates consistent profits, maintains manageable debt levels, and possesses valuable assets.
The overall performance and position of the business should be evaluated based on a set of criteria that includes liquidity, solvency, profitability, financial efficiency, and repayment capacity. Each of these criteria measures a different aspect of financial performance and/or position.
Now that we have a better understanding of why these metrics are important, let's take a look at some of the best metrics for measuring employee performance:
Analysts often look to cash flow from operations as the most important measure of performance, as it's the most transparent way to gauge the health of the underlying business.
Profitability variable is the most important performance indicator to explain performance levels of the companies in the sample. As its coefficient is significantly greater than others, it can be used as a single “surrogate” performance indicator by ignoring other variables.
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