How to Evaluate the Financial Performance of a Company

Regardless of where you are in your career trajectory, understanding how to evaluate financial performance of a company is an essential skill. Financial performance analysis offers direct insights into a company's financial health and growth opportunities.

Business owners and managers use financial performance analysis to guide operational decisions and understand their company's financial position in the market. As an executive, financial performance analysis gives you insight into your company's operations and market performance. Your company’s financial performance affects everything from payroll to project budgets. Evaluating financial performance supports effective budget management while helping assess and refine organizational goals.

As an investor, analyzing financial statements and key financial performance indicators helps you determine a company's ability to succeed in current market conditions. Comparing financial ratios across companies in the same industry provides data-driven insights for investment decisions, helping you allocate your investments effectively.

Read on to learn more about the importance of evaluating financial performance and discover tips for accurately assessing a business's finances and determining its potential for future success.

Three essential financial statements provide a comprehensive picture of a company's financial position through the portrayal of its assets, liabilities, equity, expenses, revenue, and overall profitability:¹

• The balance sheet presents current assets, accounts receivable, shareholder equity, and current liabilities, offering a snapshot of the company's financial health at a specific point in the accounting period
• The income statement (also known as a profit and loss statement) tracks sales revenue, operating expenses, and net profit, showing how much profit a company generates over time
• The statement of cash flows details cash flow from operations, financing activities, and how effectively a company manages its cash equivalents and generates revenue

These statements must contain accurate and reliable data reflecting the company's financial position for meaningful financial performance analysis.

Financial statements give you an overview of a company’s expenses and revenues. Still, to better understand how the company manages its money, you need to know how to calculate and interpret fundamental financial ratios.

These key financial performance indicators include:²

Profitability ratios measure how effectively a company generates revenue relative to its operating expenses. These include:

• Gross profit margin, which shows the relationship between gross profit and net revenues
• Operating profit margin, which indicates operational efficiency
• Return on equity, which demonstrates how well a company uses shareholder equity

Liquidity ratios assess a company's ability to meet immediate obligations and short-term liabilities, including debt payments and payroll. Important liquidity ratios include:

• Current ratio, which compares current assets to current liabilities
• Quick ratio (also called the acid test ratio), which evaluates how well a company can meet short-term obligations without selling inventory

Efficiency ratios demonstrate how well a company manages its resources through measures like:

• Asset turnover ratio, which shows how efficiently a company uses its assets
• Inventory turnover ratio, which shows how quickly a company sells and replaces inventory
• Accounts receivable turnover ratio, which indicates how effectively a company collects payment

Leverage ratios examine how much debt a company carries, including:

• Debt to equity ratio, which compares total debt to shareholders' equity
• Coverage ratio, which shows the company's ability to meet its financial obligations

It’s not enough to assess a company’s financials for a single year. To truly evaluate financial performance, you must examine data across multiple accounting periods and compare the company's financial position with others in the same industry. Calculating year-over-year growth is a simple way to benchmark a company against itself.³

To calculate year-over-year growth:

• Subtract the previous year's value from the current year's value
• Divide by the previous year's value
• Multiply by 100 to get the percentage

For example, if a company generates net revenues of $240,000 this year compared to $200,000 last year, its year-over-year growth rate would be 20% (($240,000 - $200,000)/$200,000 x 100 = 20).

Comparing a company's financial ratios against competitors provides essential context for financial performance analysis. Industry trends help determine whether changes in financial performance reflect company-specific factors or broader market conditions.

For instance, when U.S. movie ticket sales declined by 81.4% during COVID-19 lockdowns in 2020,⁴ analyzing financial performance across the same industry revealed that external economic factors, rather than individual company management, drove the revenue decrease.

A company's financial statements, particularly the cash flow statement, reveal how well it maintains liquid assets. While the income statement shows profitability through metrics like profit margin, the cash flow statement demonstrates how effectively a company manages its available funds. Having sufficient cash enables companies to meet financial obligations and invest in growth opportunities.

Cash flow analysis provides insights beyond what the balance sheet and income statement reveal about a company's financial health. A business might show strong profit margins but face operational challenges if its money is tied up in assets or investments. For example, a company that must regularly liquidate assets to meet payroll indicates poor cash management, regardless of its reported profits.

Two key types of cash flow metrics provide essential insights:

• Operating cash flow represents money generated from core business activities and sales revenue.⁵ This metric, found in the cash flow statement, indicates how well the company's primary business operations generate funds
• Free cash flow shows the actual cash available after deducting capital expenditures and other investments, offering a clearer picture of funds available for expansion or distribution⁶

Profitability and growth potential indicate whether a company is likely a good investment. The income statement and other financial statements provide key indicators of a company's future profitability. Profit margin calculations, found in the income statement, show what percentage of revenue becomes profit. To determine the net profit margin, divide net income by total revenue and multiply by 100.⁷

Assessing growth potential requires analyzing financial performance across multiple accounting periods. Examining year-over-year revenue trends reveals whether a company is consistently generating revenue and demonstrating growth. The balance sheet and cash flow statement help validate growth sustainability by showing how well the company manages its resources during expansion.

Market analysis adds context to financial statement data. Even when a company shows strong profit margins and positive cash flow, its long-term potential depends on:

• Market size and growth trajectory
• The company's competitive position
• Industry economic conditions
• Available growth opportunities

While financial statements and performance ratios provide quantitative measures, evaluating financial performance requires understanding the broader business context. A company's market position and competitive advantages significantly impact its financial health. The annual report often provides insights beyond basic financial ratios, offering detailed information about business operations and strategic direction.

Leadership quality substantially influences a company's financial position. Reviewing annual reports, Securities and Exchange Commission filings, and industry publications helps assess management effectiveness. When a company's success depends heavily on specific executives, leadership changes can significantly affect financial performance.

Consider Apple's experience: After co-founder and CEO Steve Jobs died in 2011, many questioned the company's ability to maintain its market position.⁸ Current CEO Tim Cook has maintained strong financial performance, but industry analysts note shifts in the company's innovation approach.⁹

Key qualitative factors to consider when evaluating financial performance include:

• Management team experience and track record
• Corporate governance structure
• Market reputation and brand strength
• Research and development capabilities
• Competitive market position

Effective evaluation requires examining multiple financial metrics in context. While individual ratios from the income statement, balance sheet, and cash flow statement provide specific insights about everything from owners' equity to operating expenses, combining these indicators creates a complete picture of a company's financial health. Analyzing financial ratios together lets you see how revenue growth relates to operating expenses and financing activities.

Benchmarking against previous financial statements and industry competitors adds essential context to help understand a company's financial performance. For instance, an increase in operating expenses on the income statement might initially appear concerning. But when you evaluate this alongside other financial metrics, you might see that the increase signals strategic investments in new market opportunities or geographic expansion.

• Key considerations for comprehensive analysis include:
• Trends across multiple accounting periods
• Comparison with industry standards
• Market conditions and economic factors
• Integration of data from all financial statements
• Relationship between different financial ratios

Whether you're an investor or manager, knowing how to evaluate financial performance is fundamental to career success. Your ability to interpret financial statements - from the balance sheet to the income statement and cash flow statement - drives smart decisions about budgets and investments. Santa Clara University's Online Master of Science in Finance and Analytics (MSFA) prepares you to conduct thorough financial performance analysis and make data-driven business decisions.

The Online MSFA program delivers a powerful combination of professional networking and practical expertise. It connects you with accomplished Silicon Valley professionals who excel at using financial data for strategic decision-making. The curriculum builds both financial expertise and business acumen, essential skills for success in competitive global markets. The online format makes it possible to balance your educational goals with professional commitments while accessing the same robust academics available to on-campus students.

To learn more about how Santa Clara's Online MSFA can help advance your career through the Online Master's in Finance and Analytics, contact an admissions outreach advisor today.