What is financial performance?

Definition of Financial Performance

Financial performance is a broad term that describes the overall financial health of a company. When you hear that a company has strong financial performance, it often means that it has increasing revenues, manageable debt, and a healthy amount of free cash flow.

How does Financial Performance work?

Financial performance matters to investors who make decisions about buying or selling a company’s stocks and bonds based on this information. However, investors are not the only ones interested in financial performance. Managers use this information to determine how to allocate the company’s resources. Analysts use financial performance data to make predictions about profits and future growth. Lenders use this information to assess whether the company is creditworthy.

Types of Financial Performance Metrics

Financial performance metrics or key performance indicators (KPIs) may vary by industry, but here are some important metrics that both investors and managers look at:

Net Profit Margin: This type of profit margin shows the percentage of revenue that remains after all expenses have been accounted for, including operating costs, taxes, depreciation, and amortization.

Liquidity Ratio: The liquidity ratio measures the level of cash and assets that can easily be converted to cash that the company has to meet its obligations.

Leverage Ratio: A company’s leverage ratio indicates how much of its assets are financed through shareholder equity versus debt. A company with a higher leverage ratio is more reliant on debt and is therefore usually considered a higher risk by investors.

Earnings Per Share: Earnings per share tells you how much profit a company makes for each outstanding share of stock. Examining a company’s earnings per share over time can show how its profits are trending, provided the company doesn’t issue new stock or repurchase large amounts of existing shares.

Price-to-Earnings Ratio: The price-to-earnings ratio divides the current share price by the earnings per share. Investors look for value in companies that have a low price-to-earnings ratio compared to their peers. However, growth investors tend to be less concerned about the price-to-earnings ratio because they believe that rapid growth justifies a higher price.

Operating Cash Flow: Operating cash flow refers to the cash amount that the company generates from its operations. If the figure is positive, it can sustain and expand operations. If it is negative, it needs additional funding 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 of home improvement competitors Home Depot and Lowe’s. This comparison is based on the quarterly financial data for the financial quarter ending April 30, 2021, for Lowe’s and May 2, 2021, for Home Depot, along with historical stock prices.

Home Depot Lowe’s

Net Profit Margin (TTM, or last 12 months) 10.45% 7.23%

Current Liquidity Ratio 1.11 1.17

Quick Liquidity Ratio 0.37 0.29

Leverage 21.39 32.42

Earnings Per Share (Diluted) 3.86 3.21

Price-to-Earnings Ratio (TTM) 27.11 25.32

Operating Cash Flow (TTM) $19.41 billion $11.09 billion

Based on the recent financial performance of Home Depot and Lowe’s, Home Depot has a higher profit margin and superior earnings per share. However, Lowe’s has a slightly lower price-to-earnings ratio, suggesting it could be a better value. The two companies are somewhat similar in terms of liquidity, but Lowe’s is more leveraged, indicating it relies more on debt for financing compared to Home Depot.

What does this mean for individual investors?

Individual investors should be cautious about relying on any single metric when evaluating financial performance. Analyzing financial performance is most effective when it is used to compare companies within the same industry. Otherwise, you may run into trouble comparing apples to oranges.

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Using the company’s recent financial performance and comparing it to previous performance can help uncover important trends. However, it is also important to remember that past performance does not indicate future results. Even if the company has a good track record of financial performance, it does not necessarily mean it will perform well in the future.

Source: https://www.thebalancemoney.com/financial-performance-5193413