Financial performance measurement can be defined as a systematic approach to appraise the efficiency of management in an organisation to make profits, increase liquidity, as well as create long-term value for the business or company.
Financial performance measures the stability, efficiency, as well as growth prospects for a business or firm in a competitive marketplace with margins under constant stress.
In essence, measuring financial performance involves making sense of figures. This is because it links figures extracted from the financial statements of the organisation with the goals of the enterprise.
Purpose and Significance of Financial Performance Measurement
There are various benefits of financial performance measurement for different user groups. Firstly, for management, it acts as a basis for planning, control, and strategic adjustment. Shareholders utilise financial performance measures to assess returns on investments, while others judge a company’s ability to repay debts based on its financial performance measures. The other party that relies on financial performance measures for accurate results is regulators/policymakers.
Empirical evidence proves its significance. It has been observed that when studies on global financial reporting are considered, businesses that track financial metrics on a systematic basis experience a 25% increase in financial efficiency compared with businesses that have an ad-hoc financial review process.
Key Financial Statements Used in Measurement
Financial performance measurement is based on the three main financial statements: the income statement, balance sheet, and cash flow statement. Each of these financial statements affords a unique analysis of the company’s performance.
The income statement emphasises the profitability aspect for a particular timeframe, highlighting revenues, costs, and resulting profits. The balance sheet is a reflection of the financial situation, listing various particulars such as assets, liabilities, and equity at a point in time. The cash flow statement provides information based on actual cash transactions, shedding light on cash management. All these statements are the basis for a comprehensive evaluation.
Profitability Measurement
Profitability measures determine the capacity of an organisation to create profits in relation to its sales, assets, or equity. Some of the ratios that are used to measure profitability include: Gross Profit Ratio, Operating Ratio, and Net Profit Ratio.
Return measures such as Return on Assets (ROA) or Return on Equity (ROE) focus on management efficiency. A firm with high ROE is generally associated with efficient management, assuming it is not debt-driven. In the Australian market, companies with high ROE above 15% that are listed on the ASX will generally receive more institutional fund inflows.
Liquidity and Solvency Measurement
Liquidity and solvency measurement are primarily concerned with the ability to pay off short-term debts. The ability of the company to pay its short-term liabilities is evaluated through the calculation of the current and quick ratios. If a company’s liquidity is low, then this often raises concerns about its cash flow, even if its profitability is high.
Solvency ratio analysis, on the other hand, measures the long-term viability of financial resources. Debt-to-equity ratio and interest cover measure how easily a company can repay long-term borrowing. Financial stability reports indicate that companies with a debt-to-equity ratio that exceeds the industry averages have a considerably greater risk of becoming insolvent, especially in low economic periods.
Efficiency and Activity Measurement
Efficiency ratios determine how efficiently an entity utilises its resources and activities. The inventory turnover ratio, receivables turnover ratio, and asset turnover ratio also indicate how funds are converted into sales or cash quickly. If inventory turns over slowly, it could mean that there are minimal demands or inefficient management of inventory, which results in a negative impact on profitability.
Effective companies are usually strong on both efficiency and profit margins. This means the companies are doing well and not just focused on short-term ideas like pricing or credit.
Cash Flow-Based Performance Measurement
Performance measures designed on the basis of cash flow are very important in financial performance. For example, unlike accounting profit, cash flow cannot be influenced through accounting estimates. Operating cash flow ratios as well as free cash flow ratios give a clear understanding of financial performance.
Studies conducted by financial regulators have shown that more than 60% of business failures can occur as a result of cash flow problems and not due to losses. This key trend further explains why performance measurement tools place more emphasis on cash parameters besides profitability parameters.
Limitations of Financial Performance Measurement
Although financial performance measurement is very important, there are some limitations to this process. Financial information reveals past performance, but this can impair the prospective risks and opportunities. Inflation, accounting policies, and industry can distort all such financial performances.
Additionally, concentrating too much on financial data may promote the making of short-term decisions. Techniques of cost reduction that have a positive impact on the bottom line in the short term may have a negative implication for the long-term creation of value by an enterprise if innovation or employee engagement suffers. Well-designed performance measurement may involve contextual analysis rather than simple ratio analysis.
Conclusion
Financial performance measurement is a formal method of assessing the profitability, liquidity, efficiency, and stability for the future. Financial performance measurement enables the conversion of financial statements into meaningful information. Financial performance measurement is not a technique by which performance can be completely measured by the use of financial statements. Nevertheless, financial performance measurement is a widely used technique in assessing the economic performance and the sustainability. Financial performance measurement enables building trust in the financial reporting system.
