Financial performance

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Financial performance
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Financial performance is generally defined as the ability of a company to raise and allocate funds within a certain time period. This performance is determined, among other things, on the basis of key performance indicators relating to capitalisation, liquidity, solvency, efficiencies, and profitability of the company. Financial performance also indicates the ability of a company to make efficient use of the resources and assets that are available to it. Cash flow information, or information from the balance sheet, income statement and statement of changes in capital, serves as the primary source for determining financial performance and, consequently, also as a foundation for the management's decision-making process. (Fatihudin 2018, p. 553)

Financial performance indicators

In the research community, financial performance is highly discussed and there is a lot of interest in this research area, as evidenced by the high number of scientific publications on the subject. This high level of research interest reveals that there is currently no universally accepted definition for measuring performance. A historical observation also shows that the discussion about the performance concept has changed over the past years. It is currently apparent that the opinion on the definition and measurement of financial performance diverges to a large extent and only occasionally agrees. Nevertheless, from a financial perspective, the research provides four different financial performance indicators that can be used to measure performance (Tudose et al. 2022, pp. 121–123):

  • Profit margin
  • Profit growth rate
  • Return on assets, return on equity or return on investment
  • Economic value added or market value added

The profit margin basically looks at total sales and subtracts all costs and expenses from them, which gives you earnings after taxes. Putting this amount in percentage terms in relation to revenue or sales it results in the profit margin. The higher the profit margin, the better the performance of the company (Nariswari und Nugraha 2022, pp. 88-89). The profit margin shows how many percent of one euro the company generates by selling one euro of goods. The formula for the profit margin can be found below. In the industry, generally a company with a profit margin of more than 20 % is considered as healthy, and if it is below 5 %, the company's performance is not good. However, these benchmarks vary depending on the business sector and the size of the company. (Okunev 2022, pp. 60-61):\[\mathrm{\frac{(Sales-total\ expenses\ and\ costs)*100}{Sales}=Profit\ margine}\]

However, the profit margin is only an indicator that reflects the performance of a company over a short-term period of time, as it only looks at a comparatively short history. This is different from indicators such as return on assets or return on equity. These indicators look at a time horizon that goes beyond one financial year (Tudose et al. 2022, pp. 122-123).

The return on assets is calculated as the ratio of net income or profits in relation to the total assets of the company. This financial performance indicator shows the extent to which a company is able to use its assets efficiently and generate a corresponding profit out of it. Based on this definition, this indicator is of particular interest to investors. But management also draws information from this indicator, for example for investment decisions. The return on assets says something about how quickly a product can be turned into money and when it will be available for investment agin (Okunev 2022, p. 61):\[\mathrm{\frac{Net\ income\ or\ profit}{Total\ assets}=Return\ on\ assets}\]

Economic Value Added

Economic value added was developed in the late 1990s as a tool for assessing the profitability of a company. The indicator makes a statement about the performance of a company by basically determining the extent to which a company has been able to generate an additional excess return compared to the market return. Thus, it fundamentally compares the return on an investment with the cost of that capital. This indicator is also of interest to current or potential investors and lenders, as it also takes into account opportunity costs and can be used to check whether a company achieves a required minimum performance at a comparable level of risk (Sharma und Kumar 2010, p. 201). The formula for calculating economic value added is shown below and is the product of the total net operating capital and the return on investment less the weighted average cost of capital. The return on investment determines how efficiently a company uses the invested capital to operate profitably. The weighted average cost of capital, on the other hand, measures the average financing costs, which in most companies come from equity and debt capital (Rist und Pizzica 2015, pp. 31, 53, 92):\[\mathrm{\frac{(Net\ income-[[Dividend]])}{Invested\ capital}=Return\ on\ invested\ capital}\]

\(\mathrm{Economic\ value\ added=Total\ net\ operating\ capital*(Return\ on\ invested\ capital-Weighted\ average\ cost\ of\ capital)}\)

If the Economic value added is positive, the company has gained value for the shareholders, whereas if the indicator is negative, the company's performance is poor and value has been lost (Rist und Pizzica 2015, p. 53).

Example:

A company has a total net operating capital in the amount of 100,000 € and the weighted average cost of capital amounts to 7.6 %. The net income amounts to 8,335 € and a dividend of 2,500 € was distributed to the shareholders. The total invested capital is 50,000 €.

Return on invested capital= (8,335 € - 2,500 €) / 50,000 € = 11.67 %

The return on invested capital amounts to 11.67 % and is now further used in the calculation of economic value added.

Economic value added = 100,000 € * (0.1167 – 0.076) = 4.070 €

Since the value of the indicator is positive, it can be concluded that the company is performing well and is sustainably and strongly positioned. Furthermore, the amount of 4,070 € can now be used as a benchmark for investors to compare companies or alternative investments.

References

Author: Martin Friesen