Select your language

Suggested languages for you:
Log In Start studying!
StudySmarter - The all-in-one study app.
4.8 • +11k Ratings
More than 3 Million Downloads
Free
|
|

All-in-one learning app

  • Flashcards
  • NotesNotes
  • ExplanationsExplanations
  • Study Planner
  • Textbook solutions
Start studying

Analysing Financial Performance

Save Save
Print Print
Edit Edit
Sign up to use all features for free. Sign up now
Analysing Financial Performance

All businesses have financial goals and objectives. So how can businesses make sure that they achieve set financial goals? They have to analyse their financial performance. By analysing financial performance, organisations can gain a better understanding of how where they stand currently and can assess what they need to do to achieve their future goals.

What is the purpose of analysing financial statements?

Every company aims to increase its profitability and generate more income. Owing to financial statements, we are able to understand its business model and verify whether it’s making a profit or loss. We are able to see how the company is spending, investing and earning money. We can notice whether a company is growing, is stagnant or is collapsing. Knowing how the company is performing, we are able to make better economic decisions in the future.

How to analyse the financial performance of a company?

Financial performance analysis is a process of analyzing a company’s financial position. It focuses on reviewing, assessing and comparing financial statements - a collection of data and figures organised according to recognized accounting principles. It may also include calculating and analysing financial ratios.

There are two main financial statements: income statement and balance sheet.

Income statement, in other words, profit and loss account. It shows the profit earned and loss sustained by a business entity over a particular period (usually 12 months) and how this figure is arrived at. Into the Income Statement, we place revenues earned during the period and we match them against expenses incurred during the period.

Company A is selling jeans. It bought 2000 pairs of jeans during 2019 at a price of £20 each and sold all of them for £45 each. No other inventory was traded that year.

Other payments were: rent and rates £6,000, heat and light £4,000, fixtures and fittings £30,000 (expected to last 5 years), staff wages £18,000. Moreover, the owner withdrew from the business a total of £15,000. Based on the information, we know that:

  • Turnover (total revenue) is £90,000 (£45 x 2000).
  • The cost of sales is £40,000 (£20 x 2000).
  • Gross profit is £50,000 (£90,000 - £40,000).
  • Other expenses are rent and rates, heat and light, fixtures and fittings, staff wages, and they equal £34,000 (£6,000 + £4,000 + £6,000 + £18,000). Net profit is £16,000 (£50,000 - £34,000).

The Income Statement of company A for the year ended 31.12.2019 would look as follows:

Turnover£90,000
Cost of sales£40,000
Gross profit£50,000
Rent and rates£6,000
Heat and light£4,000
Depreciation of fixtures and fittings£6,000
Staff wages£18,000
Other expenses£34,000
Net profit£16,000

Important points arising out of the above:

  • The full cost of fixtures and fittings does not appear because it is a capital expenditure. Instead, the depreciation represents this years’ revenue expenditure.

  • The money which the owner withdrew from the business does not appear because it represents a reduction in the capital, rather than an expense.

The balance sheet, in other words, a statement of financial position (abbreviations: BS, SFP), shows the assets and liabilities of a business at a specific point in time (usually the end of the financial period). Here, the assets are resources controlled by the business and the liabilities are present obligations of the business.

Financial performance analysis example

Let’s have a look at the balance sheet of a company B:

Tangible asset£140,000
Intangible assets£80,000
Non-current assets£220,000
Inventory£20,000
Receivables£90,000
Bank£15,000
Cash£5,000
Current assets£130,000
Payables£30,000
Corporation owing tax£25,000
Short-term liabilities£55,000
Net current assets£75,000
Total assets less current liabilities£295,000
Long-term liabilities£110,000
Net assets£185,000
Financed by:
Ordinary shares£100,000
Share premium£50,000
Retained earnings£35,000
Total equity£185,000

Important points arising out of the above:

  • Assets and liabilities can be short term and long term (current and non-current).

  • Net current assets are current assets minus current liabilities.

  • Net assets are total assets minus total liabilities.

  • Intangible non-current assets might be for example IPR, goodwill licences.

  • Tangible non-current assets might be for example equipment, plants, buildings.

  • Receivables is money owed to the company by credit customers.

  • Payables denote money owed by the company to credit suppliers.

  • Net assets equal total equity.

  • Liabilities are being deducted from the assets.

Income Statement vs. Balance Sheet

Both income statements and balance sheets are used by company owners, banks and investors, because they provide a good indication of the current and future financial position of a company. However, there are some key differences regarding the statements (see the table below).

Income StatementBalance Sheet
PerformanceIt shows exactly how a company was earning and spending money.It shows only what a company owns.
TimingA period of timeA moment in time
ReportingIt presents revenue and expenses.It presents assets, liabilities, and equity.
UsageEvaluating performance Determining whether a company has enough assets to meet financial obligations.

Financial Performance ratio and report analysis

We have written a separate article “Financial Ratios” introducing you to financial ratios and methods of calculating them. However, there are the most important ratios to analyze the financial performance:

  • Return on capital employed,

  • Net profit margin,

  • Gross profit margin,

  • Current ratio.

Financial Report

A financial report is a document that emphasises the strengths and weaknesses of a company. It is useful both for shareholders and potential investors since it examines the financial position of a business.

How to make a financial report?

  1. Gather information from financial statements.

  2. Calculate ratios.

  3. Conduct a risk assessment.

  4. Determine the value of a company.

Sections of the financial report

  1. Company overview - description of the business.

  2. Investment - advantages and disadvantages of investing in the business.

  3. Valuation - a value of the business.

  4. Risk Analysis - factors that might prevent the business from growing.

  5. Details - financial statements and ratios.

  6. Summary - a brief recapitulation of all the sections.

Analysing Financial Performance - Key takeaways

  • Financial Performance analysis is the process of reviewing and analysing a company's financial statements.

  • The analysis’ purpose is to measure the financial performance of a company to make better economic decisions to earn income in the future.

  • There are two most commonly used financial statements: income statements and balance sheets.

  • Both of these statements are extremely useful, but they indicate different elements.

  • There are four most important financial ratios: return on capital employed, net profit margin, gross profit margin and current ratio.

  • A financial report examines the financial position of a company highlighting its strengths and weaknesses.

Frequently Asked Questions about Analysing Financial Performance

Financial performance analysis is a process of analyzing a company’s financial position. It focuses on reviewing, assessing and comparing financial statements - a collection of data and figures organised according to recognized accounting principles. It may also include calculating and analysing financial ratios. 

The four financial performance ratios are as follows:

  • Return on capital employed,

  • Net profit margin,

  • Gross profit margin,

  • Current ratio.

Final Analysing Financial Performance Quiz

Question

What is financial performance analysis?

Show answer

Answer

It is a process of analyzing a company’s financial position.

Show question

Question

What is the purpose of analysing financial statements?


Show answer

Answer

Understanding a business model, verifying whether a company is making a profit or loss and then making better economic decisions.

Show question

Question

What are the two main financial statements showing a company’s financial performance?


Show answer

Answer

Income statement and balance sheet.

Show question

Question

What are the main elements of the income statement?


Show answer

Answer

Turnover, cost of sales, gross profit, net profit.

Show question

Question

What are the main elements of the balance sheet?


Show answer

Answer

Current assets, non-current assets, inventory, trade receivables, trade payables, current liabilities, non-current liabilities, shareholders’ funds.

Show question

Question

What is the main difference between an income statement and balance sheet?


Show answer

Answer

Income statement shows a company’s financial activities over a specific period of time whereas the balance sheet shows its financial position in a particular moment.

Show question

Question

What are the four main financial ratios?


Show answer

Answer

Return on capital employed, net profit margin, gross profit margin and current ratio.

Show question

Question

What are the sections of the financial report?


Show answer

Answer

Company overview, investment, valuation, risk analysis, details and summary.

Show question

Question

What is a cash-flow?

Show answer

Answer

Cash-flow is a movement of money.

Show question

Question

What is a basic cash flow formula?


Show answer

Answer

Free cash flow = operating cash flow - capital expenditures

Show question

Question

What is a cash flow statement?


Show answer

Answer

Likewise, by the income statement, cash flow statements show the profit earned and sustained loss by a business entity over a particular period (usually 12 months) and how this figure is concluded. However, instead of showing revenues and costs, the cash flow statement includes cash inflows and outflows.


Show question

Question

What is a budget?


Show answer

Answer

Budget is a form of financial planning and forecasting.

Show question

Question

What are the three types of budgets?


Show answer

Answer

  • Balance budget
  • Surplus budget
  • Deficit budget

Show question

Question

What is a cash budget?


Show answer

Answer

A cash budget is an estimation of a business's cash flows over a period of time.

Show question

Question

What are the advantages of budgets?


Show answer

Answer

  • Budgets help to manage the cash flow

  • Budgets may identify possible shortage of cash

  • Budgets allow planning

  • Budgets help to reach goals

Show question

Question

What are the disadvantages of budgets?


Show answer

Answer

  • Budgets can prevent a company from spending

  • Budgets can change and therefore be misleading

  • Budgets can eliminate rewards

  • It can be hard to estimate the amount of money to be spent and create a budget

Show question

Question

What is break-even analysis?

Show answer

Answer

It is a calculation of how many units a company has to produce and sell to recover its total costs.

Show question

Question

What is a fixed cost?

Show answer

Answer

Rent

Show question

Question

What is a target profit?

Show answer

Answer

Target profit is an expected amount of profit that the shareholders and/or managers of a business expect to achieve by the end of a specified accounting period.

Show question

Question

What are the advantages of break-even analysis?


Show answer

Answer

  • It provides a measurement of profit and losses at different levels of production and sales

  • It predicts the effect of changes in sales prices

  • It analyzes the relationship between fixed and variable costs

  • It predicts the effect of cost and efficiency changes on profitability

Show question

Question

What are the disadvantages of break-even analysis?


Show answer

Answer

  • It assumes that sales prices are constant at all levels of output

  • It assumes production and sales are the same

  • It may be time consuming

  • It can only apply to a single product or single mix of products

Show question

Question

What is the margin of safety?

Show answer

Answer

Margin of safety is the difference between the current level of output and the breakeven level of output.

Show question

Question

What is the margin of safety formula?


Show answer

Answer

Margin of safety = level of output - break-even level of output

Show question

Question

What are fixed costs?

Show answer

Answer

Fixed costs are costs which remain the same (in the short term) regardless of the number of units produced, for example, rent and rates. 

Show question

Question

What are variable costs?

Show answer

Answer

Variable costs are costs that rise and fall in direct proportion to the number of units produced, for example, raw materials used in production, direct labour. 

 


Show question

Question

What are total costs?

Show answer

Answer

Total costs are fixed costs and variable costs added together.


Show question

Question

What does contribution per unit mean?

Show answer

Answer

Contribution per unit is total revenue from sales of one unit. It is the selling price minus variable costs.


Show question

Question

What is the other name for the break-even analysis?

Show answer

Answer

cost-volume-profit analysis 

Show question

Question

What are the four elements of the break-even chart?

Show answer

Answer

  • variable costs
  • fixed costs
  • total costs
  • revenue 

Show question

Question

What is solvency?

Show answer

Answer

Solvency is an ability of a firm to meet long-term financial obligations.

Show question

Question

What is the difference between costs and cash outflows?

Show answer

Answer

For costs, there has been a transaction made whereas for cash outflows, there has also been cash exchanged.  

Show question

Question

What is a cash inflow?

Show answer

Answer

Cash sales made to customers 

Show question

Question

What is a depreciation?

Show answer

Answer

Depreciation refers to allocating costs of assets over their life expectancy.

Show question

Question

What are receivables?

Show answer

Answer

money owed to a firm by its customers

Show question

Question

What are payables?

Show answer

Answer

Payables refer to money owed by a firm to its suppliers.

Show question

Question

What is a balanced budget?

Show answer

Answer

A balanced budget is when revenues are equal to expenses.

Show question

Question

Which financial statement shows exactly how a company was earning and spending money?

Show answer

Answer

Income statement

Show question

Question

Which financial statement shows only what a company owns?

Show answer

Answer

Balance sheet

Show question

Question

Which financial statement presents revenue and expenses?

Show answer

Answer

Income statement

Show question

Question

Which financial statement presents assets, liabilities, and equity?

Show answer

Answer

Balance sheet

Show question

Question

Which financial statement determines whether a company has enough assets to meet financial obligations?

Show answer

Answer

Balance sheet

Show question

Question

Which financial statement evaluates the performance of a company?

Show answer

Answer

Income statement

Show question

Question

The income statement shows the profit earned and loss sustained by a business entity...

Show answer

Answer

over a particular period.

Show question

Question

Balance sheet can also be called...

Show answer

Answer

a statement of financial position.

Show question

Question

The income statement can also be called...

Show answer

Answer

profit and loss account.

Show question

Question

What is a financial report?

Show answer

Answer

A financial report is a document that emphasises the strengths and weaknesses of a company. 

Show question

Question

What are abbreviations are used for the balance sheet? 

Show answer

Answer

BS and SFP

Show question

Question

Total assets minus total liabilities equal...


Show answer

Answer

net assets.

Show question

Question

Net assets equal total equity.

Show answer

Answer

True

Show question

Question

Which figure in the income statement has the highest value?

Show answer

Answer

turnover

Show question

More about Analysing Financial Performance
60%

of the users don't pass the Analysing Financial Performance quiz! Will you pass the quiz?

Start Quiz

Discover the right content for your subjects

No need to cheat if you have everything you need to succeed! Packed into one app!

Study Plan

Be perfectly prepared on time with an individual plan.

Quizzes

Test your knowledge with gamified quizzes.

Flashcards

Create and find flashcards in record time.

Notes

Create beautiful notes faster than ever before.

Study Sets

Have all your study materials in one place.

Documents

Upload unlimited documents and save them online.

Study Analytics

Identify your study strength and weaknesses.

Weekly Goals

Set individual study goals and earn points reaching them.

Smart Reminders

Stop procrastinating with our study reminders.

Rewards

Earn points, unlock badges and level up while studying.

Magic Marker

Create flashcards in notes completely automatically.

Smart Formatting

Create the most beautiful study materials using our templates.

Sign up to highlight and take notes. It’s 100% free.