Measuring a company’s financial performance is vital for business leaders, investors, and other stakeholders. Financial metrics provide insights into the financial health and growth prospects of a business. By regularly tracking key financial performance indicators (KPIs), management can identify areas for improvement, adjust business strategy, and make informed decisions about the future of the company. This article outlines the top financial metrics and KPIs used to assess business performance across key areas like profitability, liquidity, efficiency, cash flow, growth, and valuation. It also provides a practical approach to analysing a company’s financial statements and performance.

Article Contents

• Our Top Financial Metrics
• Key Financial Performance Metrics and KPIs
  • Profitability KPIs
  • Liquidity KPIs
  • Efficiency KPIs
  • Solvency and credit KPIs
  • Valuation KPIs
  • Cash Flow KPIs
  • Growth KPIs
• Industry-Specific Considerations
• Discussing Economic Factors
• Tools and Techniques for Financial Analysis
• Analysing Financial Performance: A Practical Approach

Our Top Financial Metrics

When looking at the financial health of a business, our go-to financial KPIs are:

1. Revenue Growth: Measures percentage increase in total revenue from the previous period. Higher revenue growth indicates increasing customer demand and/or market share. Be careful of the impact of inflation. If all prices are rising, increased revenue may still be consistent with a falling market share.
   • Example: If a company’s revenue increased from 1 million pounds one year to 1.2 million pounds the next, the revenue growth is simply £0.2m/£1m = 20% year-on-year. Monitoring this annual trend is a key business health indicator.
2. Gross Profit Margin: Gross profit as a percentage of total revenue. Gross profit is revenue less Cost of sales – the direct costs associated with delivering the goods or services, without considering administrative costs. Higher margins compared to peers means a company has a financial advantage.
   • Example: A company with total revenue of 500,000 pounds and a gross profit of 200,000 pounds has a gross profit margin of (200,000 pounds divided by 500,000 pounds) multiplied by 100 percent, equalling 40 percent.
3. Operating Margin: Operating profit as a percentage of total revenue. This is revenue, less cost of sales, less all the sales, administrative and general costs of running the business (including marketing, distribution, and management costs). Operating margin simply shows the portion of revenue retained as operating profit. Higher is better.
   • Example: With an operating profit (EBIT) of £150,000 and total revenue of £500,000, the operating margin is £150,000 / £500,000 = 30%.
4. Return on capital employed (ROCE): Operating profit (EBIT) divided by the capital invested in the business (Net debt + equity). ROCE measures a company’s ability to generate operating profits from the capital invested in the business. Higher ROCE is more favourable. Companies must achieve a return greater than the cost of capital to be successful.
   • Example: A company with EBIT of £100,000, debt of £200,000, cash of £50,000 and equity (shareholders funds’) of £350,000 (so total net debt + equity = £500,000) results in an ROE of £100k/££500k = 20%.
5. Earnings Per Share (EPS): “profitability per share” being net profit (after interest and tax) allocated to each outstanding share of common stock. In itself, EPS is not comparable across companies, as the number of shares outstanding is so different from one company to another. Instead, look at the trend – is it Increasing, stable or decreasing. Rising EPS is a good sign and typically leads to higher share prices.
   • Example: A net profit of 100,000 pounds with 50,000 outstanding shares means an EPS of £100,000/ 50,000), equalling £2.00 per share.

Key Financial Performance Metrics and KPIs

Although these are our top 5, a fully balanced review of the financials and key performance indicators needs to be undertaken. Analysts will typically categorise these as follows:

Profitability KPIs

Profitability metrics indicate the company’s ability to generate profits from its operations. Common profitability KPIs include:

• Gross profit margin = [Sales less Cost of Sales] / Revenue * 100%
• Operating margin = [Sales less Cost of Sales less Other Operating Expenses / Revenue] * 100%
• Net profit margin = Net Income / Revenue *100%

Return on capital employed

OCE is an important ratio for measuring quality of earnings: ROCE measures the ability of the company to generate a profit on the capital invested in it. All the denominator items are at cost NOT market value. You can think of ROCE as the “profit yield” of the company in the same way that a bond yield shows the return on a bond: if this company invests £1, what continuing profit can I expect on that? If a company has a ROCE of 4%, you might ask the question why we don’t close it down and put our money in the bank instead and earn 5.25% with less risk. A high ROCE vs. a peer group is an indicator of competitive advantage. If Tesco can make more profit per shop than Sainsbury (which is basically what ROCE tells us) – does that mean that Tesco is just a better more successful business? The obvious answer is yes. Analysts like ROCE as a measure of the strength of a business and of the sustainability of its earnings and their potential for growth.

“Underlying” profit, which excludes non-core and non-recurring items, is often taken to give a view on the core business profitability.

Liquidity KPIs

Liquidity ratios measure a company’s ability to pay short-term financial obligations and convert assets into cash. Key liquidity metrics include:

• Current ratio = Current assets / Current liabilities (if >1, it indicates that a company has sufficient short-terms (such as cash, receivables, and inventories) assets to cover its short-term liabilities
• Quick ratio = like the current ratio, but more conservative as it excludes inventories which may take longer to liquidate.
• Cash ratio = Cash / current liabilities. A very ‘harsh’ liquidity measure which will indicate the proportion of current liabilities a company could pay off even if receivables were not collected and inventory not sold.

Efficiency KPIs

Efficiency metrics show how well a company utilises its assets and manages overheads and working capital. Examples include:

• Inventory turnover = Cost of goods sold / inventory = an estimate of how many times the inventory would be turned over in one year (using annualised financials)
• Days sales outstanding = receivables / revenue *365. Indicating the average time (in days) taken to collect from our customers.
• Fixed asset turnover = revenue / fixed assets (e.g. PPE) shows you how efficiently the assets are generating revenue. Monitoring the trend is essential and note that a rising turnover could either indicate that the assets are generating more revenue (being more efficiently used, or a lower spare capacity) BUT it could also be a sign that a company has under-invested.
• Total asset turnover = similar to Fixed asset turnover but including all operating assets (not financial assets as these do not generate revenue. They do generate income, but this will be included in Finance income and not Revenue!)

Solvency and credit KPIs

Solvency ratios indicate a company’s ability to meet long-term financial obligations. Key solvency metrics are:

Debt to equity ratio (“gearing”)- Total debt includes all debt on balance sheet. This is a useful basic measure of financial risk in a business, sector averages vary a lot, the average for the all-share index In the UK excluding financials is 56%.

Debt (gross or net) to EBITDA = a key leverage ratio monitored and used by ratings agencies and credit analysts. Industry sectors will support different levels of ‘normal’ leverage, but a good rule of thumb is that a ratio of >3 is ‘high’ and not such a good credit risk.

Total liabilities / net assets – This (not so common) balance sheet approach compares all on-balance-sheet liabilities with the net worth of the company and by this definition leverage for firms is a greater value than gearing. It is useful to draw out the fact that this ratio includes trade payables whilst gearing does not. In this way the leverage ratio is a useful check on firms that are perhaps over-extending their credit.

Interest coverage ratio = EBIT / Interest expense. This is a basic measure of financial risk and financial flexibility – EBIT/I or EBITDA/I are often covenants in loan agreements. For smaller businesses this is a better ratio than EBITDA/I.

Valuation KPIs

Valuation metrics help assess the overall value and financial health of a business. Common valuation KPIs:

• Price/earnings ratio = share price / earnings per share. Comparing over time, or comparing to peers gives an indication relative value of the shares – do they look over or under priced? Why is that?
• Price/book ratio = share price / net asset value per share. If this ratio is relatively high, it is an indicator that the company is more attractive to investors. Why is that? Looking at this ratio alongside other ratios will give a clue. Perhaps it has better efficiency ratios, or better growth prospects?
• Enterprise value/EBITDA – a key corporate finance and valuation measure used to compare companies within the same industry and measure their relative valuation.

Cash Flow KPIs

Cash flow KPIs measure the company’s ability to generate cash and liquidity. Examples include:

• Cash flow from operations – by comparing to operating profit in the P&L, it gives an indicator of a company’s ability to convert profit into cash.
• Free cash flow = although there are many different types of ‘free cash flow’ it is essentially cash flows that are freely available to return to investors if desired.  It is, at is basic level, Operating cash flows less capex less tax. Although capex may be seen as discretionary in its timing, it is an essential investment to maintain and grow the business, so it is a number that is essential to take out of free cash flows.

Growth KPIs

Growth ratios indicate improvement or decline in financial performance. A basic, but first indicator, of high-level health in a company. Typical growth metrics are:

• Revenue growth %
• Earnings growth %
• Net income growth %
• EPS growth %

Industry-Specific Considerations

Retail Sector

In the fast-paced retail environment, inventory turnover and days sales outstanding are critical metrics. High inventory turnover suggests efficient stock management and strong sales, whereas lower turnover may indicate overstocking or declining demand. Similarly, a lower days sales outstanding value implies quick collection of receivables, crucial for maintaining cash flow. Retail businesses also need to closely monitor gross profit margins to understand product profitability, especially in competitive markets where pricing strategies can significantly impact margins.

Manufacturing Sector

Efficiency metrics like total asset turnover are particularly relevant in the manufacturing industry. This sector often involves substantial investment in machinery and equipment, making it vital to assess how effectively these assets are being utilised to generate revenue. The debt-to-equity ratio also gains importance in manufacturing due to typically higher levels of capital investment, indicating the balance between debt and equity financing used to fund these assets. Additionally, operating margins are a key indicator of production efficiency and cost management in the manufacturing process.

Discussing Economic Factors

Economic Downturns

During economic recessions, liquidity ratios like the current ratio and quick ratio gain prominence. These metrics are crucial for evaluating a company’s ability to meet short-term obligations, especially in times of reduced revenue or tightened credit conditions. A strong liquidity position can provide a buffer during downturns, enabling businesses to navigate financial challenges more effectively.

Inflation

Inflationary periods can significantly impact financial metrics, particularly those related to costs and pricing. For example, rising costs due to inflation may reduce net profit margins if companies are unable to proportionately increase their prices. Understanding the impact of inflation on purchasing power and cost structures is essential for accurately interpreting profitability metrics.

Interest Rates

Changes in interest rates can affect several financial metrics, particularly for businesses with significant debt. An increase in interest rates will raise the cost of borrowing, impacting interest coverage ratios and potentially affecting a company’s solvency. Conversely, lower interest rates can reduce borrowing costs, positively impacting profitability and cash flow.

Tools and Techniques for Financial Analysis

We have covered the fundamental key ratios above, to help analysts perform their job, but you may also hear of related techniques that enhance the analysis.

• Common Size Analysis: Converts financial statement line items into percentages of total assets/revenue for comparison.
• Trend Analysis: Review changes in financial metrics over time to identify trends.
• Ratio Analysis: Calculate key ratios for liquidity, profitability, efficiency, etc. Compare ratios to industry benchmarks.
• DuPont Analysis: Breaks down ROE into profit margin, asset turnover, and leverage factors to understand drivers.
• Horizontal/Vertical Analysis: Compare financial data across previous periods (horizontal) or within the same period (vertical).
• Benchmarking: Compare performance metrics and ratios to those of competitors and industry averages.

Analysing Financial Performance: A Practical Approach

Here are some useful steps to help you think through a structure for analysing a company’s financial performance:

1. Obtain financial statements for at least last 3 years and industry peer group data.
2. Calculate key profitability, efficiency, liquidity, leverage, and cash flow ratios for each period.
3. Perform common size analysis by calculating line items as % of revenue or assets.
4. Conduct trend analysis to identify changes in ratios over time.
5. Compare ratios to competitors and industry averages through benchmarking.
6. Analyse causes behind trends and deviations to understand what is driving performance.
7. Assess working capital, cash flow adequacy, and leverage to gauge short and long-term liquidity.
8. Review company valuation multiples like P/E and P/B ratios relative to peers.
9. Use DuPont analysis to break down drivers of ROE.
10. Develop insights into company’s operating and financial strengths and weaknesses. Use a simple framework such as SWOT analysis, or Porter’s 5 forces model to help structure your insights.

Regular financial analysis using key metrics, ratios and tools provides vital insights into a company’s financial condition and performance trends. Financial KPIs help assess current performance and project future results to support strategic decisions.