Monitoring Financial Performance: Strategies For Success

Monitoring the financial performance of a business is crucial for its success. It involves tracking and analysing various financial indicators and metrics to gain insights into the financial health and stability of the company. This includes understanding profitability, liquidity, solvency, efficiency, and valuation. By monitoring financial performance, business owners and managers can make informed decisions, improve performance, and ensure the long-term growth of the business.

There are several key financial statements and ratios that are essential for monitoring financial performance, including balance sheets, income statements, cash flow statements, and financial ratios such as gross profit margin, net profit margin, current ratio, and debt-to-equity ratio. These tools provide an overview of the financial health of the business, helping owners and managers make data-driven decisions and identify areas for improvement.

Additionally, monitoring financial performance allows businesses to assess their competitiveness in the market and make strategic decisions to enhance their position. By understanding the financial performance of their industry and competitors, businesses can identify areas where they can control costs, increase revenues, and improve overall financial management.

Preparation of Key Financial Statements

Financial statements are reports compiled by businesses that detail the company's financial activities and health. They are fundamental for assessing a company’s financial health, enabling informed decision-making, and identifying areas for growth and improvement. Financial statements are also audited by government agencies and accountants to ensure accuracy and for tax, financing, or investing purposes.

The primary financial statements of for-profit businesses include the balance sheet, income statement, statement of cash flow, and statement of changes in equity. These three core statements are intricately linked to each other.

Income Statement

The income statement illustrates the profitability of a company under accrual accounting rules. It presents a company’s financial performance over a period, detailing revenues earned and expenses incurred. On an income statement, you’ll be able to see a company’s:

• Revenues: All income earned from business activities
• Expenses: Costs incurred in earning revenue
• Net profit/loss: The difference between total revenue and total expenses

Think of an income statement as your company’s report card. It shows if your business has made money (profit) or lost money (loss) during a specific time.

Balance Sheet

The balance sheet provides an overview of a company’s assets, liabilities, and shareholders’ equity at a specific point in time. The two sides of the balance sheet must balance: assets must equal liabilities plus equity.

A balance sheet gives you a snapshot of your company’s financial health at one moment in time. Here’s how to make one:

• Add up assets: These are things the company owns, like cash, inventory, buildings, and equipment.
• List liabilities: These are debts the company owes, like bills and loans.
• Subtract total liabilities from total assets: This gives you shareholders’ equity, the value belonging to the owners.

Cash Flow Statement

The cash flow statement shows cash movements from operating, investing, and financing activities. It is like your company’s bank statement. It shows how cash moves in and out during a specific time.

The cash flow statement contains three sections that report on the various activities for which a company uses its cash:

• Operating Activities: Any sources and uses of cash from running the business and selling its products or services.
• Investing Activities: Any sources and uses of cash from a company's investments in its long-term future, including changes in equipment, assets, or investments related to cash from investing.
• Financing Activities: Cash from investors or banks, as well as the cash paid to shareholders.

Statement of Changes in Equity

The statement of changes in equity tracks total equity over time. This information ties back to a balance sheet for the same period; the ending balance on the change of equity statement equals the total equity reported on the balance sheet. Investors use this information to understand the profitability of a company and its stock.

Inventory Records

Well-maintained inventory records enable businesses to make informed decisions about future purchases, preventing over-ordering and reducing the risk of stockouts. They are a critical tool for effective inventory management, helping businesses avoid tying up cash in excessive inventory and ensuring they have sufficient stock to meet customer demand.

A good inventory record-keeping system should include the following:

• Detailed Information on Inventory Items: This includes descriptions, quantities, and prices of each item. It is important to track inventory at the SKU level, especially if there are variations in colour, size, or other attributes.
• Regular Updates: Inventory records should be updated frequently to reflect the current state of inventory. The update frequency will depend on sales volume and the amount of safety stock carried. Higher sales volume and lower safety stock levels require more frequent updates.
• Visuals and Clear Presentation: Using visuals, such as charts or graphs, can make it easier to understand inventory levels at a glance. A clear and concise presentation ensures that inventory information is easily digestible.
• Automation: Automating inventory records with specialised software or platforms can save time and reduce manual errors. Automation also enables real-time updates, ensuring that inventory data is always current.
• Inventory Tracking Within Warehouses: For businesses with large inventories and high sales volumes, tracking inventory locations within warehouses is crucial. This prevents unnecessary movement, double-handling, and loss of inventory.
• Categorisation and Segmentation: Organising inventory into categories based on value, demand, carrying costs, and other factors helps in making informed purchasing and inventory management decisions.
• Inventory Value Reporting: Understanding the total value of inventory, including the value of each SKU, is essential for effective cash flow management. It helps businesses avoid tying up too much capital in inventory.
• Inventory Performance Reporting: Tracking SKU velocity and turnover provides insights into best-selling and slow-moving products, helping businesses optimise their inventory mix.
• Inventory Forecasting: Using historical data to identify sales patterns, businesses can forecast future demand and determine the quantity of inventory needed to meet that demand.
• Integration with Other Systems: Connecting inventory records with supply chain, customer order data, and point-of-sale software ensures seamless data flow and enables more accurate forecasting and demand planning.

Working Capital Statements and Financial Ratios

Working capital statements reflect a company's available operating liquidity, which is essential for funding day-to-day operations. It is calculated by subtracting current liabilities from current assets:

> Working Capital = Current Assets - Current Liabilities

Financial ratios are metrics that use numerical values from financial statements, such as the balance sheet, income statement, and cash flow statement. These ratios provide meaningful information and quantitative analysis about a company's performance. They are grouped into several categories, including liquidity, profitability, efficiency, and leverage ratios.

Liquidity ratios measure a company's ability to repay short-term and long-term obligations. Examples include the current ratio, acid-test ratio (or quick ratio), cash ratio, and operating cash flow ratio. The current ratio, for instance, assesses a company's ability to pay off short-term liabilities with its current assets:

> Current Ratio = Current Assets / Current Liabilities

Profitability ratios evaluate a company's ability to generate income relative to revenue, assets, operating costs, and equity. Common profitability ratios include gross margin ratio, operating margin ratio, net profit margin, return on assets ratio, and return on equity ratio. The net profit margin, for example, measures the percentage of revenue and other income left after deducting all costs:

> Net Profit Margin = Net Profit / Revenue * 100

Efficiency ratios, or activity ratios, gauge how effectively a company uses its assets and resources to generate sales and income. Examples include the asset turnover ratio, inventory turnover ratio, accounts receivable turnover ratio, and days sales in inventory ratio. The inventory turnover ratio calculates how many times a company's inventory is sold and replaced over a given period:

> Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

Leverage ratios, or debt ratios, assess a company's debt levels and overall debt position. Common leverage ratios include the debt ratio, debt-to-equity ratio, interest coverage ratio, and debt service coverage ratio. The debt-to-equity ratio, for instance, compares a company's total liabilities to its shareholders' equity:

> Debt to Equity Ratio = Total Liabilities / Shareholder’s Equity

In conclusion, working capital statements and financial ratios are essential tools for business owners and managers to assess their company's financial health and performance. These tools provide valuable insights into liquidity, profitability, efficiency, and solvency, enabling better decision-making and strategic planning.

Fund and Cash Flow Statements

A cash flow statement is one of the three main financial statements, alongside the balance sheet and the income statement. It summarises the amount of cash and cash equivalents entering and leaving a company, and is typically divided into three sections:

• Cash flow from operating activities: This includes any sources and uses of cash from business activities, such as receipts from sales of goods and services, payments to suppliers, salary and wage payments, and other operating expenses.
• Cash flow from investing activities: This covers any sources and uses of cash from a company's investments, including purchases or sales of assets, loans made to or received from customers, and payments related to mergers and acquisitions.
• Cash flow from financing activities: This includes the sources of cash from investors and banks, as well as cash paid to shareholders, such as dividends, and repayment of debt principal.

These statements allow businesses to monitor their liquid cash position and ensure they have sufficient earnings to remain operational. They also provide valuable insights for investors, helping them make informed decisions about their investments.

Additionally, fund flow statements are important for businesses to understand their financial position and make strategic decisions. These statements provide an overview of the business's financial health and can be compared with competitors to gauge relative performance. They are essential for proper financial management and ensuring the long-term success of the company.

Analysis of Overheads

Overhead expenses are a crucial aspect of financial performance monitoring, and they can significantly impact a company's profitability. Overheads include costs such as rent, salaries, marketing expenses, and other operational expenditures. Analysing these expenses is essential to identify areas where costs may be optimised or reduced without compromising the quality of operations.

When reviewing financial statements, it is important to look beyond the numbers and seek insights into the efficiency of the business. For example, an increase in marketing expenses may be justified if it results in higher sales and revenue. On the other hand, if marketing expenses are high but sales are stagnant or declining, it may indicate that marketing strategies are not effective, and adjustments are necessary.

Similarly, salaries and employee-related costs are a significant overhead for most businesses. A high employee turnover rate can be costly, as it often leads to increased spending on recruitment, staffing agencies, and training for new employees. Analysing these overheads can help businesses identify areas where they may need to improve retention strategies or explore more cost-effective recruitment methods.

Another critical aspect of overhead analysis is identifying unnecessary or excessive expenses. For example, a company may discover that its office rent is significantly higher than similar businesses in the same area, indicating a need to renegotiate lease terms or consider alternative locations.

Additionally, businesses should regularly review their overhead expenses to ensure they align with their financial goals and objectives. This may involve setting budgets for different overhead categories and monitoring actual spending against these budgets. By doing so, businesses can identify areas where costs may be optimised without sacrificing the quality of their operations.

Furthermore, analysing overheads can help businesses identify areas where they can gain tax advantages. For instance, certain overhead expenses, such as equipment purchases or research and development costs, may qualify for tax deductions or incentives. By carefully reviewing these expenses, businesses can maximise their tax benefits and improve their overall financial health.

In conclusion, analysing overheads is a critical aspect of financial performance monitoring. It enables businesses to identify areas of optimisation, ensure cost-effectiveness, and make informed decisions to improve their overall financial health and achieve their financial goals.

Frequently asked questions