Analysing the financial performance of a business

Analysing financial performance in business is key to achieving success. Businesses use

key financial statements to help them achieve this.

Purpose of financial statements

Financial statements are a very important tool for all businesses, as they allow
managers and investors to make informed future business decisions and understand
the of the business over time. By interpreting financial
statements, businesses are able to move in a direction to improve their finances and
secure the future of a business.

With certain types of business ownership, such as and

companies, producing financial statements is also a legal requirement. Failure to create
such documents can have severe sanctions, such as fines.

There are two main financial statements used in business, the

and the , or balance sheet. These two financial statements give
a range of business stakeholders an understanding of the financial performance of a
business at a given point in time. As part of these financial documents, businesses will
also consider their and , two key pieces of financial
information required to understand business performance.

Financial statements have a range of advantages:

● they allow a business to

● they allow other businesses
● they give a of the business
There are also some drawbacks:

● they can be to prepare

● they make it financial information from competitors or
potential investors

Components of financial statements – income statements

The income statement is a financial document that demonstrates the financial

performance of a business based on its and how this has changed over a
period of time, usually months. The income statement allows shareholders
and owners to monitor business performance in line with business objectives and the
rest of the industry. The key information shown on an income statement includes
information about revenue, cost of sales, and any other expenses, along with gross and
net profit.

Example of an income statement:

● Revenue is any money received from the sale of goods and services in a business.
 ● Cost of sales refers to the incurred as a direct result of
making a product or providing a service, eg .
● An expense refers to any other , such as , ,
bills and advertising.
● Gross profit is revenue minus the cost of sales. This figure does not take into
account any other expenses involved in running a business. The calculation would
look like this:
○ Gross profit =
● Net profit is stage of the income statement. Net profit allows a business
to measure their overall financial performance to see if they are successful or not in a
given time period. The calculation would look like this:
○ Net profit =
● Figures are often rounded to a consistent level of accuracy, for example to the nearest
pound, or to one decimal place

Components of financial statements – statement of financial position

A statement of financial position, or balance sheet, considers key financial information

that allows a business to monitor where the money comes from and where is has been
spent, along with the overall value of a business. This document is often referred to as a

A statement of financial position is a snapshot in time, so it can only consider business

performance and value at a particular point in time. The statement of financial position
has a number of important business calculations. The overall aim of a balance sheet is
to get the to match, thus balancing the sheet.
There are several key elements on a statement of financial position. These include assets,
liabilities, working capital (net current assets), and capital employed.

In broad terms, assets are things that a business owns, whilst liabilities are things or money that
a business owes.

● Assets are split into two different categories, (or

non-current):
 ○ Current assets are , they will be owned for, or last for, less than
a year. This may include things such as , , and
cash.
○ Fixed (non-current) assets are , they will be owned, or last for,
more than a year. These may include things such as ,
equipment and .
● Liabilities are also split into two different categories, current and long-term (or
non-current):
○ Current liabilities, or short-term debts, are any debts a business owes that
will need to be paid back for example an overdraft, trade credit
or a short-term business loan.
○ Long-term (non-current) liabilities is money borrowed that is paid back in
more than a year, for example mortgages or a long-term bank loan.
● Net current assets and working capital are the . This is calculated by
subtracting current liabilities from current assets. Net current assets is the money
available for the day-to-day running and operation of a business, such as paying
wages and purchasing stock.
● Net assets is essentially . This is calculated by adding fixed
assets and net current assets (working capital) together. It can also be calculated as
the difference between total assets and total liabilities.
● Capital employed is achieved by adding any equity and reserves, such as shareholder
funds, to the long-term liabilities. This figure should always match the net assets
figure, to make the sheet balance.

Interpretation of data given on financial statements

Financial information can help a business make judgements about

, performance against previous years, performance against competitors and
performance from the perspective of a range of stakeholders. Assessing business
performance is one of the main benefits of creating financial documents.

Comparing against previous years

Both income statements and statements of financial position can be compared over a
number of years. For example they could compare 2017, 2018, 2019 and 2020 to see
how the business has performed compared to each previous year. Businesses may
want to measure key elements over several years, such as:
 ●
● Gross and net profits
●
● Liabilities
●

If in 2019, a desert-making business had a net profit of £10 million, and then in 2020 it
had a net profit of £12 million; it can see there has been an improvement in the financial
performance of the business. Similarly, a business may also notice that they were
making less net profit than in previous years, which would highlight a decline in financial
performance.

Comparison with competitors

Both income statements and statements of financial position can be compared with
competitors. Businesses may be interested to see how their competitors are performing
as a way of judging their own success. In the below example, it is clear to see
thatFarhad’s Bakery has better financial performance better than Tim’s Bakery.

Performance from the perspective of stakeholders

A range of stakeholders such as shareholders, employees and suppliers will take a
great interest in the financial performance of a business.

Shareholders are interested in how much has been made, along with
reducing the overall expenses for a business where possible. Shareholders generally
have an expectation that a business’ financial performance will improve each year to
help them gain more from their investment.

Suppliers are interested in the financial performance of a business so that they can rely
on payment from a business. In addition, if a business is making a huge amount of
profit, a supplier may view this as an opportunity to try to increase its prices. If a
business is making a loss, a supplier may begin to question whether a business will be
able to continue purchasing supplies from them.

Employees may want to see the financial performance of a business for a number of
reasons. Firstly, they may expect to receive a when a business is
making large amounts of profit. Secondly, some employees may receive a share of
business . Lastly, employees may become concerned about their
if a business is consistently making a loss.

Profit

The profit made by a business is the money left over once all of the expenses incurred
in running the business have been paid. Businesses usually separate their costs into
variable costs and fixed costs. This means that a business can calculate two different
types of profit, gross profit and net profit.

Gross profit margin

The gross profit margin is the that is left once

the cost of sales has been paid. It tells a business how much gross profit is made for
every pound of sales revenue received. For example, a gross profit margin of 75%
means that every pound of sales provides 75 pence of gross profit.

In order to calculate the gross profit margin, a business will use the following formula:

Comparing gross profit margins over time can be useful for businesses. In the example
above, the gross profit margin decreased despite the fact that the sales revenue tripled
and gross profit doubled. This indicates that the cost of sales, which includes raw
materials, increased faster than the business increased the price it charged its
customers. This business might respond by increasing the price that it charges its
customers or by negotiating lower prices for raw materials with its suppliers.

Net profit margin

The net profit margin is the proportion of sales revenue that is left once all costs have
been paid. It tells a business how much net profit is made for every pound of sales
revenue received. For example, a net profit margin of 32% means that every pound of
sales provides 32 pence of net profit.

In order to calculate the net profit margin, a business will use the following formula:
Using the net profit margin

Businesses can use the net profit margin to identify what is happening to their fixed
costs. They can do this in two ways:

● Comparing the net profit margin with the gross profit margin - by
comparing the net profit margin with the gross profit margin for the same time
period, a business can identify how , or
, are. For example, a business that has a gross profit margin of 50% and a net
profit margin of 10% knows that for every pound of goods sold, 40 pence is
used to pay fixed costs. This can then be used to identify whether there is any
scope to reduce these fixed costs.
● Comparing net profit margins - by comparing net profit
margins over time, a business can identify what is happening to its costs. For
example, a decrease in net profit margin indicates either that sales revenue
has fallen faster than costs or that costs have increased faster than sales
revenue.