How to Evaluate Financial Performance

Investors use a variety of factors to decide whether to buy, sell or hold a stock. In addition to risk, the other key factor investors use is financial performance. Using a variety of objective ratios to make a financial performance evaluation, you can eliminate some of the guesswork when looking at individual businesses and deciding if they are right for your portfolio.

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According to the Corporate Finance Institute, financial performance, as it applies to an individual business, refers to where a company stands in terms of its:

• Assets
• Liabilities
• Equity
• Revenue
• Profitability

This list does not measure the company's risk, which is measured by factors such as debt-to-equity, earnings before interest, taxes, amortization, debt capacity and interest coverage ratio. Investors look at the combination of the company's financial performance and risk as to the best financial metrics for evaluating a company's health.

Important accounting ratios, looking at factors such as liquidity, efficiency, leverage and inventory turnover, are some of the best financial ratios for investors to use to evaluate financial performance.

Liquidity refers to cash and other assets you can quickly use to pay bills and debt. If you have an asset that would take months to sell, that's not a very liquid asset. If you have receivables or inventory you can discount and use to bring in cash almost immediately, that asset is more liquid. Using quick ratios and current ratios, a company determines how much capital it would have to meet immediate or short-term capital needs.

You divide your current assets by your current liabilities to get your quick ratio. Performing the math above, but excluding your inventory and your long-term debt, gives you your quick ratio.

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Another area to look at when examining a company's financial performance is its ability to make and sell its product in a one-year period. This is known as its inventory turnover ratio. The longer a company has to hold onto inventory to sell it, the longer it takes to get in cash, which it needs to service debt, increase marketing or pay its bills.

Investors look at a company's efficiency ratios, which take into consideration the company's inventory turnover ratio, along with its ability to turn over assets (asset turnover ratio) and receivables (receivables turnover ratio). All three of these areas combined show the company's ability to generate working capital and make up the company's efficiency ratio.

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One area of risk investors use when looking at a company's financial performance is the business's long-term ability to pay its debt. The more debt the company has, the more leveraged it is. Analysts look at metrics like debt-to-equity and debt-to-asset ratios to help assess a company's financial risk.

Obviously, a key indicator of a company's financial health is its ability to turn a profit. Analysts take into account not only bottom-line profits, but also how they are generated. Investors look at things like a business's profit margins and earnings before interest and taxes, return on assets and return on equity.