In understanding how far revenue is important to assess the financial performance of a company, we must understand what is meant by assessment of financial performance of a company. In simple terms it means the diagnosis of financial soundness of a business, meaning thereby, evaluation of the overall health of a company.
Now, our next question should be that why do we need to even assess the financial performance of a company? The answer to which varies according to the interest of the parties involved i.e. whether we are potential investors or creditors-financial or otherwise or are we the management of the company.
Beginning with the perspective of a retail individual investor, I would like to invest where I earn more regular dividends and the market valuation of the share price is also high, which means, an investor will majorly focus on three things- profitability ratios, asset turnover ratio and stability prospects of the company.
Analysis of the profitability of a company generally involves computation of gross profit ratio and return on equity by an investor to determine the performance of a company. Herein we notice that the revenue of a company is being used to make an assessment while calculating the gross profit ratio or asset turnover ratio and such other ratios as the investor may calculate to base his decision. However, apart from revenue, factors such equity and the return generation capacity of the company on such equity, the size of its assets and certain qualitative factors also play a crucial role to truly interpret the performance of a company. Qualitative factors being the growth rate of a company, mission and strategies of the company and the credibility of management of the company.
Here, I would like to quote the example of the very famous – Nokia. Nokia, which was once recorded huge revenues failed and as per an article from the Forbes, in September 2013, Stephen Elop the CEO of the company was alleged to be the wrong person for the job and claimed that it would destroy Nokia because of his ill intentions. Without a doubt, he was a competent person, nevertheless, it was all a way to position himself as the CEO of Microsoft! Consequently, strategies which were not in the favour of Nokia were made and ultimately, the valuation of the company fell by substantial levels and the company incurred humungous losses!
Therefore, as an investor, it is crucial to consider all the factors as we just discussed and judging a performance solely on the basis of revenue can be dangerous!
Moving onto assessment of the financial performance of a company from the perspective of creditors-financial as well as operational. A creditor, before granting a loan would try to ensure that the company has the capability of generating enough cash flows to pay the interest and repay the debt. Accordingly, focus would now be more on solvency ratios, liquidity ratios, activity ratios and the cash flow statement of the company.
A company would be in a good financial position if the debt-equity ratio, total assets to debt ratio, interest coverage ratios, Payables turnover ratio, current assets ratio etc. move towards the ideal level of ratios. Further, it is to be seen whether the operations of the company are generating the desired level of cash-flows.
A company with high revenue may have low cash flows which in the long run may question the going concern of the business as it is often said that REVENUE IS VANITY, MARGIN IS SANITY AND CASH IS THE KING! And thus, again, factors like other income, assets of the company, level of equity, the value of liabilities and revenue, all contribute in the assessment of the company’s financial performance.
Now, we move towards the factors which influence the financial performance of a company from the standpoint of management.
The management must consider various indicators of financial performance such as business climate, business model, operational excellence and the business strategies apart from the factors that we have discussed before.
The quality of the customers, the customer base, and strength of distribution networks are other qualitative aspects that mould the future of a company.
For example, Kingfisher airlines, an airline synonymous with five star air travels, which was one of the largest airlines and earned huge revenues turned bankrupt due to lack of a proper strategy and unfavorable mergers.
At last but not the least, I would like to conclude by stating that, just like a healthy human heart doesn’t ensure overall health of a person, similarly, revenue doesn’t obviate the soundness of this artificial juridical person!
Indeed, revenue is one of the most crucial factors in assessing the financial performance of the company; however, it is not the sole criteria. Factors like, solvency, liquidity, profitability, cash flows, capital structure and other qualitative factors are equally important to understand the performance of a business.