Small and Medium-Sized Enterprises (SMEs) play a crucial part in a country’s economic growth and sustainable development. The purpose of this study is to investigate the relationship between innovation and the performance of SMEs. An external environmental factor acts as a moderating variable between the exogenous and endogenous variables. Data were collected from 350 textile SMEs operating in Pakistan using a cross-sectional study design through self-administered questionnaires. Of these, only 335 surveys were valid for further analysis. The structural equational modeling technique was used for analyzing the data and testing the hypotheses that innovation and the external environment affect an SME’s performance. The results indicate a significant association between innovation and SME performance, and the external environment has a moderating impact on innovation and SME performance. This paper offers valuable recommendations to senior managers and owners of SMEs to consider the innovation and external environment as crucial factors when assessing their SME’s performance. This study contributes towards the body of knowledge on this subject and can help practitioners and researchers explore the effects of innovation and the external environment on the performance of SMEs.