It almost goes without saying that even a fit and healthy person still has to keep an eye on their personal health. A small nagging problem needs checking out to ensure it doesn’t develop into something more serious. It’s the same in businesses. Even if your financial health is looking good and you’re in the black, it’s worth digging deeper to discover meaningful insights and identify potential areas of concern that may need addressing moving forward.
The Importance of a Financial Health Check-Up
Ongoing internal analysis and financial health checks let you know where you spend money and how you make money. A complete picture of your company’s financial health offers a range of benefits, including:
- Resource allocation based on the returned value
- Insight on value centers driving success
- Insight on cost centers holding the business back
- Detailed information for investors
- And better-informed decision making all around
Whether it’s something simple, like how and when to pay business bills or big picture decisions on the direction of your company, determining the financial health of your business makes all the difference.
There Isn’t a Single Magic Metric
Unfortunately, you can’t encapsulate the entirety of a company and its financial health into a single metric. If you could, the business world would be much simpler. While profitability is a great place to start, it doesn’t tell the whole story. For example, you gain no information regarding debt, your ability to ride out a short-term drop in revenue, whether you can cover long-term obligations, or how efficiently your business is operating.
To achieve a greater understanding, we often discuss financial performance in terms of ratios. These offer greater insight than lone numbers and show the relationship between vital properties within your business. However, even financial ratios need to be used in conjunction with one another along with further analysis of financial statements to understand your business’s true health and viability.
It’s also essential to consider how financial health indicators evolve with time. A snapshot of economic performance is far less informative than a recording that reveals ongoing trends. Tracking key performance indicators allow you to determine whether you’re growing or declining as well as comparing yourself to competitors.
Vital areas to consider when determining the financial health of your business are:
Liquidity
Liquidity defines a company’s ability to cover short-term obligations such as purchases or paying invoices. It measures the amount of cash (or assets converted to cash easily) a company has on hand for use immediately.
It is typically measured using the current ratio and the quick ratio. The current ratio compares your company’s current assets with its current liabilities. The quick ratio is the same, but without considering inventory within the current assets.
It offers a more realistic indicator of whether your company can manage its short-term obligations. A quick ratio less than one is a worrying sign, meaning your current liabilities are more significant than your current assets.
Solvency
Solvency is similar to liquidity, except with a longer-term view. Where liquidity only considers current assets and liabilities, solvency looks at total assets vs. total liabilities. Put simply, solvency is a measure of your company’s ability to pay its ongoing debts over an extended period of time.
The most common ratio for measuring solvency is the debt to equity (D/E) ratio. It calculates debt against stockholder equity and is a good indicator of both long-term viability and the level of confidence/investor interest in your company. Low D/E ratios show shareholders, not creditors, are financing your company.
Operating Efficiency
Operating efficiency measures how much profit your company makes for its spending on operating costs. Greater operating efficiency means greater profit margins, with more income for the same or lower outlay. Operating efficiency indicates how well your company controls costs, uses its resources, and maximizes potential.
Profitability
While taking a holistic view of a company is essential, profitability is still the headline. However, go beyond just revenue minus expenses. Metrics such as gross or net profit margin and others show a more precise picture of your company’s financial health. By calculating the ratio of profit to revenue, you can determine the effects a change in operating costs or market conditions may have on your bottom line.
Where Should You Be Focusing Your Energy?
So how do you calculate these critical financial health indicators? What do you need to keep track of, and where should you look?
Balance Sheet
Your balance sheet shows your current financial position, providing information on assets, liabilities, debt, and equity for a specific point in time. From a balance sheet, you can determine the liquidity, D/E ratio, the nature of your assets (tangible, from financial transactions, etc.), and many other factors important to understanding your company’s financial health.
Income Statement
Also known as a profit and loss account, the income statement shows revenue vs. expenses for a given period. You can determine gross profit, net income, and operating income for a given period and determine if revenue is growing from your income statement.
Cash Flow Statement
The cash flow statement provides detailed information on how your company used its cash for a given accounting period. What was the source of cash flow? And in what areas was money spent? Typically divided into three categories: operations, investing, and financing.
Whereas the balance sheet and income statement utilize accrual accounting, the cash flow statement shows the actual cash movement in and out of your company.
Getting Beyond the Bottom Line
Your company is more than just its bottom line. Taking the time to analyze key financial statements, calculate financial ratios, and track them with time, allows you to see the steps along the way to the final net profit. With financial health insights, you can zoom in and go into detail on the peaks and valleys that make your bottom line where it is and help it grow in the future.
