How can you tell whether a business is in good financial health? It’s tempting to answer this question simply: Look at the bottom line profit margin, of course. We gather that that the profitability of a business is probably the best standalone indicator of good financial health. And it’s also a predictor of long-term success. However, it isn’t the whole picture. A business owner wishing for a deeper understanding of their business’s financial health would do well to consider a number of other factors. The more comprehensive the approach to understanding the financial health of a business, the better equipped the business owner will be in keeping their company as healthy as possible.
How to Use Ratios to Assess Business Financial Health
When it comes to assessing financial health, financial ratios have a large part to play. They compare the different figures on a company’s income statement or balance sheet and provide more insight than single figures like profit margin. To get the most out of financial ratios, it’s smart to re-examine them every month to stay aware of any trends in your business.
We’ll look at some of these ratios and what they say about the financial health of your business.
Liquidity Ratios
Liquidity ratios measure the amount of cash and easily-converted-to-cash assets that you can use to cover your short-term debt obligations. They signal your company’s ability to survive in the short-term and provide a broad look at financial health. Companies usually build liquidity through positive cash flow.
There are two common ratios to measure a company’s liquidity. They are the current ratio and the quick ratio (also known as the acid test).
Current ratio
The current ratio is used to demonstrate your company’s ability to generate cash to settle short-term financial obligations. It’s calculated by dividing your current assets (cash, inventory, accounts receivable, etc.) by your current liabilities (accounts payable, long-term debts, etc.).
Quick ratio
The more precise of the two ratios is the quick ratio. It is also calculated by dividing current assets by liabilities, but it excludes inventory and long-term debts. This paints a clearer picture of a company’s ability to pay off short-term obligations with cash on hand. This is the number that illustrates how well a company is prepared to handle emergency and unforeseen short-term financial burdens. A ratio of less than 1.0 can be cause for alarm, as it means liabilities currently outnumber assets.
Solvency Ratios
Where liquidity looks at the ability of a business to manage its financial obligations in the short term, solvency shows how well the business can meet these obligations on an ongoing basis. Solvency is calculated using the debt-to-equity ratio. Simply divide the total of your company’s liabilities by your total equity.
By comparing your company’s total amount of debt to its total equity, you can see how much of your funding is coming from investors and how much is coming from creditors. Along with measuring how well a company is prepared to pay its debts into the future, this ratio demonstrates investor interest in a company. A low ratio means that more financing is coming from investors than creditors and is a sign of strong financial health.
A debt-to-equity ratio that is steadily declining is a great indicator of growing financial health. It suggests that a business is becoming more financially stable.
Profitability Ratios
Liquidity and solvency are important parts of the picture when it comes to determining your company’s financial health. Perhaps the most important ratio, though, is still profitability. The one thing all businesses must eventually do to become successful is to turn a profit. Profitability ratios can help evaluate the financial viability of your company as well as how it compares with the competition.
Your net profit margin measures your ratio of profits to total revenue. It compares your company’s total sales with its after-tax earnings. This is a better metric for evaluating financial health than simply a dollar amount for profit, which can be misleading.
The size of the net profit margin shows:
- how much financial safety a company has
- how much capital it will be able to dedicate to growth
- its level of flexibility
Efficiency Ratios
These ratios aim to measure the efficiency of your business. The more efficient a company, the fewer resources it needs to create wealth. Efficiency makes for good financial health.
Operating efficiency takes a look at the operational costs that come with creating revenue. An indicator of operating efficiency is the operating margin. Specifically, this ratio looks at the profit made from sales after deducting the costs of production. It’s calculated by dividing the operating profit by net sales.
This is a useful ratio because it shines a light on how efficient is the management of your operations. Good management is one of the most important aspects of a well-run business, but it can be difficult to measure. Use this ratio to make sure your business is streamlined in its operation and maximizing profit.
Signs of Financial Health
Using finance ratios is a reliable way to assess your company’s financial health. They provide valuable insight into multiple aspects of your business’s financial viability. But there are some other things you can look for if you’re not sure about your business’s financial health.
Here are some easy-to-look-for signals that your business is financially healthy.
Your Expenses Aren’t Outgrowing Your Revenue
An increase in revenue every year is a fantastic indicator of good financial health. Even relatively small increases in profitability, if steady and continual, make for a positive financial outlook.
While your company’s revenue continues to increase, you can expect expenses will increase as well. It’s usually a necessary part of business growth. What your growing expenses say about your financial health depends on whether they exceed the growth of your revenue. Expenses that remain flat in comparison to revenue are a good sign. A financially healthy company shouldn’t see their expenses grow any more than their revenue over time.
Your Cash Balance is Healthy
This one might come as a no-brainer, but it’s a mistake businesses sometimes make. Consistently having a large enough cash balance is a sign of a healthy business. Investing money back into your company is essential for growth and maintenance, but it can be overdone. Becoming overly rich in non-liquid assets won’t help you when something urgent comes up and you need the cash on hand to handle it.
You’ve Got Both Repeat and New Customers
Your customers are what keep your business viable. The difference between new and repeat customers is an important distinction to make. In some industries, new customers cost more money to attract than repeat customers. Repeat customers provide reliable streams of revenue. On the other hand, purchases made from new customers can be harder to predict. A company with only repeat customers, however, isn’t growing.
Having a mix of the two types of customers is a great signal for good financial health. Simply, the more options for generating revenue, the better.
How to Improve Your Business’s Financial Health
Successful business owners understand the value of their company’s financial health. It offers a snapshot of how viable, sustainable, and competitive their business is. Taking the steps to evaluate your business’s financial health is important, but you don’t have to stop there.
If you don’t like what you see when it comes to your business’s financial health, you’ll want to take steps to improve its standing. If you do like what you see, how can you do even better? Is there potential for growth?
In the effort of improving your business’s financial health, solid planning is key. Checking your financial health is the first step. Keeping track of how your financial health indicators change over time is the second. It takes regularly monitoring metrics like financial ratios to be able to identify trends and make necessary adjustments. If you haven’t already, getting a CFO involved in straightening out your finances can make a world of difference. They’ll help you produce, keep track of, and make sense of all of the necessary financial statements.
Take the Time to Understand Your Business
Any business owner would be hard-pressed to find something more important than the financial health of their business. A business that isn’t financially healthy is a business that is closer to failure.
Make sure your business is and remains viable. Take the time to truly understand where it stands financially. Take into consideration all of the information you have at your disposal, more than just the amount of profit you’ve created. Nothing will put you in a better position to succeed than the best understanding of your own business’s financial health.
At Saddock Adivsory, we can help determine if your business is financially healthy. Get in touch with us here to find out more.
