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How To Determine The Financial Health Of Your Business

How To Determine The Financial Health Of Your Business

Determining a company's financial health is an invaluable skill for any business owner or investor. Gaining insight into your company's performance allows you to make wise decisions. These protect your assets, improve your company's competitive edge, boost profitability, and redirect the organization as needed. You can also identify whether your resources align in a way to benefit the owners, creditors, and shareholders. Lastly, your company's financial standing could significantly influence its ability to grow and expand. This is primarily why owners need to know how to check its economic pulse.

Regardless of the size of your operations, you'll need to look at different perspectives if you want a clear picture of your business performance. Here are some of the different types of analyzes that can help you determine the financial health of your business:

1. Evaluate Profitability 

Companies must become profitable and maintain their standing for them to succeed. While it's helpful to have investors and creditors finance a company's endeavors, its ability to earn profits will ultimately define its financial health.

You can look at your company's net margin to determine its profitability. The net margin refers to the correlation of the net profit to total revenue. Looking at the rough figures for the profits without considering how much was earned for a specific period won't give you a clear idea of your financial performance. Thus, taking net margin into account is crucial.

Your company may have earned millions of dollars in profit. However, it may be in poor financial standing if the gain is only a fraction of the total revenue. This situation isn't ideal since any movement in the operating costs might negatively affect the company's overall profitability. Depending on the price volatility of the goods, transportation, energy, and other expenditures, the company can quickly lose its profitability and competitive edge in the market.

The larger the net margin is, the better your company's financial standing is since it indicates safety and stability amidst price movements and competition. Moreover, a profitable company has a firmer footing for expansion and development, which are both excellent indicators of financial health.

You can also look at your business's profit and loss or P&L statement to analyze the expenses and income for a specific period to understand its financial health. This statement can give you a detailed insight into the overall expenses and profitability of your business. Additionally, you can study trends in the report, which can help you decide whether to expand, save resources, or reposition your assets to let them grow in other areas.  

2. Study The Balance Sheet 

One of the first references you can use to study the financial performance of your business is the balance sheet. Looking into the balance sheet gives you a detailed view of your assets, liabilities, and equity, which helps determine your company's financial health. When studying the balance sheet, you'll obtain essential information, such as the amount of debt the company has compared to its equity, its short-term liquidity, and when customer payments are expected. Finally, you can identify the value of your inventory and assess the time it would take to liquidize it.

Indicators of financial health include the company's ability to cover operational costs, meet future obligations, and distribute inventory to clients. By analyzing your balance sheet, you'll be able to tell if your business is in good standing on all three points and see what can be done if there are any issues in your finances.  

3. Assess Your Liquidity 

Liquidity refers to the availability of cash and readily convertible assets for immediate use. A company's high liquidity is a good indicator of stable financial standing as the organization can fulfill primary obligations. Furthermore, it can indicate that a company owns assets that can easily be turned into cash should there be any emergency.

For companies, attaining ideal liquidity levels can help them attract more investors and gain creditors' trust. Owning assets that can be used for urgent requirements is an effective way to prove the stable financial health of a business, which is why it's considered an attractive trait for a company.

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You'll also benefit from monitoring your liquidity indicators as a business owner. For one, you can make sound and timely decisions concerning your available resources. While having a high liquidity ratio is ideal, having too much of it means that you have idle assets that aren't being put to good use. Hence, knowing when you have enough liquidity will help you take appropriate actions to propel your business to growth and expansion.

Meanwhile, having a low liquidity ratio might indicate financial challenges. Ensure you address these immediately to restore stability and balance within the enterprise.   

4. Review Your Solvency Ratio 

Solvency refers to a company's ability to repay debts in the long term. Using solvency ratios, you can compare the number of obligations to its equity or assets, and determine the company's sustainability for a long time. Calculate it by dividing a company's total debt by its total shareholders' equity. A high debt-to-equity ratio means the company is struggling to meet all its financial liabilities, which isn't ideal, especially for the long term.

For a business to have an excellent financial standing, it should have a low D/E ratio indicating that most of the company's operations run on funds from the shareholders instead of those from creditors. This ratio shows the investor's confidence in the company and its performance for the long term, which is why they entrust their assets to the organization. It is an advantage for the company since it won't have to pay interest on shareholder financing when comparing to funding from creditors. The D/E ratio should also have a consistent downward trend to be a good indicator of the company's firm financial footing.  

5. Assess Operational Efficiency 

Operational efficiency is key to a company's financial success, and you can determine this by calculating the operating margin. This metric determines the company's profitability based on the income generated after deducting production and marketing costs. The greater the profit, the better the operational efficiency since it indicates the company's ability to manage costs and generate income. 

6. Analyze The Income Statement 

When determining the financial health of your business, you'll also need to consider your income. This significantly influences your economic stability and market performance. You can study your revenue growth by looking at your income statement for a specific period. Then, compare it with the gross profit margins and net profit after expenses. Moreover, your income statement can also show the company's ability to repay debt and interest. Not to mention, the amount refunded to shareholders compared to the reinvested funds.

Here's how to study an income statement to help you get the pulse of your business's economic stability:

  • Check the accuracy of the figures and the computations.
  • See if all the sources of funds are accounted for.
  • Study the list of expenses and highlight the most significant contributor to the category.
  • Look at the bottom line or the net income. A positive figure indicates earnings, while a negative one signifies loss.
  • Compare year-over-year net income.

By taking the steps above, you'll gain better insight into your company's annual performance. This can help you predict its growth and stability in the years to come. The income statement also allows you to look into your fund handling and find areas for improvement. Finally, and most importantly, you can determine whether your current processes produce the type of income that you want to generate. This insight will ultimately tell you about your financial standing as an organization.

7. Study The Cash Flow Statement 

The financial health of your business can also be indicated by the cash flow. This refers to the incoming and outgoing cash movement within an accounting period. By studying your cash flow statement, you'll see the sources of income and how the money was spent. This covers all different financial obligations, such as operations, liabilities, and investments. You can also use it as a reference when analyzing the changes in your cash balance over a particular period.

As a business owner, understanding your company's cash flow will help determine liquidity levels, fund sources, income generation, and obligations. The statement also clarifies your financial standing because it excludes non-cash transactions. Finally, your cash flow statement will help you see whether your funds are growing or depleting.

Conclusion 

It’d be best to consider several indicators and analyses to thoroughly understand your business's financial health. These indicators include the company's financial statements, assets, liabilities, and profitability. By analyzing all this information, you'll gain insight into the company's competitive edge in the market. You can also gain support from investors and creditors, and see the potential market performance in the foreseeable future. While doing so, it's vital to remember that one metric alone isn't enough to depict the company's current performance or predict its potential growth.

Furthermore, the company's future financial performance depends on other elements besides figures and ratios. Hence, it's best to consider multiple factors to get a holistic view of its financial health and stability.

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