One of the most important business skills of an entrepreneur is knowing how to determine the financial health of their business. Having a clear picture of financial health helps you make a lot of informed decisions including investment choices, how to allocate resources and financing opportunities.
What is financial health?
Financial health is a term used to describe the state of a company’s monetary affairs. There are many dimensions to the financial health of your business including liquidity, solvency, operating efficiency and profitability. All of these indicators help to paint a complete picture of the financial health and viability of an organization.
Although there are several other methods and factors you can use to evaluate financial health, financial statement analysis remains one of the most effective means. Here are different types of analyses you can conduct to get a better understanding of your company’s financial health:
- Analyze the Balance Sheet
The balance sheet is the statement of the assets, liabilities, and capital of a business or other organization at a particular point in time, detailing the balance of income and expenditure over the preceding period. Assets are resources owned or controlled by a business or economic entity. They are anything that can be used to generate positive economic value. While liability is something a company owes, usually a sum of money. They are always recorded on the right side of the balance sheet, and they include loans, mortgages, bonds, warranties.
It is always important to note that assets should be equal to the sum of liabilities and owners’ equity. The balance sheet helps you analyze the following:
- How much debt the business has relative to equity
- What percentage of assets are tangible and what percentage comes from financial transactions
- How long it takes to receive outstanding payments from customers and repay customers
- Analyze the Income Statement
An income statement also called a profit and loss account is one of the financial statements of a company and shows the company’s revenues and expenses during a particular period. It contains three main parts; revenues, expenses and profit. It generally starts with the revenue earned for the period minus the cost of production for goods sold to determine the gross profit.
- It provides information on a company’s financial health by helping you analyze the following:
- The gross profit margin for goods sold
- How much revenue is growing over certain accounting periods
- How much the business repays to shareholders as compared to how much it reinvests
- Analyze the Cash Flow Statement
A cash flow statement, also known as the statement of cash flows, shows how changes in a balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing and financing activities. It reconciles the beginning and ending cash balance over the period.
The cash flow statement provides information on a company’s health by helping you analyze the following:
- The liquidity situation of the company
- The company’s sources of cash
- The free cash flow the company generates to further invest in assets or operations
- Whether the capital has increased or decreased
- Financial Ratio Analysis
A financial ratio is a relative magnitude of two selected numerical values taken from an enterprise’s financial statements. They are powerful tools for determining the overall health of your company. They fall under different categories including profitability, liquidity, solvency, efficiency and valuation.
Some of the common financial ratios include:
- Gross profit margin: This is the percentage of profit the company generates after the direct cost of sales expenses have been deducted from the revenue
- Net profit margin: The percentage of profit the company generates after all expenses have been deducted from revenue.
- Current ratio: The company’s ability to meet short-term obligations of less than one year
Understanding the current financial health of a business is important for all professionals, managers, business owners and entrepreneurs. However, the most critical aspect is to be able to convert all these insights into actions. By carrying out these analyses, you can get a perfect view of your company’s financial health, and also turn these insights into positive actions.