It is difficult to guarantee a company’s success if you don’t know how to assess its financial health. Actually, what separates a successful business with a future from one without is the meticulous analysis of financial results. This information enables educated choices to be made about corporate expansion, asset sales, and investments.
In order to comprehend and enhance your company’s financial health, you should be aware with key indicators, such as operating cash flow and profit margin, as the market and investors thoroughly examine financial data at the conclusion of each quarter.
What is a company’s financial health?
Financial health refers to a company’s ability to adequately manage its capital to pay its expenses, make investments, and generate revenue and profits. Therefore, organizations with good financial health can:
- Make more investments;
- Attract more customers;
- Expand your business;
Meet your strategic objectives.
Determining how to assess a company’s financial health therefore involves paying attention to multiple specific indicators known as KPIs.
How to assess a company’s financial health with KPIs?
For any company, it’s undoubtedly imperative to constantly monitor financial results. But how? Through frequent analysis of key performance indicators (KPIs), essential for corporate financial management, you can stay up-to-date, avoid surprises, and adapt to changes.
KPIs are indicators that, as the name suggests, help companies monitor the achievement of their strategic objectives. To this end, each defined KPI must follow the SMART criteria , meaning it must be:
- Specific ;
- Measurable ;
- Achievable ;
- Relevant ;
- Time-based (Situated in time).
In particular, liquidity, profitability, and solvency ratios are the most pertinent measures from the standpoint of financial performance when figuring out how to evaluate a company’s financial health. As a result, it’s critical to comprehend these indicators’ components and operation in greater detail.
Liquidity ratios
These are the main financial indicators of a company used to determine its ability to meet short-term debt payment obligations , taking into account current assets, that is, without resorting to external capital.
These financial liquidity ratios, essential for understanding how to assess a company’s financial health, are divided into three distinct categories:
Current ratio |
Immediate ratio |
Operating cash flow ratio |
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The current indicator measures the company’s ability to pay its current obligations using its total current assets, namely: cash, payments receivable (for example, for the provision of services or the sale of products to customers) and inventories. |
This data follows the same logic as the previous point, with the exception that the assets accounted for to pay obligations include your most liquid assets, excluding inventories. |
This indicator assesses whether a business can meet its short-term obligations with its regular activities. Operating cash flow, or the money the business makes from its regular activities, is divided by its current liabilities, such as debts payable, to arrive at the computation. |
Profitability ratios
Profitability ratios are used to assess a company’s capacity to make a profit. When assessing this capacity, revenue, operational costs, assets, and shareholders’ equity must all be taken into account.
Generally speaking, these profitability ratios are the most significant in quarterly, semiannual, or annual financial statements. These metrics are really used to compare a company’s performance to that of its competitors in the market as well as to its historical performance.
These profitability statistics fall into two different groups and are essential for comprehending how to evaluate a company’s financial health:
Margin ratios
In short, companies’ margin ratios measure their profitability at different levels or calculation moments, encompassing crucial indicators such as:
- Gross margin;
- Operating margin;
- Pre-tax margin;
- Profit margin.
Profit margin is undoubtedly the most important ratio for assessing a company’s financial health. It refers to the amount the company earned from its business after accounting for all income and expenses.
Return ratios
Return refers to the amount received after an investment. In this case, return ratios analyze a company’s ability to reward its shareholders. Among these indicators, for example, is return on equity (ROE), the return a company obtains from investing its capital.
Solvency ratios
grasp how to evaluate a company’s financial health requires a grasp of solvency ratios. Ultimately, their study enables us to ascertain the company’s long-term debt-paying capacity.
Therefore, solvency ratios take into account all of a company’s liabilities, including medium-, long-, and very-long-term ones, rather than just short-term debts. Thus, this is the primary distinction between liquidity and solvency ratios.
Additionally, investors use solvency ratios to determine whether or not their investments in the company are risk-free and valuable.
What challenges affect a company’s financial health and how can they be overcome?
Multiple variables can negatively impact a company’s financial health. Market changes, such as shifts in consumer behavior or financial crises, pose challenges for organizations.
To face any challenge and safeguard its financial health, a company must:
- Develop a solid financial plan aligned with your strategic objectives. This will help you better manage risks in the event of a crisis, avoiding mistakes and unnecessary debt.
- Establish an emergency fund sufficient to cover the business’s operations for a minimum of one year. This protection will guarantee that even in times of crisis, the business will have financial independence and flexibility.
To maintain a company’s sustainability, you must not only take all these steps but also know how to evaluate its financial health. After all, you can never realize the full potential of your business unless you conduct a thorough financial analysis of financial statements and key indicators.