There’s no perfect way to determine your company’s financial health, however, there are four critical areas of financial well-being that can be scrutinized closely for signs of strength or vulnerability.
Financial liquidity refers to how easily assets can be converted into cash. Liquidity is important for learning how easily your company can pay off its short term liabilities and debts. Cash is the most liquid asset, as it does not require any type of conversion and maintains its value. It’s wise for entrepreneurs to have cash available as an emergency fund, because you almost always have access to it when you need it without waiting.
Understanding your financial assets and their levels of liquidity is important. Your business will likely have ups and downs, with some financial curveballs along the way. Investing in different sorts of assets may help keep your finances more stable, given something difficult comes your way.
How To Measure Liquidity:
- Current Ratio: the current ratio measures a company’s ability to pay short-term obligations, which are obligations due within one year. It uses all of the current assets and divides their total by the total amount of current liabilities. This ratio tells investors and analysts how a company can maximize the current assets on its balance sheet to satisfy its current debt and other payables. If your company has a current ratio of less than 1, it may be a warning sign that you might experience problems meeting your short-term obligations, which could put your business at serious financial risk.
- Quick Ratio: The quick ratio measures the company’s ability to meet its short-term obligation with its most liquid assets. The ratio only uses cash and cash equivalents, short-term marketable securities, and accounts receivables. A quick ratio below 1 is a danger signal, and it may be a warning signal you are unable to pay off current liabilities in the short term.
Solvency is the degree to which the current assets of an entity exceed the current liabilities of that entity. It can be described as the ability of a business to meet its long-term fixed expenses and to accomplish long-term expansion and growth. Solvency enables a business to continue operating. It is critical since most businesses have occasional cash flow problems, especially when starting out. Once solvency is lost the company is said to be insolvent, and it has few other choices than to enter bankruptcy or to liquidate.
How to Measure Solvency:
- Debt-to-Equity: The debt-to-equity ratio is a financial ratio indicating the relative proportion of shareholders’ equity and debt used to finance a company’s assets. This is an important ratio to understand as it measures the degree to which a company is financing is operations through debt versus wholly-owned funds. More importantly, it reflects the ability of shareholder equity to cover all outstanding debts in the event of a business downturn. The optimal ratio will vary by industry, but typically, it should not be above a level of 2.0. High debt-to-equity ratios may signal that your company is in financial distress and unable to pay your debtors. A downward trend over time is a good indicator that your company is on increasingly solid financial ground.
All companies should seek to be efficient to ensure long-term survival. Good management is essential to a company’s long-term sustainability and success. A company’s operating efficiency is key to its financial success.
Operating Efficiency is a concept that encompasses the practice of improving all your processes. The goal of operations is to run efficiently, provide consistent, high-quality products or services, and continually improve the customer experience.
How to Measure Efficiency:
- Operating Margin: the operating margin is the best indicator of a business’s operating efficiency. This metric measures how much profit a company makes on a dollar of sales, after paying for variable costs of production such as wages and raw materials, but before paying interest or tax. This can be found by dividing a company’s operating profit by your net sales.
A business that is capable of generating operating profit rather than operating at a loss is a positive sign for potential investors and existing creditors. A high profit margin means the company’s operating margin creates value for shareholders. If your company has an operating profit margin of less than 5%, let this serve as a danger sign that your business isn’t efficiently converting revenue into profit.
Although liquidity, basic solvency, and operating efficiency are all important factors to consider the financial health of your business, the bottom line remains in your company’s bottom line: its net profitability. Although your business may be able to survive in the short-run for years without being profitable, it is essential to long-term sustainability and success, a company must eventually attain and maintain profitability.
Firms often make the mistake of focusing just on revenues, operating under the assumption that greater revenue means greater profit. Earning a profit is important when your company is looking to secure financing from a bank or attract investors to fund operations and grow your business.
How to Measure Profitability:
- Net Margin: net margin is the best metric for evaluating profitability. It is the percentage of revenue raining after all operating expenses, interest, taxes, and preferred stock dividends have been deducted from a company’s total revenue. This is one of the most important indicators of a company’s financial health. A low net margin should serve as a serious warning sign to your business. A low ratio can result from inefficient management, high costs, or weak pricing strategies. Low margins are determined relative to your industry and historical context of your company.
Profitability is all about the bottom-line of your business: your revenues minus costs and expenses. It is critical to make a serious commitment to promoting both the growth side of your business while also acknowledging the importance of managing costs. This will help create a strong foundation for your firm that can weather future uncertainties.
A Single Metric Can’t Determine the Financial Health of Your Business
When running a small business, you can’t rely on your gut instinct when it comes to evaluating your company’s financial health. It is important to be to be objective when determine the financial health of your company rather subjective. Keeping close tabs on your small business’s financial performance is essential to long-term success.
Accounting is Vital to the Success of Your Small Business
Poor financial management is one of the primary reasons for small business failure. Accounting is critical for small business owners as it helps the owners, managers, and investors evaluate the financial health and performance of the business. A solid accounting function provides vital information regarding cost, earnings, profit & loss, liabilities, and assets for planning and decision making.
Exemplar Companies Can Offer a Team of Proactive Accountants
Exemplar companies partners with small business owners to give them current, relevant information, so that they can make decisions and achieve their goals. We pride ourselves in being proactive accountants that give entrepreneurs advice and alert them when red flags arise. Schedule a free consultation today to learn how the Exemplar’s professional business accountants & CPAs can help your business.
Managing Director, Exemplar Tax & Accounting
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