Having a clear picture of business financial health can help you make more informed decisions about your business’s course. As a business owner, it is vital to know how your business is doing and understand the underlying reason for any loss or profit. Doing so enables you to avoid any previous mistakes and take advantage of any opportunity if it presents itself again. Few other reasons why you must be aware of business financial health are –
- You will be able to allocate your resources better helping in better functioning of business
- You will be able to understand your financial capability to take investment decisions based on actual figures
- Financing decisions like seeking funds or attracting investor can be a hassle, but in the presence of an accurate picture of your financial standing, this could be as easy for you and the investor alike
It is important that your accountant or your outsourced accounting services provider assist you in evaluating the business’s financial health with the help of various tools. Let us discuss a few critical tools that can help you get a clear picture of your business’s financial health.
- Financial Statement Analysis:
While it is impossible for a business owner to check every record and follow up with your bookkeeper regularly, you can always check your business financial statement as it provides comprehensive detail about all your economic activity.
- First and foremost, you can start by analysing your Cash Flow Statement. This statement is the best tool if you want to examine your cash flow. Analysing your cash flow statement provides an in-depth examination of your business’s cash sources, liquidity solutions, or whether if there is any cash leakage.
- An income Statement is another financial statement that can be utilised to analyse your business’s financial health. It shows your business’s financial position in the form of revenue, expenses, and profits earned. It helps a business owner to understand how much revenue has the business in a particular period and how much of it is actual net profit after all expenses. Net profit is the bottom line for any business, and hence it is important to prepare an income statement on time.
- Lastly, we have a balance sheet statement that helps the business owner understand its financial standing in a particular period. You will analyse all critical aspects of your business: assets and liabilities along with the owner’s equity. This statement will help you to understand that your business can cover its short-term obligations along with the business’s ability to generate cash and sustain operations. Having an accurate balance sheet statement can also help in securing investments and loans. It also serves as a base for ratio analysis used widely by investors and analysts to evaluate its financial position.
2. Financial Ratio Analysis:
As we talk earlier, ratio analysis is derived from the comparison of different items appearing in the books of accounts or financial statements like a balance sheet. It provides a precise and understandable interpretation of the business’s health. Ratio analysis helps you simplify the complex numbers in financial statements. Ratios fall under various categories, let us discuss each category in detail and few important ratios as well –
- Profitability Ratios: It compares the business’s ability to earn or generate revenue with its expenses so that it can arrive at a desired rate of return and recognise if there is any shortfall. Gross Profit Ratio is one such important ratio. It helps measure the profitability of the business of just a product or item line, without accounting for overheads. Another important profitability ratio is the net profit margin. It helps measure the percentage of revenue left after subtracting all costs. Some other important profitability ratios are the operational profit ratio and interest coverage ratio
- Liquidity Ratios: It measures the ability of a business to pay its day-to-day debt on time. It is an important ratio or test to determine the business’s ability to cover short-term obligations and cash flow. The current ratio is one of the important liquidity ratios that help you understand whether the business can pay its short-term obligations with its current assets and liabilities. Working capital ratio and quick ratio are also utilised frequently by business
- Solvency Ratios & Leverage Ratios: It measures the business’s ability to make payments and pay off its long-term obligations to creditors. A balanced solvency & leverage ratios indicate a more creditworthy and financially sound business in the long-term. One such ratio is the debt to equity ratio, this ratio measures the ability of the business’s equity to cover all debt in case of any downturn in the business. Few other frequently utilised solvency and liquidity ratios are -debt to capital, debt to tangible net worth, total liabilities to equity, total assets to equity, and debt to EBITDA
- Efficiency Ratios or Activity Ratio: It measures how well a business operate their assets to generate income. These ratios are also used by the business as well as its investors and creditors in assessing the profitability of the business’s operation. One important activity ratio is inventory turnover that measures how many times the business sold its entire inventory during a particular period. It gives insight into whether a business has excessive inventory relative to its sales levels. There is also accounts receivable ratio, accounts receivable days, accounts payable ratio, accounts payable days, working capital turnover, Cash turnover
- Return on Investment Ratios: Return on Investment or Return on Assets measures the amount of return on investment concerning the investment cost. It is a broad measure of investment profitability. Return on equity (ROE) is one such ratio that measures how well the business can utilize equity investments to earn profit. Another such ratio is Return on Assets (ROA) which measures how well the business is managing its available resources and assets to net higher profits.
- Market Ratios: These ratios help to understand the economic status of the stock of a particular public traded business. They determine the connection between the price per share of a business and its earnings, growth, and assets, or we can say it helps in indicating the value of a business. Few important market ratios are – Dividend Yield, Earnings Per Share and Price Earnings Ratio
Understand that no single ratio or statement is sufficient to analyse the overall financial health of your organisation, you have to use a combination of ratio analyses. These two tools can help you in getting a clear picture of your business’s financial health. If you want assistance in calculating these values for you, you can contact our accountants at Whiz Consulting who are experts in preparing financial statement analysis and calculating ratios on your behalf.