Figuring out the Financial Health of your Business
posted 17th September 2021
Why understand the Financial Health of your Business
As an entrepreneur, having a clear picture of your business financial health is critical - it can help you make more informed decisions about your organization's direction and how resources are allocated. Equally, if you plan to attract investors or seek financing, you need to be able to speak to your financial position.
If you are a manager, you need to understand the financial health of your organization so you can better direct your team. This will help you prioritise projects with defined return on investment or initiatives that contribute to the wellbeing of your company.
Employees can benefit too by understanding when your employer is doing well - you can ask for promotion or raise at the right time. When your employer is struggling, you can take steps to either demonstrate your worth or seek opportunities elsewhere.
How to determine the Financial Health of a Company
1. Analyse the Balance Sheet
The balance sheet is a statement that shows a company's financial position at a specific point in time. It provides a snapshot of its assets, liabilities, and owners' equity.
Assets are what a company uses to operate its business. Liabilities refer to money that's borrowed from other sources and needs to be repaid by the company. Owners' equity represents the financing that owners, whether private or public, put into the business. This relationship is the basis of the accounting equation: Assets = Liabilities + Owners' Equity.
The balance sheet helps you analyse:
• How much debt the company has relative to equity
• How liquid the business is in the short term (less than one year)
• 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 suppliers
• How long it takes to sell inventory the business keeps on hand
2. Analyse the Income Statement
The income statement shows a company's financial position and performance over a period by looking at revenue, expenses, and profits earned. It can be created for any period using a trial balance of transactions from any two points in time.
The income statement generally starts with the revenue earned for the period minus the cost of production for goods sold to determine the gross profit.
It then subtracts all other expenses, including staff salaries, rent, electricity, and non-cash expenses, such as depreciation, to determine the earnings before interest and tax (EBIT). Finally, it deducts money paid for interest and tax to determine the net profit that remains for owners. This money can be paid out as dividends or reinvested back into the company.
The income statement helps you analyse:
• How much revenue is growing over certain accounting periods
• The gross profit margin for goods sold
• What percentage of revenue results in net profit after all expenses
• If the business can cover its interest repayments on debt
• How much the business repays to shareholders versus how much it reinvests
3. Analyse the Cash Flow Statement
The cash flow statement provides detailed insights into how a company used its cash during an accounting period. It shows the sources of cash flow and different areas where money was spent, categorized into operations, investing, and financing activities. Finally, it reconciles the beginning and ending cash balance over the period.
The cash flow statement is one of the most important documents used to analyse a company's finances, as it provides key insights into the generation and use of cash. The income statement and balance sheet are based around accrual accounting, which doesn't necessarily match the actual cash movements of the business. That's why the cash flow statement exists—to remove the impacts of non-cash transactions and provide a clearer financial picture to managers, owners, and investors.
The cash flow statement helps you analyse:
• 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 overall cash has increased or decreased
• The cash flow statement provides key insights into the generation and use of cash
4. Financial Ratio Analysis
Financial ratios help you make sense of the numbers presented in financial statements, and are powerful tools for determining the overall financial health of your company. Ratios fall under a variety of categories, including profitability, liquidity, solvency, efficiency, and valuation.
Some of the financial ratios:
• Gross/Net profit margin: The % of profit after direct cost of sales have been deducted from the revenue (Net: after interest and tax)
• Current ratio: ability to meet short-term obligations of less than one year
• Quick ratio: ability to meet short-term obligations of less than one year using only highly liquid assets
• Debt-to-equity ratio: The percentage of debt versus equity that the company uses to finance itself
Financial ratios should be compared across periods and against competitors to see whether your company is improving or declining, and how it's faring against direct and indirect competitors in the industry. No single ratio or statement is sufficient to analyse the overall financial health of your organization. Instead, a combination of ratio analyses across all statements should be used.
Understanding the financial health of a company is critical for all professionals: business owners, entrepreneurs, employees, and investors. By analysing the information in financial statements, you can learn about your company's fiscal health and turn insights gleaned from data into actions that benefit your business and career.
At Mothern Accountants, we help Business Owners produce and maintain their Statutory Accounts and Management Reports that provides relevant information and insight to make effective business decisions.
Please contact us:
+447817836905
services@mothernsolutions.co.uk
www.mothernsolutions.co.uk
