What is Financial Health?
A company’s financial health is a term used to describe the state of an organization’s financial affairs. It is a snapshot of the company’s financial strength and stability. When assessing financial health, a variety of factors come into play, including whether a company is thriving, just surviving, or facing minor or severe challenges.
The financial health of a company can be likened to a doctor examining a patient’s vital signs to diagnose their overall wellbeing. Without a clear grasp of a company’s financial condition, investors, creditors, and even the company’s management could be in the dark, potentially leading to ill-informed decisions and missed opportunities.
This blog post aims to help you make sense of the signs and signals that companies project through their financial statements, other indicators, and how to analyze the key indicators.
Table of Contents
Indicators of financial health
Factors worth considering to determine the financial health of a business can be divided into two:
- Financial indicators
- Non-financial indicators.
Financial indicators: financial statements (the income statement, the balance sheet, and the cash flow statement); Financial ratios (Profitability ratios, Debt ratios, Liquidity ratios, and Efficiency ratios)
Non-financial indicators: customer satisfaction and retention, employee satisfaction and turnover rate, market share and growth.
The Importance of Financial Health
It is crucial to know the financial health of an organization for these key reasons:
1) Investors: To build investors’ confidence that their investment is safe and likely to grow. Strong financial health indicates a company has the potential to provide a return on investment.
2) Creditors: Banks and other financial institutions are more willing to lend money to businesses that show signs of solid financial health.
3) Employees: Job stability and growth opportunities are often tied to a company’s financial health. It is peculiar for a troubled company to lay off staff, if not the right measures are put in place, they may shut down.
4) Company Management: Understanding the company’s financial health enables management to make informed decisions about growth strategies, budgets, and potential investments.
Key Financial Statements to Consider
Getting the financial health of a business isn’t majorly determined by the number of branches it has or just by the number of its workforce, but rather its financial statements.
To get important information about a business’s health financially, take a dive into its financial statements. These documents tell you about the earnings of a business, the value of its assets, its debts, and many more. Primarily, we focus on three key statements:
- the Income Statement,
- the Balance Sheet, and
- The Cash Flow Statement
Also known as the “Profitability Indicator” or “profit and loss statement”, the income statement tells us about a company’s earnings. It shows the revenue (money coming in) and expenses (money going out) over a particular period. So, by subtracting expenses from revenue, we find out whether the company made a profit or incurred a loss.
Also known as the “Snapshot of Assets and Liabilities”, a balance sheet captures the business’s assets, liabilities, and equity at the end of the financial year. Let’s break it down:
Assets: Buildings, equipment, and cash are categorized as assets
Liabilities: Liabilities represent what it owes (such as loans and unpaid bills).
Equity: Also known as shareholders’ equity, is essentially the difference between assets and liabilities. It’s the portion of the assets that the shareholders would theoretically own if all liabilities were paid off.
Cash Flow Statement
The cash flow statement divides cash activities into three categories: operations (day-to-day business), investing (buying or selling assets), and financing (borrowing or repaying debt, issuing or buying back shares).
The cash flow statement which may simply be described as the “Cash Reality Check”, reveals how much actual cash the company generated.
It’s possible for a company to show profits on the income statement while having little to no cash—perhaps because it invested heavily in equipment or has not yet received payment from customers.
So, let’s explore other important aspects of an organization’s financial health – financial ratios – to help you understand some complex financial data.
Significance of Financial Ratios
Financial ratios help simplify complex financial data and make comparisons easier -between different companies or between a company’s past and present performance. The most critical financial ratios used in assessing the financial health of a business are:
- Profitability ratios,
- Debt ratios,
- Liquidity ratios, and
- Efficiency ratios
The first question you should raise when the profitability ratio is mentioned is: “Is the business making money? This is because profitability ratios show how efficiently a company generates profit. The few ones to consider include: net profit margin, gross margin ratio, and return on assets.
Gross Margin Ratio (GMR): This ratio tells you how much profit a company makes after subtracting the cost of goods sold (COGS), excluding overheads and other expenses. It’s a good indicator of production efficiency and pricing strategy.
Net Profit Margin (NPM): This is calculated by dividing net profit by total revenue. It shows what percentage of revenue is left after all expenses are deducted. It’s a reliable measure of overall profitability.
Return on Assets (ROA): This ratio shows how efficiently a company is using its assets to generate profits.
Can the company pay its bills? Can it meet its obligations? The Liquidity ratios tell you if a company can pay off its short-term obligations such as bills and any debts due within a year.
The two key liquidity ratios are:
1) Current Ratio: This is calculated by dividing the company’s current assets (cash, accounts receivable, and inventory) by its current liabilities (debts and bills due within a year). A ratio over one suggests the company can pay its short-term debts, while a ratio under one might be a warning sign.
2) Quick Ratio: Also known as the acid-test ratio, it’s similar to the current ratio but excludes inventory from current assets. It’s a more stringent test of short-term financial strength.
Debt ratios provide insight into a company’s debt management, that is, how well does the company manage debt? They include:
1) Debt to Equity Ratio: This ratio compares a company’s total debt to its shareholders’ equity. A high ratio might indicate that the company is heavily financed by debt, which could be risky.
2) Debt Ratio: It shows the proportion of a company’s assets financed by debt. A lower ratio is typically better, indicating less reliance on borrowed money.
Efficiency ratios tell you how well an establishment is using its resources, that is, how well is the company using its resources? The key efficiency ratios are:
- Inventory Turnover Ratio: This indicates how quickly a company sells its inventory. A higher ratio is usually better, suggesting strong sales.
- Accounts Receivable Turnover Ratio: This ratio shows how efficiently a company collects payment from its customers. A higher ratio indicates that customers pay their debts quickly, which is good for the company’s cash flow.
Non-financial Indicators of Company’s Financial Health
While financial ratios and statements are fundamental to understanding the financial health of a company, they’re not the only factors worth considering. Non-financial indicators are also very important to a company’s overall health. The non-financial indicators are:
Customer Satisfaction and Retention
Happy customers are often repeat customers, and they can bring in new customers through positive word-of-mouth. Surveys and reviews can give us a sense of customer satisfaction. A high customer retention rate is also a positive sign – it’s generally cheaper to keep existing customers to acquire new ones.
Employee Satisfaction and Turnover Rate
High employee satisfaction often leads to increased productivity and better company performance. On the other hand, a high employee turnover rate can be a red flag: it’s expensive to hire and train new employees, and frequent turnover can disrupt operations.
Market Share and Growth
Market share – the company’s sales as a percentage of the total market – can indicate competitiveness. A growing market share suggests the company is outperforming its competitors. The company’s growth rate compared to the industry average can reveal whether it’s keeping up with, lagging behind, or surpassing its peers.
Analyzing Financial Health
Now that we’ve explored financial statements, ratios, and non-financial indicators, let’s see how you can analyze these to know the financial health of a business.
Analyzing Financial Statements
Start with the income statement, balance sheet, and cash flow statement. Look for trends over several years by asking these questions:
- Is revenue growing?
- Are profits keeping pace?
- Are assets growing faster than liabilities, indicating increasing equity?
- Is the company generating positive cash flow from its operations?
How to calculate and interpret financial ratios
Next, calculate the key financial ratios we earlier discussed to have a deeper understanding of the company’s liquidity, profitability, debt management, and operational efficiency.
But don’t look at these ratios in isolation. Compare them to previous years’ figures to see the trends. Also, compare them to industry averages to get a sense of how the company is doing relative to its peers.
Analyze the Non-Financial indicators
Finally, consider the non-financial indicators. Customer and employee satisfaction can have long-term impacts on a company’s financial performance. Market share and growth rate can indicate the company’s competitive position and potential for future profitability.
Measuring a company’s financial health is a comprehensive process that involves much more than looking at a single figure on a balance sheet. It requires a careful and holistic examination of financial statements, thorough calculations and interpretation of financial ratios, and a keen understanding of non-financial factors.
The goal isn’t just to know the numbers but to understand what they mean. By doing so, you’ll be able to make more informed decisions.
Evaluating a company’s financial health is not a one-time task. It should be done regularly, as conditions can change quickly in the business world.