One business skill that isn’t talked about enough is knowing how to determine the financial health of your business.
As a business owner, it is your duty to know how your business is performing. A clear picture of the business’s financial health will not only help you make more informed decisions but also help you allocate resources properly.
Along with this, if you wish to attract investors, you would need to do a financial health check. But how can you do it? Here are steps that will help you measure the financial health of your business this year.
Analyse the Balance Sheet
But what’s the need to analyse the balance sheet?
The balance sheet serves as a financial snapshot of a company at a specific moment in time, revealing a company’s assets, liabilities, and owner’s equity.
Assets represent the resources a company employs to conduct its operations, while liabilities denote borrowed funds requiring repayment. Owners’ equity reflects the investment owners—be they private individuals or public stakeholders—have made in the business.
Crucially, the balance sheet adheres to the accounting equation: Assets = Liabilities + Owners’ Equity.
Assets and liabilities are categorised as current or non-current, indicating their short- or long-term nature. Current assets are anticipated to be converted into cash within a year, whereas long-term assets are not. Similarly, short-term liabilities are due within a year, contrasting with long-term liabilities.
The balance sheet acts as a financial health indicator, revealing:
- Debt-to-equity ratio: How much debt a company holds compared to equity.
- Short-term liquidity: The company’s ability to meet short-term obligations (less than a year).
- Composition of assets: Proportion of tangible assets versus financial holdings.
- Accounts receivable and payable: Time taken to receive payments from customers and repay suppliers.
- Inventory turnover: How quickly inventory is sold.
Analyse the Income Statement
The next step is analysing the income statement.
The income statement serves as a window into a company’s financial journey, capturing its revenue, expenses, and ultimately, its profitability over a defined period. In order to create this, trial balance of transactions from any two points in time are used.
Creating an income statement is pretty straightforward. It starts with tallying up the revenue earned during a certain period. Then, it subtracts the cost of making the products sold to find out the gross profit.
Next comes the fun part—subtracting all other expenses like salaries, rent, and bills from the gross profit. This gives us what’s called the earnings before interest and tax (EBIT).
Once we’ve got the EBIT, we subtract any money paid for interest and tax to find the net profit. This is what’s left for the owners to either pocket as dividends or reinvest in the business.
Now, why is this important? Well, the income statement helps us answer some key questions:
- Is the company making more money over time? (That’s revenue growth.)
- How much profit is it making from selling its products? (That’s the gross profit margin.)
- After all the bills are paid, what percentage of revenue turns into profit? (That’s the net profit margin.)
- Can the company afford to pay off its debts? (That’s if it can cover interest payments.)
- And finally, is the company giving back to its shareholders or reinvesting in itself? (That’s dividends versus reinvestment.)
Overall, the income statement gives us a sneak peek into a company’s financial health and helps us understand how it’s doing over time.
Analyse the Cash Flow Statement
Now comes the turn of the cash flow statement.
The cash flow statement gives details about the usage of cash by a company during an accounting period. Not only does it represent the sources of cash flow, but it also shows different areas where money was spent.
The cash flow statement breaks down cash movements into three main categories—operations, investing, and financing activities.
First off, it tracks the sources of cash flow—like sales revenue and investments. Then, it details where that cash is spent, whether on day-to-day operations, buying new equipment, or paying off debts.
The cash flow statement isn’t just about tallying up cash movements. It’s about providing a crystal-clear view of a company’s financial health. While the income statement and balance sheet deal with things like profits and assets, they often use accounting methods that don’t exactly match up with real cash movements.
That’s where the cash flow statement comes in to save the day! By stripping away non-cash transactions, it paints a more accurate picture of a company’s cash position. It helps answer some very important questions:
- How liquid is the company? (That’s about its ability to meet short-term financial obligations.)
- Where does the company get its cash from? (Those are the sources of cash flow.)
- How much cash does the company have left over after covering expenses? (That’s free cash flow, which can be used for further investments.)
- And perhaps most importantly, is the company ending up with more cash than it started with? (That’s the bottom line—whether overall cash has increased or decreased.)
In essence, the cash flow statement is the unsung hero of financial analysis, providing a window into a company’s financial fluidity and guiding decision-makers towards informed choices.
Financial Ratio Analysis
Financial ratios serve as indispensable tools in discerning the financial health of a company. These metrics, categorised into profitability, liquidity, solvency, efficiency, and valuation, offer invaluable insights into various facets of organisational performance.
The following are the key financial ratios:
- Gross Profit Margin: Indicates the percentage of profit remaining after deducting direct costs from revenue.
- Net Profit Margin: Reflects the proportion of profit relative to total revenue after accounting for all expenses, including interest and taxes.
- Coverage Ratio: Measures the capacity of a company to meet its financial obligations, particularly debt and interest payments.
- Current Ratio: Assesses the ability of a company to cover short-term liabilities within a year.
- Quick Ratio: Evaluates the capacity of a company to meet immediate short-term obligations using highly liquid assets.
- Debt-to-Equity Ratio: Highlights the balance between debt and equity utilised for financing.
- Inventory Turnover: Indicates how efficiently a company manages inventory by measuring the frequency of inventory turnover within a specified period.
- Total Asset Turnover: Assesses the efficiency with which a company generates revenue from its total asset base.
- Return on Equity (ROE): Illustrates the ability of a company to generate profit from equity investments.
- Return on Assets (ROA): Assesses the effectiveness of asset utilisation in generating profit.
It’s essential to compare these ratios over time and against competitors to spot trends and assess your company’s performance.
Remember, no single ratio or statement can paint the entire picture. It’s the combination of ratio analyses across all financial statements that provides a detailed view of your company’s financial health.
Ready to take control of your business’s financial health and attract potential investors?
Let our team of expert tax accountants in Melbourne guide you through the process. Contact us today and discover how Clear Tax Accountants can help you make informed decisions and maximise your resources.
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