Checking your business’s financial health regularly gives you the upper hand over your finances. It also shows you if your business goals are achievable based on your current financial status. But what exactly is a financial health check and why must you set aside time for this activity?
What is a financial health check?
A financial health check is a process of assessing your company’s financial position. It aims to know if you have enough budget to accommodate your business expenses, plans and goals. You can also use it to identify potential cash flow issues and resolve those issues as early as possible.
When conducting a financial health check, you’ll need to examine several financial ratios. Among the key areas to consider are your company’s profitability, liquidity and solvency.
Why should you conduct a regular financial health check?
A 360-degree view of your finances keeps you away from making wrong business decisions, especially about how you should save or invest your hard-earned money. Aside from this, monitoring the financial health of your company regularly helps you:
- Run your business smoothly
- Be in control of your finances
- Understand how you manage your business’s finances and if you need to change your approach
- Know if you’re on track of your business goals based on your available budget
- Make smart and informed decisions on allocating business resources
- Determine if you’re overspending or underspending in any business areas
- Be prepared for financing applications, such as taking out loans or applying for investments
- Prioritise projects with high returns
- Better direct your team towards income-generating activities
How to measure financial health
An ideal way to measure the financial health of a company is by looking through financial ratios that are relevant to its operations, such as the ones listed below.
1. Profitability ratios
Profitability ratios measure your company’s capacity to make a profit from its revenue. They’re also good indicators of how well you maximise your assets to provide more value to customers and shareholders.
The most common profitability ratios are:
- Profit margins (e.g., gross margin, net margin, operating margin and cash flow margin)
- Return on assets (ROA)
- Return on equity (ROE)
- Return on invested capital (ROIC)
2. Liquidity ratios
Liquidity ratios measure your company’s ability to pay short-term debts based on your liquid assets. Cash, for instance, is the most liquid asset. Stocks and bonds are also liquid since you can readily sell them whenever needed.
Creditors and investors use liquidity ratios to obtain information about your business, especially when you’re seeking financing.
The 3 main liquidity ratios are:
- Cash ratio
- Quick ratio
- Current ratio
3. Solvency ratios
Solvency ratios, meanwhile, are used to assess your company’s capacity to pay long-term debts while remaining profitable. Creditors and investors also use this to evaluate your creditworthiness.
Examples of solvency ratios:
- Interest coverage ratio
- Debt-to-asset ratio
- Equity ratio
- Debt-to-equity ratio
4. Efficiency ratios
Efficiency ratios indicate how well your company utilises its assets and resources to generate income. A high efficiency ratio means you’re capable of achieving maximum profitability in the long term.
Example of efficiency ratios:
- Accounts payable turnover ratio
- Accounts receivable turnover ratio
- Asset turnover ratio
- Inventory turnover ratio
- Days sales in inventory
The acceptable percentage for each financial ratio can differ from one industry to another. That’s why it’s important to know what the standard is in your industry for an effective financial health check.
Common indicators of a financially healthy company
Is your company financially healthy? When you’re done evaluating your financial ratios, check out for these indicators to determine if your finances are in the green:
- Your profitability ratio is at the high end. This means your revenue is growing at a steady pace. Another indicator is when you have lots of repeat business while getting a steady stream of new customers.
- Your expenses remain flat. If your company is currently growing, and you need to spend more than usual, the increase in your expenses should still be aligned with your increase in revenue. If your expenses are higher than your revenue, you might want to look at the areas where you’re spending the most and evaluate the importance of this spend.
- You have enough cash to cover unexpected expenses and avoid incurring debts.
- You have low solvency ratios.
- You have a high liquidity ratio.
Financial health check for businesses
Do you need expert assistance in checking your business’s financial health? Contact us today to get a free financial health check from our team and review how we can help to make your accounting processes more efficient.
