The Best Measure of a Business Financial Health

In many instances, people always infer that the bottom line profit margin is the best single indication that a business is financially healthy. However, there is more to just evaluating the profit margins at the end of a financial period. There are other factors to consider before making a conclusion. Notably, investors always look for one golden key measurement that can be found on the financial statement. That is not as simple as it sounds.

Experts argue that a number of financial ratios can be assessed to gauge the overall financial health of a business.  The information gathered may be used to make a determination of the likelihood of the business continuing as a viable business. Normally, standalone numbers such as total debt or net profit are less meaningful. That is as compared to financial ratios that associate and compare the various numbers on a business balance sheet or income statement. According to many financial advisors and accountants, the general trend of financial ratios is also an important consideration.

To obtain an accurate evaluation of the financial status and long-term sustainability of a business, one should consider various factors. One should examine four main areas of financial health while establishing the financial health of a business. These are solvency, liquidity, operating efficiency, and profitability. Among the four, the best measurement of business financial health is the level of its profitability.

Solvency

Solvency is the ability of a business to meet its debt obligations on an ongoing basis and not just for a short term. Solvency ratios calculate a business’s long-term debt in relation to its assets. For instance, the debt-to-equity (D/E) ratio is generally a solid indicator of a business’s long-term sustainability. That is because it provides a measurement of debt against stockholders’ equity. Therefore, it is also a measure of investor interest and confidence in a business.

A small D/E ratio implies that more of a business’s operations are financed by shareholders and not by creditors. Ideally, this is a huge benefit for business since shareholders do not charge interest on the financial resources they provide. A downward trend over time in the D/E ratio is a positive indicator that a business is on increasingly solid financial ground. However, it is prudent to note that D/E ratios vary widely between industries.

Liquidity

Many people are of the opinion that liquidity should be a key factor in assessing a company’s basic financial health. Well, that may be true! Liquidity is the available amount of cash and easily-convertible-to-cash assets that a business owns to accomplish its short-term debt obligations. Before prospering in the long term, a business must first be able to survive in the short term. The two most commonly used metrics to measure liquidity are the current ratio and quick ratio.

Sometimes, the quick ratio is called the ‘acid test’. It is a more precise measure because it divides current assets by current liabilities. For example, it excludes inventory from assets as well as the current part of long-term debt from liabilities. Consequently, it provides a realistic and practical indication of a business’s ability to manage short-term obligations with cash and assists on hand. It is imperative to note that a quick ratio lower than 1.0 is a danger signal. Usually, it serves as an indication that current liabilities exceed current assets.

Operating Efficiency

Every successful business must have maximum operating efficiency. Operating margin is the best indicator of a business operating efficiency. This metric not only indicates a business’s basic operational profit margin but also provides an indication of how well the business controls costs. In addition, it highlights the efforts of business management to control crucial costs. Essentially, good management is vital to a business’s long-term sustainability. That is because good management has the ability to overcome an array of problems. On the other hand, bad management can lead to the collapse of even the most promising business establishment.

Profitability

It is no secret that liquidity, basic solvency, and operating efficiency are all essential factors to consider in evaluating the success of a business. Nonetheless, the bottom line remains that the most vital measure of business financial health is its profitability. Even though a business may indeed survive for years without being profitable, that may not be for long. A healthy business should eventually attain and maintain profitability.

The best metric for evaluating profitability is net margin. This is the ratio of profits to total revenues. It is prudent to consider the net margin ratio because a simple dollar figure of profit is inadequate to assess the business financial health. A large net margin implies a greater margin of financial safety. It also indicates that a business is in a better financial position to commit available capital to growth and expansion.

If you have any query about measuring the financial wellbeing of business, get in touch with us. Our team of experts will be happy to educate you.