Let’s Determine the Financial Health of your Business: 4 Key Indicators
Running a business is no joke – it takes up immense effort and mental space. You can get so absorbed in the day-to-day tasks that you skip monitoring the progress. The financial health of your business will determine its sustainability. We are all in it for our passions and beliefs but for the money too! An enterprise with poor financial indicators does not bode well for its founder, employees, and future.
We have collected the four prime indicators you should gauge to assess whether your business is flourishing or floundering.
Pivotal Business Indicators for Financial Health
Profitability: Are you making profits?
This one is almost a no-brainer. Why are we even doing business if the company isn’t making – or getting set to make – profits? In the start-up culture so omnipresent nowadays, new businesses fail every year. Not making profits will lead to your downfall before you can say, Jack Robinson.
You can calculate profitability from the net margin, i.e., the ratio of net profits to revenues. The rule of thumb is that your firm should start making profits within 2-3 years of commencing operations.
Tips to increase profitability
The number one strategy is to cut costs. Are your business spendings too high? What can you reduce starting now – perhaps, overheads in logistics, office space, and electricity bills? Even a simple technique like using a free check stub maker with calculator instead of wasting time and effort doing manual computations can reap rich dividends. StubCheck.com offers affordable and customized solutions to business owners, helping them generate detailed and legal checkstubs for their staff within minutes. It is also a greener approach to payroll management, saving you paper, storage space, and precious time searching for records during tax season.
Another strategy to improve profitability is better and more targeted marketing campaigns. You might even be able to charge a premium for your goods and services if you can find the right audience that needs you.
Liquidity: How many liquid assets do you have now?
This critical metric denotes how many liquid assets you have available for immediate and urgent expenditures, such as taking out a loan or making an essential purchase. Cash is the most liquid asset, followed by stocks, bonds, securities, etc.
Good liquidity is imperative for sound financial health. You can find this by referring to the working capital, i.e., the difference between short-term liabilities and assets. A standard liquidity ratio compares current assets and current liabilities. You can also use more stringent measures like the quick ratio (excluding inventories). It is also called the acid-test ratio.
The minimum liquidity ratio you need is 1. However, investors will seek at least 2 or 3 to deem your enterprise worthy of their input.
Solvency: Can you fulfill long-term financial obligations?
This metric is similar to liquidity. However, it focuses on the long-term availability of cash to pay debts and meet other financial commitments. A straightforward way to calculate this is through the shareholders’ equity, i.e., a company’s assets minus liabilities. You can find this on the balance sheet. A negative equity indicates insolvency.
Another technique uses the solvency ratio: net income and depreciation vs. amortization and total liabilities. However, the solvency ratios vary by industry. We suggest you consider that before jumping to conclusions or becoming overly cautious. That said, a safe solvency ratio is 0.5. Anything lower than 20% or 30% is a good target for financial wellness.
Liquidity and solvency are best analyzed together. It won’t do for a firm to have high liquidity but poor solvency. It will be a huge red flag for your clients and affect your business relationships and employee retention. In the long run, you will encounter unpaid debt, a poor credit score, and a possible shutdown.
Efficiency: Are you using resources smartly?
A business depends on its resources: money, effort, creativity, and time. Unless you maximize your resource assignment, you may run headfirst into a deficit. An inefficient business will likely have poor financial health.
You can calculate financial efficiency by determining how much of your company’s revenue gets spent on expenses. However, business owners must understand different kinds of efficiency, such as ROI, process, and operation. Energy efficiency and labor productivity are crucial for your company’s long-term growth and reputation.
Some common areas where firms can optimize resource utilization are:
- Allocating work to national and global teams instead of only local employees
- Investing in skill development as a means to improve productivity
- Using automated tools like a paystub generator free for routine tasks
- Improving time management
- Conducting shorter meetings and reducing interruptions during work
Other Indicators of Financial Health
The above four metrics are the most commonly used measures to evaluate a business’s financial stability. Some other metrics also get used from time to time for specific analyses. For instance, the budget variance tells you how the actual figures compare with the budgeted ones. A difference of over 10% can indicate necessary action.
Another significant calculation is inventory turnover. It shows how much of your inventory sold compared to the whole stock. A poor figure denotes weak sales or overstocking. It indicates you must work on marketing and stocking to improve sales and profitability.
Which documents should you refer to for financial analysis?
Periodic assessment of your company’s finances is essential for entrepreneurs, investors, and shareholders. The balance sheet will give you a quick snapshot of the assets, liabilities, and equity at a particular time. You can also check the income statement to understand the revenue, expenses, and profits. Another crucial document is the cash flow statement. It reveals how the business uses cash during the accounting period getting studied.
Business owners must keep constant tabs on the financial health of their enterprise. Times are tough; inflation is rising, and the threat of recession looms around us. It has become mandatory to embrace technology to keep updated on all the crucial numbers and indicators. Saving valuable time for creative ideas and growth instead of squandering resources in the humdrum might be the only way to keep your head above water.
