Understanding of financial health of a company is important for different types of people. For shareholders, it’s important to know whether the business that you’ve invested so much in is heading in the right direction. For the management, it can be an indicator that you’re not doing something right and a chance to change things for the better before it is too late.
Still, how does one determine the financial health of a company? Well, there are several KPIs (key performance indicators) to keep an eye out for. Here are five of them.
1. Analysis of the balance sheet
The simplest way to figure out the financial health of your company is to just take a look at the balance sheet. Here, you’ll see three things:
Assets are all that your company owns in order to operate. If your company is incorporated, in the eyes of the law, it’s treated as a natural person, which means that it directly owns the property. In a sole proprietorship, there’s no such separation between the owner and the company.
Liabilities are the money that the company needs to pay. First of all, its debt is owed to others and it needs to be repaid by the company. Rent, operational costs, startup debt, etc., all go into a liability.
Equity is the money that all the owners are putting into the business.
2. Points to analyze
There are several items you need to analyze in order to make an estimate of the financial health of the company. First, you need to figure out the amount of debt that the company has and compare it to the equity. The liquidity of the business in the previous year is another point of interest.
While trying to make a fiscal projection, try to figure out how long it will take you to receive payments from your customers (those that are currently treated as account receivables). Also, evaluate your current relationships with suppliers.
In the end, try to make an estimate of your inventory. How long will it take you to sell all the items in your inventory or use all the resources necessary for production?
3. Independent business review
Sometimes, in order to get a professional estimate of the business, shareholders or financial institutions will insist on the independent business review. This is a review of the business conducted by trained and licensed professionals, usually with a background in finance and business. The best thing about the IBR is the fact that it can be tailor-made in agreement with the client. This means that you can tell the reviewer your expectations, as well as your purpose with the results of this IBR. Needless to say, this would make it more specific, more useless and even more accurate.
4. What are your profits?
The profit is an interesting thing, seeing as how it shows your potential for growth as much as anything else. You see, profit usually grows exponentially instead of linearly, which is why analyzing it historically may unveil your future potential. Just remember that your profit will be essential for your cash flow management, which is another major factor for the long-term financial health of your business.
Keep in mind that the profit may be immediately affected by a change in the company’s performance, different assessments of your products, as well as by finding a different pricing structure. Here, it’s also important that you know how to calculate the cost of goods sold (COGS). The equation is fairly simple. You start with the beginning inventory and add inventory purchases, then, subtract the ending inventory. What you’ll get is the COGS, which can further be calculated in order to get a gross margin.
5. Gross margin
One of the most important metrics on how your business is currently doing is the calculation of how much money you’re keeping after you sell all the goods. It can be brought down to a level of a single unit. This will show you how much money you’re making per unit sold. This figure can access the efficiency of your current business model. It can also show you if your business can really thrive under the current circumstances or if you need a potential price adjustment in order to make money. Overall, it can reveal how much maneuvering space you have under certain circumstances.
Regardless if your company is in good financial shape or not, you need to be aware of this. In order to make proper business decisions, you need to work with accurate information. Sun Tzu claims that the key to success in deception is to appear strong when you are weak and appear weak when you are strong. However, he also claimed that in order to win in every battle, you need to know both your enemy and yourself. Truly knowing your business is only possible by determining its financial health.