Financial Health Check: Is Your Business in Good Financial Health?

Understanding your business’s financial health is the first step to improving it.

Maybe you’re a business owner who is afraid your business isn’t financially healthy and wants to understand why, or maybe you’re a manager who’s been tasked with auditing your company’s financial health, and you feel lost. You might even be an investor trying to understand the financial health of a company you’re interested in taking a financial risk on.

This article is designed to help you evaluate the financial health of any company and understand what’s financially healthy—and what isn’t.

Key Takeaways

  • Understanding a business’s financial health is essential to understanding how to lead it, invest in it, or lend money to it.
  • The key to understanding a company’s financial health is analyzing its financial statements.
  • There are several financial ratios that speak volumes about the financial health of a business and make it comparable to other businesses in the same industry.

What Is Financial Health?

Financial health can refer to many elements of a business, including:

  • The company’s net income on the income statement.
  • The company’s assets relative to their debt on the balance sheet.
  • Several important financial ratios (which we’ll discuss below).
  • The financial decision-making of the business’s leadership.

Understanding a company’s financial health involves evaluating its assets and liabilities, profitability, cash flow, liquidity, and more using accounting software. The better these financial metrics are, the more financially healthy the business is.

In general, the more profitable a business is, the more cash it generates, and the more assets it owns relative to its debt, the more financially healthy the business is. In the steps below, we’ll discuss specific financial ratios that you can use to evaluate the financial health of any business.

Why Is Understanding Financial Health Important?

Understanding financial health is important because it gives business owners, investors, and lenders an understanding of how well a business’ leadership is doing and how well their investments are likely to do.

When a business does well, its owners are successful, its investors make money, and any lenders will be paid back. Everybody wins.

Understanding the financial health of your business is also important because:

  • It helps you understand what parts of the business may need to be improved.
  • It lets you know how much you can reinvest back into the business without eating into your profit margins.
  • If you’ve taken out a loan, it allows you to estimate at what point you’ll be debt-free.

How To Determine the Financial Health of a Company: A Step-By-Step Guide

We created the following step-by-step guide to help you determine the financial health of any company. We’ll talk about how to analyze financial statements, what different financial figures mean, and how to use financial ratios to quickly and easily understand how healthy a business is.

Step 1: Locate the Company’s Financial Statements

The first step in analyzing a company’s financial health is to find its financial statements. These include the income statement, the balance sheet, and the statement of cash flows.

If the company is public, its financial statements should be available on its website or a platform such as Yahoo Finance, Google Finance, or your brokerage account. Simply Googling “X company income statement 20XX” can also do the trick.

Step 2: Analyze the Income Statement

The income statement summarizes income, expenses, gains, and losses over a specific period—usually either a calendar year or the company’s fiscal year. The income statement is used by a company’s leadership to understand how profitable the company is and what opportunities it has to improve sales, reduce expenses, and improve profitability.

Investors and lenders also utilize income statements to understand how profitable investing in, or lending to, the business might be. The income statement helps them understand how good the business is at paying off debt, the profit the business can pay out to shareholders, and how much income it has left over to reinvest in operations.

Analyzing the income statement can help you answer questions such as:

  • How profitable is the company—does it have net income or a net loss?
  • Has revenue grown or shrunk from one period to the next?
  • What is the gross profit margin? What about the operating profit margin?
  • How much is spent on research and development (R&D)?
  • How much does the business spend on the Cost of Goods Sold (COGS)?
  • How much is paid to shareholders as dividends, and how much does it reinvest?

Step 3: Analyze the Balance Sheet

The balance sheet is a record of a company’s assets, liabilities, and equity as of a specific point in time. The balance sheet is used by a company’s leadership to understand what assets the company owns, what debts it’s liable for paying, and the difference between the two, which is the amount of equity the business has.

Investors and lenders also utilize balance sheets to understand how risky the company is to invest in. If it has too much debt, it’s more risky, but if it has more assets than debt, it’s less risky.

Analyzing the balance sheet can help you answer questions such as:

  • How liquid is the business—how much cash and cash equivalents does it own?
  • How many long-term assets does the company own (property, plant, and equipment)?
  • How much debt does the company have relative to its equity?
  • How long does it take to collect accounts receivable?
  • How long does it take to sell its inventory?

Step 4: Analyze the Cash Flow Statement

The statement of cash flows shows the cash inflows and outflows the company experienced during a specific period. The greater the net cash inflows, the better the business is at converting income into cash.

Owners, investors, and lenders all use the cash flow statement to understand how much cash the business has to invest in its growth, distribute to investors as dividends, and pay off debt.

Analyzing the cash flow statement can help you answer questions such as:

  • How much cash does the company generate?
  • Is its ability to generate cash increasing or decreasing over time?
  • What are the main sources of cash inflows?
  • What are the main sources of cash outflows? Do they seem reasonable?

Step 5: Analyze Key Financial Ratios

Once you’ve developed an understanding of the business’s financial statements, it’s time to analyze its key financial ratios.

Financial ratios are simple formulas that can be used to quickly understand how well a business is doing in terms of its profit, assets, debt, cash, and more.

We recommend using Microsoft Excel, Google Sheets, OpenOffice Calc, or another similar service to calculate these financial ratios.

For public companies, many of these ratios are included in their financial reporting or are calculated automatically by services such as Yahoo Finance, Google Finance, or your brokerage account.

Alternatively, there are several dedicated financial software options, such as ReadyRatios, Oracle Netsuite, Zoho Analytics, G2, Datarails, Cube, and more.

Calculate Profitability Ratios

Profitability ratios are used to determine how profitable a company is. The greater the ratio, the more profitable—and therefore financially healthy—the company is.

Gross profit margin: This is the percentage of income remaining after subtracting the cost of goods sold (COGS). COGS are the expenses directly related to the production and sale of goods or services, such as raw materials, manufacturing costs, shipping, etc.

Gross Profit Margin = (Gross Sales – COGS) / Gross Sales

Operating profit margin: This is the percentage of income remaining after subtracting COGS and operating expenses, depreciation, and amortization. Operating expenses are expenses businesses incur during their normal operations, such as rent, equipment, inventory, utilities, marketing, payroll, insurance, and more.

Operating Profit Margin = (Gross Profit – Operating Expenses – Depreciation – Amortization) / Gross Sales

EBITDA margin: This shows the percentage of Earnings that remain Before Interest, Taxes, Depreciation, and Amortization have been subtracted. EBITDA is one of the best financial metrics for understanding how profitable a company is because it ignores artificial expenses that don’t actually affect the business.

EBITDA Margin = (Operating Income + Depreciation + Amortization) / Gross Sales

Net profit margin: This shows the percentage of income that remains after all expenses have been paid.

Net Profit Margin = (Gross Sales – All Expenses) / Gross Sales

Cash flow margin: This shows how good a company is at converting income into cash. Net sales are sales after returns, discounts, and the value of lost or damaged goods.

Cash Flow Margin = Cash Flow / Net Sales

Return on Assets (ROA): ROA shows how good a business is at utilizing its assets to earn profit.

ROA = Net Income / Total Assets

Return on Equity (ROE): ROE shows how good a business is at turning invested capital into profit.

ROE = Net Income / Shareholder Equity

Return on Invested Capital (ROIC): ROIC shows how good a business is at turning invested capital and debt into profit.

ROIC = Net Operating Profit After Taxes / (Shareholder Equity + Debt)

Calculate Liquidity Ratios

Liquidity ratios measure a business’ “liquidity,” or how quickly a company could convert its assets into cash if it needed to. They’re used to determine a business’s ability to meet its short-term obligations.

The higher the liquidity ratio, the more easily the company can pay off debt. However, if the ratio is too high, the company may be under-utilizing debt and might achieve higher growth by taking on more debt.

Current ratio: This measures a company’s ability to pay off its current liabilities using its current assets, which include cash, investments, accounts receivable, and inventory.

Current Ratio = Current Assets / Current Liabilities

Quick ratio: This measures a company’s ability to pay off its current liabilities using current assets, excluding inventory. This is because inventory can take a while to sell, so it’s not as liquid as other assets like cash, investments, or accounts receivable.

Quick Ratio = (Cash + Investments + Accounts Receivable) / Current Liabilities

Cash ratio: This measures a company’s ability to pay off its current liabilities using only current assets that can be converted into cash immediately. This leaves out accounts receivable because it can take customers a while to pay what they owe.

Cash Ratio = (Cash + investments) / Current Liabilities

Days Sales Outstanding (DSO): DSO measures the average time it takes a business to collect payment after a sale. The fewer days it takes to collect, the healthier the business is.

DSO = Average A/R / Revenue Per Day

Calculate Debt Ratios

Debt ratios measure the extent to which a business is funded by debt. Some debt can help a business grow and can be healthy, but too much can be a sign that the business is over-leveraged and may not be able to pay off its debt.

Debt-to-assets ratio: This shows the amount of debt a business has relative to its assets. A ratio of greater than one shows that the business has more liabilities than assets and vice versa.

Debt-To-Assets Ratio = Total Debt / Total Assets

Debt-to-equity ratio: This shows the amount of debt a business has relative to its equity. A ratio of greater than one indicates the business is funded more by debt than by equity investments, and vice versa.

Debt-To-Equity Ratio = Total Debt / Total Equity

Interest coverage ratio: This evaluates a business’s ability to pay the interest on its outstanding debt. It’s calculated by dividing a company’s Earnings Before Interest and Taxes (EBIT) by its interest expense.

Interest Coverage Ratio = EBIT / Interest Expense

Step 6: Evaluate the Results

Now it’s time to evaluate the results. Here are some general rules you can use to understand what is healthy or unhealthy in financial statements and financial ratios:

  • Healthy: A higher percentage of profit is financially healthier than a lower one.
  • Unhealthy: Too much debt relative to assets can pose a financial risk.
  • Healthy: Higher return on equity equals more profitability and happier investors.
  • Unhealthy: A low-interest coverage ratio means a company is struggling to pay its debts.

Conclusion

While there are many ways to understand a business’s financial health, this article drills down and discusses actionable items you can take to understand the financial health of any company.

Whether you’re a business owner looking to evaluate your own company, or a manager trying to perform a financial audit on your business, the financial statement analysis and financial ratios discussed here will set you up for success.

FAQs

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David Kindness
Editor

David is a CPA and nationally-recognized financial writer and editor, specialising in taxes, business accounting, and corporate finance. He has 4+ years experience writing and editing thousands of articles for millions of monthly readers, and has contributed to the likes of Investopedia, The Balance, OnPay, and now Techopedia. Prior to launching his writing career, he spent several years working as a CPA, tax accountant, and senior financial accountant.