How to Know If My Business Is Financially Healthy?
Knowing the financial health of a company is essential to future success. As a business owner, you need to know how your company performs. Understanding your company’s financial health can help you make informed decisions about your company’s future and allocate resources to avoid wasting money on projects that do not strengthen your financial position.
Cost Analysis
Statistical indicators can be used to analyze your costs. For example, What is:
- the cost of an individual product
- my capacity utilization
- my market share
- our output per hour
- the response to a mailing campaign
- this year’s sales orders vs. last year
Productivity measures are immediate and are called real-time indicators.
They can be monitored hourly or daily, and management can make immediate adjustments in response to them.
Financial Ratios
Ratios are mathematical calculations your company can use to evaluate its performance to determine whether it is improving or declining and as goals for future performance.
Ratios are calculated by comparing two numbers with each other. The most practical uses of ratios are to compare this year’s ratios 1) with the same ratios for the previous year and 2) with other companies in your industry.
Financial ratios provide more of an overview. They help management to monitor the company’s performance over a period, perhaps a week or a month.
Financial ratios can be divided into four major groupings:
- Liquidity ratios
- Working capital management ratios
- Measures of profitability
- Financial leverage ratios
In this article, we will be focusing on liquidity ratios because they are a good indicator of a company’s financial health. Liquidity ratios measure and help evaluate a company’s regular ability to pay its bills. Two commonly used ratios that help evaluate a company’s financial health are the current and the quick ratios.
Current Ratio
The current ratio compares current assets with current liabilities. The ratio is:
Current Ratio = Cash + Marketable Securities + Accounts Receivable + Inventory + Other Current Assets /
Accounts Payable + Bank (Short-Term) Debt + Accrued Liabilities + Other Current Liabilities
A ratio below 1.0 means current assets are less than current liabilities and indicate the company has liquidity problems. The ratio may be low because your company does not have the inventory levels necessary to serve your customers in a competitive manner. What is the cause of this? Do you have insufficient capital to buy the inventory level you need, or are you having supply chain issues?
A ratio over 1.0 may indicate the company is sufficiently liquid, but higher is not necessarily better. You would need to analyze why. The ratio may be high because your company has too much inventory or poorly collects its accounts receivable.
Current Ratio Example:
Current Ratio = $10,000 (Total Current Assets) / $5.400.00 (Total Current Liabilities) = 1.85
This value for the current ratio shows that the firm’s current assets are 1.85 times its current liabilities. Another way to put it is, the firm carries $1.85 of current assets for each $1 of current liabilities.
Your creditors are interested in this ratio because a higher current ratio generally indicates less default risk. For example, if a recession is looming and sales might drop, you will be better positioned to meet current liabilities if your company has a larger current asset base.
Quick Ratio
The quick ratio is also known as the acid test ratio. An acid test is a difficult situation or task that shows if a company is good enough to succeed. The ratio is:
Quick Ratio = Cash + Marketable Securities + Accounts Receivable + Other Current Assets /
Accounts Payable + Bank (Short-Term) Debt + Accrued Liabilities + Other Current Liabilities
As with the current ratio, a higher value for the quick ratio implies less risk for creditors.
The quick ratio is a more stringent measure of liquidity than the current ratio, excluding inventory due to its lower liquidity. The quick ratio also excludes prepaid expenses, which are unlikely to convert to cash. The quick ratio is calculated as follows:
The quick ratio has the same purpose as the current ratio, but its time frame is more immediate. It is calculated the same way as the current ratio, except it does not include inventory because there is a great difference in liquidity between accounts receivable and inventory. Accounts receivable is completed, but the company must spend additional funds to make inventory liquid.
Quick Ratio Example:
Quick Ratio = Cash + Short-Term Investments + Accounts Receivable / Total Current Liabilities = $1,750 + $1,400 + $2300 / $3,811 = 1.43
The firm has $1.43 of liquid assets for each $1 of current liabilities.
To learn more about financial ratios, consider the following course: