Which of the following statements is the best measure of a companys financial health?

The “financial health” of a small business is open to interpretation, dependent on the health of its industry or the stage of the company’s journey or the challenges it has faced. But there are some proven metrics that investors, owners, leaders and other stakeholders can use to objectively assess the health of any company.

In this article, we explore the key performance metrics that anyone can use to benchmark small business financial health and gain a better understanding of the organization’s long-term viability.

What Is the Best Way to Measure the Health of a Small Business?

Because most small businesses are privately held and not required to release official financial results to the public, gauging their solvency and long-term viability requires some additional examination. In other words, you can’t just pull up a quarterly or annual statement or read a press release to get these metrics.

The good news is that there are some established ways to measure a smaller organization’s health. Whether you’re investing in such a company, running one yourself or even looking to start a business, you can use metrics like current liquidity, solvency, operating efficiency and profitability to gain a good understanding of the company’s current position and future prospects.

These metrics are extremely useful in a world where a company may look busy (i.e., signing up new customers, sending out a lot of orders) but actually be suffering financially. On the other hand, a firm may not look especially profitable to the outsider, but it may indeed be faring quite well financially and braced for growth in the future.

Key Takeaways

• There is no magic “silver bullet” metric for determining a small company’s financial health.
• The most important indicators of a small business’ financial health are liquidity, solvency, operating efficiency and profitability.
• Combined, these indicators help to paint a complete picture of a small organization’s financial health and viability.
• Above all, profitability tends to be the most used and relied upon measure of a small firm’s health, but profitability is not an end-all metric that can be used in all cases.

Key Performance Metrics to Understand Financial Health

When evaluating a small firm’s financial health, there is no single, magic metric that’s going to answer all of your questions. Instead, you should factor in all of the metrics listed below—or, as many as possible—to come up with a well-rounded assumption about the company’s health.

Liquidity

Financial ratios are used to rate the overall financial health of a small firm and decide whether its current operating model is viable (or not). Liquidity is the cash that a company has on hand and that can be immediately used to purchase an item or pay an invoice. To determine a company’s liquidity, you can use these two ratios:

Current ratio is computed by comparing a firm’s current assets (e.g., cash, receivables and inventory) with its current liabilities.

Quick ratio is the current ratio, but without inventory added in (e.g., cash plus receivables versus current liabilities). This ratio shows whether a company has enough money on hand to pay for its short-term obligations. In most cases, a quick ratio of lower than 1.0 is a red flag as it indicates that the organization’s current liabilities exceed its current assets.

Solvency

Solvency tells whether a company can meet its long-term financial obligations. You can determine a company’s solvency by comparing the total value of its assets to its total liabilities.

Typically, a company is considered solvent when its current assets exceed its existing liabilities (using the current ratio, as described above). If the current ratio is more than 1:1, then the company is solvent.

A solvent company can achieve its goals of long-term growth and expansion while also meeting its financial obligations. In its simplest form, solvency measures if a company is able to pay off its debts over the long term.

Operating Efficiency

Operating efficiency (aka, “operational efficiency”) is a measure of the efficiency of profit earned as a function of operating costs.

Operating ratio formula = Operating expenses / Net sales x 100

Put simply, the greater a company’s operational efficiency, the more profitable that company will be. With a high operating efficiency, the organization will be able to generate greater income or returns for the same or lower cost than it would if it had a low operating efficiency.

Operational efficiency includes the various strategies that a small company uses to serve its customers in the most profitable and cost-effective manner possible. Through smart utilization of resources, efficient production techniques and good inventory management, companies can maximize their operational efficiency and improve their overall profitability.

Profitability

Profitability is a comparison of the firm’s profit to its total revenue and costs. Profitability takes a wide-angle view of the entire organization’s viability and helps its owners and other stakeholders better understand its current financial position.

Gross Profit Margin = [(Revenue – Cost of Goods Sold) / Revenue] x 100%

Net Profit Margin = (PAT / Revenue) x 100%

EBITDA Margin = [(PAT + Interest + Taxes + Dep & Amort) / Revenue] x 100%

A company’s profits are what’s “left over” after deducting expenses from revenue (profit = revenue – expenses). Those expenses include costs like employee wages, the cost of buying new equipment, sales and marketing expenses, and the cost of inventory.

How to Evaluate Your Small Business’s Financial Health

There are three tools you can use to accurately measure your small company’s health, and that you can use to make good operational and strategic decisions for your organization. The balance sheet, income statement and cash flow statement all provide a clear, multi-faceted view of a firm’s current viability and future prospects. Here’s a breakdown of each tool and how it can be used to assess your company’s financial health.

Balance Sheet

The balance sheet is a financial statement that includes a company’s assets, liabilities, equity capital and total debt at a certain time. It helps business owners understand whether their companies are viable, or if they are in financial trouble.

The balance sheet also addresses both debt and liquidity. Here’s a closer look at each of these metrics and the roles they play in determining a small business’ overall financial health.

Debt

By dividing total debt by total assets, you’ll see which of your company’s assets are funded by debt. And while you may need to borrow money to make money as a business owner, you don’t want to over-leverage your firm by taking on too much debt.

If your company’s debt levels are high, it could be a potential sign of faltering or poor financial health. Using your balance sheet, you can determine your debt-to-equity ratio (total debt versus equity). If your business owes $200,000 in debt and if its owners have $50,000 in equity, then the organization has a debt-to-equity ratio of 4:1.

Liquidity

Just how easily your firm’s assets can be converted to cash and used to cover short-term financial obligations is its “liquidity.” This is a financial metric that is based on several different ratios of your company’s assets and liabilities.

Current ratio covers a firm’s ability to generate enough cash to meet its short-term financial obligations while the quick ratio is the current ratio minus inventory.

Income statement

A calculation of revenue-versus-expenses over a certain period of time, an income statement includes a company’s gross profit, operating income, and net income or profit. Also known as a profit and loss (P&L) statement, this provides important insights into a firm’s sales, attrition and expenses.

Your income statement reflects your firm’s gross revenues minus the expenses and reveals your profit or loss. In most cases, income statements cover specific periods, though they’re required every fiscal year.

Profitability

A measure of just how profitable a small business is (or isn’t), profitability is the quick-and-easy way to figure out if a small business is healthy or not. For example, if the firm is bringing in $1 million in sales per month, but if it’s paying out $1.2 million every month for overhead, payroll and other costs of doing business, then it’s losing money and won’t be financially viable for long.

While the other metrics outlined in this article help provide a well-rounded view of a company’s financial health, profitability is often the ultimate determiner of an organization’s future prospects. Put simply, if it’s losing money on every sale, then it’s time for some serious financial assessments, belt-tightening and improved financial controls.

Cash flow statement

The cash flow statement is used to record and track your company’s operating, investing and financing activities. Because it tracks all cash outflows and inflows, this statement bridges the gap between the income statement and balance sheet.

The cash flow statement also includes information about the company’s:

• Operating Activities: These are the organization’s primary revenue-generating activities (excluding investing and financing).
• Investing Activities: This covers any money made from the acquisition and disposal of long-term assets and other investments.
• Financing Activities: These are the activities that impact the contributed equity capital or borrowings of the entity (i.e., bonds, stock, dividends).

Using all of the information that’s stored on your cash flow statement, you’ll be able to manage your company’s finances and make educated decisions that can stabilize and/or improve your company’s financial health.

Cash flow

The total quantity of cash that a small business receives and spends during a specific period of time (i.e., a month, a quarter, etc.), cash flow must remain positive in order for a company to remain viable. Because cash flow is considered a lifeline for companies of all sizes, it’s a key consideration when assessing an organization’s financial health.

Cash inflows come from the following sources:

• Operations: This is the money that customers pay for your company’s products or services.
• Financing activities: For example, debt incurred by the entity (i.e., a PPP small business grant).
• Investment activities: Any financial gain that the company makes on its invested funds.

Having a persistent negative cash flow should be a cause of serious concern for any small business owner, since it means the business needs more money to avoid having to file for bankruptcy and/or close its doors.

How Can Automation of Bookkeeping and Accounting Can Help

By automating their bookkeeping and accounting functions, small businesses can save time and money previously eaten up by manual and spreadsheet-based systems. With an integrated, unified cloud enterprise resource planning (ERP) system, companies can take a big step forward in supporting their good financial health while also saving time, money and hassle.

With access to real-time data, reports and dashboards, for example, figuring out whether a company is financially healthy is fairly easy. It’s also easy to detect when an operational shift or customer issue will translate into a potential cash flow problem. With this valuable information at their fingertips, small business owners can take quick steps to proactively fix the problem.

Using the tools and strategies outlined in this article, small business owners and other stakeholders can rest easy knowing that they have a finger on the pulse of the company’s health. This allows them to focus on more important tasks, like implementing growth strategies, improving the customer experience and planning for the future.