Financial Health: How To Measure The Financial Health Of A Company?

If you are running a monetized business for about a year or more, then you must be aware of the financial health status of your company. Financial health analysis is important to take your investment and expenses in the right direction.

There are various factors that determine the financial health of an organisation, such as financial ratios, risk analysis, financial management, cash flow, and other insights. In this article, we will learn more about financial health and why it is important to understand a company’s financial health, especially for investors.

What is Financial Health?

Financial health is an important indicator of a company’s well being. Like we humans visit doctors to confirm that everything is going well inside our body, similarly various factors, performance, and efficiency are analysed to determine whether a company is good for investment or not.

Financial Health Key Takeaways

Financial health determines the present state and stability of an enterprise.
It is a strong sign for the investors for a higher chance of good returns over investment.
Financial health is determined by a number of factors such as financial management, financial ratios, credit and debt management, risk management, cash flow, etc.

Understanding Financial Health

Financial Health

If you are about to invest in a company, the first thing you will watch is its market value, then you will analyse different factors such as financial performance over the year, different financial ratios, market capitalization, dividend yield, and much more before selecting a company for your investment.

Let us highlight the three major reasons for understanding the financial health of a company.

It provides greater insights into the financial performance of a company over the year which includes profitability, financial stability, returns, and more. This is an important indicator for investors to help them assess the future growth and returns from the company.
A good overall financial health of a company represents significantly less risk. A thorough financial health analysis can help investors identify the potential risks and opportunities in the market.
If the company’s financial health is not good enough and its securities do not have high liquidity, then this helps investors make informed decisions.
Financial health analysis can help analyse and compare competitors in the same sector. It gives better insights on what we need to improve to become better than our rivals.

Also, Check Importance and Components of Financial Service Sector

4 Major Steps to Determine the Financial Health of a Company

There are various factors that can be used to determine the financial health of a company. However, we will uncover four major points to determine the financial health of a company.

1. Balance Sheet Analysis

The first step you could take is analyse the balance sheet of the company. The balance sheet shows important parameters that can be used to determine the financial health of a company i,e. Assets, liabilities, and equity.

Assets: An asset is a wealth or resource held by an individual, company, or government of the country.
Liabilities: Liabilities are the withstanding money borrowed from the external sources that must be paid back by the company.
Equity: An owner’s equity means the financial investment made by the owner to the business. It does not matter whether it is in the record or off record.

It is important that Assets must be equal to the sum of liabilities and the owner’s equity.

Assets = Liabilities + Equity (Owner)

When choosing a security you must ask yourself a certain question while analysing the balance statement.

Is the country in deep debt for a much longer period of time?
What is the liquidity of the business?
What is the percentage of tangible assets?
How long will the outstanding payment be repaid to its suppliers?

2. Cash Flow Statement Analysis

Analysing a cash flow statement is an important step to gaining knowledge of how the company is using its cash in the book of accounts. It mentions the source of cash flow and other details. This statement holds an important value as it shows key insights into cash transactions and their uses.

This information is used to analyse the liquidity of the company, source of cash, frequency of cash flows, and the overall cash flow changes over a financial year.

When choosing a statement analysis you must be aware of certain questions.

The liquidity state of the company
Source of cash (Withdrawals and credits)
Overall benefits (increased or decreased)

Also, Check What is Financial Statement Analysis?

3. Income Statement Analysis

The income statement is used to represent the revenue, expenses and profits made by the company over a quarter of a financial year. The income statement generally consists of the revenue earned minus the net money invested on goods, rent, electricity and other amenities.

All the expenses such as staff salaries, electricity, rent, and more is subtracted from the overall revenue made by the company. You will have to give away money as tax or interest. You will however, get the money through dividends or reinvested company.

Ask yourself some of these frequent questions while analysing income statements.

What is the revenue growth made by the company over a financial period?
The gross profit margin of the products being sold
Check whether the business can cover their liabilities from the returns it makes.

4. Financial Ratio analysis

This is one of the most important criteria for determining the financial health of a company. Financial statements represent various numerical values that are used to determine the overall financial health of a company.

These Financial ratios consist of various categories such as Profitability ratios, solvency ratios, efficiency ratios, and valuation ratios. Let us know some major financial ratios used frequently in financial statement analysis.

- Net Profit Margin: This is the measure of profit generated by a company after all expenses incurred to the revenue generated. The net profit margin can be expressed as the net profits to net sales made over a financial period.
- Coverage Ratio: This represents a company’s ability to meet its financial expenses such as debts, leases, and interest payments.
- Quick Ratio: This marks the ability of a company to meet its short-term obligations within a year using its high liquid assets.
- Debt to Equity Ratio: This ratio is used to evaluate the total liabilities to its shareholder’s equities.
- Return on Assets (ROA): The Return on Asset (ROA) is the ability of a company to use its assets as an investment to generate profit.
- Return on Equity (ROE): This marks the ability of a company to use its equities as a method to gain profit over investment.
- Total Asset Turnover: This measures the ability of a company to generate revenue from the total asset.
- Inventory Turnover: This measures the number of times a company finishes all its inventory.

Key Financial Ratios Used to Determine Financial Health

Let us check how the major financial categories such as liquidity ratios, profitability ratios, solvency ratios, and efficiency ratios, affect the financial health of a company.

Liquidity Ratio

The Liquidity ratio determines whether a company can pay its bills which include its liabilities, interest payments, and monthly expenses. The two important liquidity ratios are the current ratio and the quick ratio.

Solvency Ratio

This ratio measures the financial stability of a company to get high returns for future investments. It includes debt to equity ratios, interest coverage ratios, etc.

Profitability Ratio

The Profitability ratio is used to determine how easily a company can generate profit in a financial period. It includes net profit margin, return on equity, and gross profit margin.

Efficiency Ratio

This ratio is used to determine how well a company can use its resources to generate profit in return. It includes Asset Turnover Ratio, Inventory Turnover Ratio, etc.

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Financial Health FAQs

Q1. What is financial health?

Ans: The financial health of a company measures its suitability for the investors to invest their money. It is marked by a steady flow of income, good revenue generation, strong returns on investment, steady cash flow transactions, etc.

Q2. How to measure the financial health of a company?

Ans: Financial health of a company is measured by analysing the income statement, balance sheet, income statement, and financial ratios.

Q3. What are the four keys to financial health?

Ans: The four keys to financial health are spending, saving, borrowing, and planning. It is crucial to maintain a balance between all these parameters to gain stability in a business.

Q4. Are financial ratios used to determine the financial health of a company?

Ans: Financial health is used to determine the financial well being of a company. It measures different factors such as profitability, efficiency, solvency, and other ratios to determine the overall financial health of a company.