However, it is not that simple. Several factors must be considered to accurately evaluate a company’s financial health and sustainability. Financial health can be measured based on four key main criteria:
- Operating efficiency
Assessing the Company’s Liquidity
Liquidity is one of the factors in assessing a company’s financial health. Before a company can thrive long-term, it must sustain itself in the short-term. Liquidity is the cash or assets available that can be turned into cash to pay for short-term debt. Two metrics are commonly used to measure a company’s liquidity:
- Quick ratio
- Current ratio
Out of the two options, quick ratio (acid test) is the more precise option. It divides current assets by current liabilities. However, this excludes inventory from assets and also the current long-term debt. This provides a more realistic indication of a company’s ability to handle short-term obligations based on their available cash and assets. A quick ratio of lower than 1.0 is not a good indication. This means that the current liabilities are exceeding the company’s current assets.
Assessing the Company’s Profitability
The next area of assessment for a company’s financial health is based on profitability. The bottom line of a company’s financial health is a company’s net profitability. A company can survive for years without making any profit by surviving on the goodwill and trust of investors and creditors. However, this is not a viable long-term option.
A company must attain profitability and find a way to maintain it. The best way to gauge profitability is through net margin. This is the ratio of profit to total revenue. Net margin ratio is important because a simple dollar figure of profit is not enough to assess a company’s financial health. A larger net margin means a greater margin of financial safety. This also means a company is in good condition to commit more capital towards growth and expansion.
Assessing a Company’s Solvency
In relation to liquidity, solvency is another concept to see a company’s ability to meet debt obligation. A solvency ratio is used to calculate a company’s long-term debt in relation to its assets or equity.
Debt-to-equity (D/E) ratio is an indicator of a company’s long-term sustainability. The lower ratio means the company is financed more by shareholders rather than creditors. D/E ratio varies between industries. Regardless of the nature of an industry, a lower ratio is generally a good indication that the company is gaining more stability.
Assessing a Company’s Operating Efficiency
Operating efficiency is the key to a company’s financial health and success. As mentioned above, operating margins are the best indicator of its operating efficiency. It tells us how well the company manages cost control.
Good management is crucial to a company’s long-term sustainability. With it, a company can overcome a lot of problems and iron out minor or major issues.
This article was first published on 3E Accounting. Information is correct at the time of publication.