Do you worry about the company’s financial stability? In today’s dynamic landscape, enterprises’ success and failure depend on finances. Unavailability of cash in the business can lead to a liquidity crisis, making it impossible to incur day-to-day expenses. On the other hand, effective financial management can open doors to growth opportunities. To understand where your company stands financially, keep a close eye on its financial performance.
You can look into a company’s financial statements, including income statements and balance sheets, to determine profitability. The overview of revenue, costs, and expenses can give business owners an idea of how business is performing. Likewise, look into the cash flow statement to see if inflows are enough to bear the routine business costs. Having stable inflows and outflows ensures the business is handling its finances adequately.
However, if you don’t know much about finances, let us show you the ropes. Here we are highlighting five ways to evaluate a company’s financial position.
Table of Contents
1. Assess Profitability
Undeniably, profitability is the primary indicator of financial performance. Stakeholders, investors, and everyone want to know how much the business is making. Therefore, entrepreneurs should assess business’s profitability. You can look into annual reports and income statements to catch sight of profit after taxation. Otherwise, you can leverage financial metrics like net or gross profit margin to evaluate profitability.
As a business owner, you should also measure the return on the company’s assets. After all, one must know how profitable the operations are relative to its assets. In case you don’t have a knack for numbers and finances, consider learning the basics. It doesn’t matter if you have an accounts-related background or not; you can continue your education in this field. You can earn an online masters in accounting for non accounting majors and familiarize yourself with the financial world. You will learn how to disaggregate return and profitability measures into impactful factors, improving performance.
2. Monitor Debt
Entrepreneurs try to keep their hands off debt, but at some point, they acquire loans and credit to raise capital. Unfortunately, debt is always risky. In addition to putting pressure on the company’s financial position, it consumes a significant chunk of profits. Hence, while analyzing the financial situation, don’t forget to monitor the debt. You can calculate debt as a percentage of equity or assets to assess a company’s dependency on credit.
At the same time, you have to ensure the company uses long-term loans to support the business. You can oversee the projects or equipment financed through debt and evaluate the returns generated on them. Besides this, implement measures to keep the debt as low as possible. The financial institutes consider lower debt a good indicator of your ability to repay loans.
3. Watch Out for Liquidity Problems
The term ‘liquidity’ refers to how quickly a business can convert its assets into cash. In case the enterprise has illiquid assets, it can lead to multiple insolvency issues. Hence, watch out for liquidity problems in your financial analysis. Firstly, assess your company’s ability to generate cash and meet short-term financial obligations. It means you should be able to pay accruals and creditors with available current assets.
Secondly, compare your current liabilities with assets. It will determine whether you have sufficient cash available to support immediate demands. If the creditors’ payments exceed accounts receivables, adjust the credit terms with suppliers. It will make sure you are not overutilizing the capital, closing doors for potential liquidity problems.
4. Evaluate Inventory
Often, entrepreneurs accumulate a lot of inventory to avoid shortages. It might look like an intelligent approach, but it ties up a lot of cash. Having $15,000 of stock means you could have used $15,000 for business operations. Therefore, you should continually evaluate inventory and order enough products to meet the demand. Alongside closing doors for cash flow problems, low stock levels will help you save up on warehousing costs.
Additionally, you can also evaluate inventory as a measure of a company’s financial performance. You can calculate how many times the company has sold and bought inventory in a given period. Likewise, you can divide it by the number of days in that period to see how long it takes to sell the inventory on hand. The quicker you sell the stock, the higher will be the company’s revenue. Understanding these inventory changes can help businesses make better decisions regarding manufacturing, pricing, and purchasing new stock.
5. Conduct a Ratio Analysis
Financial ratios make comparisons between different aspects of a business’s performance. It checks whether you have stockpiled inventory, accumulated debt, or offered fair dividends. In short, they reveal crucial financial information that can help entrepreneurs make more apt business decisions. Also, positive ratios can gain investor’s trust in the company, opening doors to growth. Here are three ratios you should calculate for a detailed analysis.
- Return on Equity: It measures business performance against the initial amount of capital invested into the business. It tells shareholders how much you are earning for each of the dollar invested. You can calculate it by dividing profit after tax with total equity.
- Total Asset Turnover: Using this ratio, you can assess how efficiently the company generates revenue from its asset. The higher the turnover, the higher will be profitability.
- Market-to-book Multiple: It compares the share’s book value with market value to determine whether your stock is over or underpriced. It is a crucial indicator for investors as low market-to-book value shows the company is performing well.
Final Thoughts
Understanding the company’s financial health is critical for every business owner. You can analyze the information in financial statements and use those insights to improve performance. Perhaps, you can increase profitability by decreasing costs or evaluate inventory to grow turnover. Likewise, you can use financial metrics to track a company’s progress. In addition to ensuring effective financial management, evaluating financial situations can help you make data-driven decisions.