While you know that the financial health of your business is important, it’s actually a pretty difficult topic to discuss. Business financial health involves all sorts of accounting and financial terms, which don’t always roll off the tips of everyone’s tongues. But, more than that, most business simply have no idea where to start.
Rather than waiting until you have a cash flow crisis, using insights and analysis can help you better understand the financial health of your business.
What is business financial health and how do you measure it?
Like 64.4% of businesses, you use accounting software to help track financial health by systematically recording your income and expenses and other crucial data. In turn, this information becomes the foundation for key financial statements, like your balance sheet, profit and loss statement and cash flow statement.
Why should you routinely review your business’ financial statements?
According to Mike Kappel, CEO of Patriot Software, the best way to measure success and overall financial health is to look at your financial statements.
“Measuring business performance means checking out the money flow (cash flow) of your business. If you want to see how profitable your business is, check out the financial statements.”
The challenge with financial statements and financial health
While most business owners recognize the significance of reviewing their financials, business coach Adam Sonnhalter notes that he and his business partner have seen:
“Grown, husky men cry when we ask them to tell us what they see on their financial statements and tell us what the numbers mean.”
The difference between financial statements and financial reports
In truth, the terms are often used interchangeably. However, in the world of business accounting and determining financial health, there are inferred differences.
- Financial statements are often considered internal documents intended for stakeholders within the business itself.
- Building upon, summarizing and visualizing the data from within the business statements, a financial report (business assessment) is most often used to quantify or substantiate the business’ performers to external stakeholders, like lenders.
Financial assessments and analysis, like cash flow forecasting, bridge the gap between having the numbers in hand and actually having a handle on what they really mean. When financial insights are presented in a clear, concise report, it’s easier for business owners to see what these numbers are telling them about the financial health of their company.
Although in a textbook sense, reports have traditionally been used to provide information to third-parties, the financial analysis and insights within the reports are also highly valuable to the businesses themselves. After all, you can’t make informed decisions if you don’t have the right information in the first place.
Putting all the pieces together for better financial health
In order to get the information you need to measure your company’s financial health, you need to know what you’re looking for, where to find it and what it all means.
The four main indicators of a business’ financial health
In an article written for Investopedia, contributor J.B. Maverick writes that liquidity, solvency, profitability and operating efficiencies are the four main areas that should be examined to determine a business’ overall and long-term financial health.
- Liquidity — The amount of cash or assets easily convertible into cash that a company has available in order to meet short-term obligations.
- Solvency — A company’s ability to meet long-term payment responsibilities.
- Operating efficiency — A measure of how much profit the company makes with each transaction, once the cost of production or providing the services is accounted for.
- Profitability — Put simply, this is whether or not the company is making money.
Your financial statements — what they are and what they tell you
There are three financial statements that a business should produce and review on a regular basis for the data needed to measure financial health and inform better decision making in relation to your financial health.
A balance sheet (statement of financial worth or statement of net worth) compares a company’s assets to its debts detailing what it owns versus what it owes. Assets are listed in order of liquidity (how quickly they can be converted to cash) while liabilities are listed in the order in which they’ll be paid.
A balance sheet is often described as a “snapshot” of one particular point in time in a company’s financial health. The date at the top of the balance sheet tells you the period of time (year, quarter or month) for which the information applies.
A business’ working capital ratio (assets divided by liabilities) is derived from the information provided in the balance sheet.
While a balance sheet shows how well a business is managing its liabilities, a profit and loss statement (P&L statement, income statement or statement of operations) tracks revenues, costs and expenses over a quarter or fiscal year, providing measures of profitability.
Answering the question, “Is this business profitable?” — a P&L statement starts with top-line revenue items from which the costs of doing business, such as costs of goods and services (COGS), taxes and other operating expenses are deducted. The resulting amount is the famous “bottom line.”
Gross profit margin (gross profit divided by revenues), operating profit margin (operating earnings divided by revenue), net profit margin (net profit divided by revenue) and operating ratio (operating expenses divided by net sales) are generated from a business’ P&L statement.
A cash flow statement (statement of cash flow) is the third document in this trifecta. By comparing metrics from a business’ operations, purchasing and borrowing activities (merging the balance sheet and P&L statement) it shows where a company’s money comes from and where it’s going (or has gone).
A company’s cash flow ratio (operational cash flow or free cash flow) represented as the operating cash flow divided by current liabilities is considered a measure of operational efficiency and solvency.
The difference between cash flow and profitability
Cash flow and profit are not the same things, especially in relation to financial health. Unlike a balance sheet or P&L statement which are static — a cash flow statement shows movement by accounting for funds coming in or out of the business as credit, such as paid or unpaid invoices.
It’s entirely possible for a profitable business to have limited cash flow, especially if a business’ inventory, accounts receivable or fixed assets are growing rapidly. Unlike Fortune 500 companies with large cash reserves, independently owned businesses are more likely to reinvest their funds into their business — as a result, they are also more likely to be cash poor.
What financial reporting can tell you about your business’s financial health
A financial report takes the information in a business’ financial statements and translates them into analysis and insights. A cash flow forecast, like the one generated by PayPie, puts your cash flow, debts, assets and other factors related to financial health front and center.
The assessments we generate are a visual way to help you understand the metrics that matter most to your business’ financial health. In your report (pictured earlier in this post), you’ll find charts, graphs and other breakdowns that help give you the big picture of what you need to know in order to make the right decisions for your business.
How does it work? Simply sign up for PayPie, connect your accounting software to use your current financial information and you’re ready to go. You may also run daily and monthly cash flow forecasts to help you monitor cash flow.
This article is intended to be informational only and does not replace the expertise that comes from working with an accountant, bookkeeper or financial professional.
Stock photo from Pexels.