How Can You Measure The Financial Health of Your Business

Running a business can be tricky at times. One needs to constantly monitor the finances of one’s business for measuring the financial health of a business. Any negligence may put the company into losses. If you are an investor, then your foremost task before investing is analyzing the company’s financial health.

A business may incur losses in the short term, as is the case with most companies and start-ups today, which use the deep-discount model. However, in the long run, a company has to become profitable at any cost to offer returns to investors as no company can afford haywire cash burns.

One may wonder, how can I know the financial health of my business? The need to consider financial health especially arises when a person needs business loans such as MSME loans for new business. This involves a series of careful considerations and analysis of various factors. The most reliable tool to analyze the financial health of any business is its financial statements. Financial statements are like a summary of all the operations and outcomes of every decision that has been taken over a period of time. They are particularly useful for availing business loans, whether MSME business loans or term loans for business. Depending on the company’s size, its constitution, and the applicable laws, financial statements are prepared annually, half-yearly, and even quarterly.

Components of the financial statements of a business comprise the following:

Balance Sheet

Simply put, a balance sheet is all about what a company “owns” and “owes.” It is a part of financial statements that comprises three components, viz. assets, liabilities, and equity (also known as shareholders’ funds).

To sum up:

Assets = Liabilities + Equity

The balance sheet indicates the position of a company as on a particular date, which is usually the quarter ending, half-year ending, or the financial year-end. Most small- and medium-scale businesses prepare a single balance sheet annually as of March 31, that is, the financial year-end.

One may determine the scale and size of a business by just studying a balance sheet. As a business grows, its profits increase, which the company then invests to increase its assets. A company may also leverage its position by borrowing debt from lenders and financial institutions. All these assets and borrowings form part of the balance sheet. Moreover, whether the business risk is on secured creditors (banks, NBFCs, financial institutions, etc.) or the shareholders can be determined through the balance sheet. Loans for new business are also provided after considering the balance sheet.

Income Statement

An income statement provides the profitability and revenue details. It shows net profits or losses, gross profits or losses, turnover, expenses associated with the business, other incomes, and extraordinary gains accrued to the company.

It shows the financial performance of any business over a period of time, and like a balance sheet, it can be prepared on a quarterly, half-yearly, or annual basis.

For analyzing the income statement, one should consider the following points:

• Do the turnover or gross receipts show an increasing trend year on year?
• Is the gross profit ratio maintained consistently? If the gross profit ratio is decreasing, then there might be a possibility that the company is either selling its products below market prices or there is an increase in purchase and production costs, which is a negative indicator.
• Has the company accrued any extraordinary gains during the period?
• Is the company earning enough to fulfill its debt commitments in the form of interest and principal repayment?
• What are the earnings per share (EPS) of the company?

These questions can tell a lot about the company.

Cash Flow Statement

The cash flow statement is a part of financial statements that shows how the company operations and changes in the balance sheet and income statement affect the cash and cash equivalents of a company. As stated, it is usually prepared by the companies and corporations as a part of financial statements.

Cash flow statements bifurcate the entire transactions of the company into three different categories:

Operating Activities

This includes the transactions of the company that form a part of the day-to-day operations. It considers the revenue, expenses, profitability, and changes in working capital to determine their effect on cash and cash equivalents.

Investing Activities

This includes changes in the investments done by the company to determine their effect on cash and cash equivalents. Investments include fixed assets of the company as well.

Financing Activities

This indicates the effect of financing transactions of the company on cash and cash equivalents. Amount raised as capital from shareholders, the redemption of shares, borrowings from lenders, repayment of loans, etc., will fall under this category. In short, how a company raises funds and how it utilizes those funds will fall here.

Net cash flows from these three categories are added and adjusted from the opening balance of cash and cash equivalents to arrive at the closing balance.

Cash flow statements can show the reasons behind the profits and losses of the companies. If cash flow from operations is negative, then there is a high probability that the company is incurring losses.

The above statements are primary business loan requirements, without which business loans are not sanctioned by financial institutions.

Ratio Analysis

Ratio analysis is the most important part of financial statement analysis. The financial health of a business cannot be determined by referring to the above-mentioned financial statements on a standalone basis. All the elements forming part of financial statements, viz. turnover, profits, assets, liabilities, etc., interact with each other and should be analyzed on a relative basis as they usually form part of business loan eligibility criteria. Some of the most important ratios that can give a clear picture of any business include:

Conclusion

The above analysis may be performed to know the financial health of any business, and one does not need high technical knowledge to understand the financial statements. Maintaining the financial health of the business is important for both the owners and the investors, and it is up to the owners to protect their business from taking a downside turn.

Documents required for business loans are usually the above-mentioned financial statements, and after receiving the same, banks conduct ratio analysis to know the financial health of the business.

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