Keeping track of your company’s financial health is crucial because it’s the only way to measure how your business is doing financially.
Doing that can often be tricky:
- You can easily omit many of the essential metrics and ratios
- Your employees can make mistakes that will create inaccurate numbers that don't show the actual state of the company’s finances
Most importantly, if you don’t track the finances properly, the cost will end up being great, especially for growth companies. Missing out on your estimated growth due to a few omissions or errors can lead you to fall behind your competition.
With that in mind, we wanted to give you a detailed report on what you need to do to keep track of your financial health in the right way. Let’s take a look at what needs to be done:
Following the correct ratios
The key to accurately tracking your company's financial health is to follow the right financial ratios. Many investors and owners believe that they can find the golden number – a single ratio that will portray the full picture of their company's financial wellbeing. However, it's not that simple. Having a single metric showing your financial health is nothing more than a fantasy.
The good thing is that you can get close to this fantasy by following a few key ratios. You can also follow standalone numbers like:
- Total debt
- Cash flow
- Net profit
However, these numbers don’t give a complete picture and are less meaningful than financial ratios.
Ratios can connect a lot of different numbers and compare them. They can also paint a great picture of financial health when you follow their change over time.
The key factor – liquidity
One of the most important ratios you need to keep track of is liquidity. It measures the amount of cash and easily converted assets you have for covering debt. However, more importantly, liquidity gives a broad overview of your financial health, as well.
Two liquidity ratios exist which you can never omit:
- The current ratio (working capital ratio) – shows how able your company is to generate cash for fulfilling short-term obligations. It's easily calculated by dividing the existing assets of your business with the current liabilities it has.
- Quick ratio (acid test) – shows how able your business is to quickly access cash to support abrupt demands. It’s calculated in the same way as the current ratio, but it excludes inventory from the assets and the current portion of debts from liabilities.
The bigger these ratios are, the better your company will be to meet obligations and take advantage of unexpected opportunities that demand a cash injection. For these reasons, liquidity is one of the best ratios for tracking the wellbeing of your company's finances.
One of the keys to a company's financial success is undoubtedly its efficiency, or more precisely, its operating efficiency. The operating margin measures the efficiency, and it indicates:
- The company's underlying operating profit margin
- An indication of how well managed the control costs of the company are
If you control the wellbeing of your company’s management, you can also determine its financial health and sustainability.
Other efficiency ratios can also be useful. They are usually measured over a three to five year period and can give you additional, essential insights into things like:
- Operational results
- Cash flow
Solvency a company's ability to meet debt obligations on an ongoing basis and not just in the short term. For that reason, it's another excellent way of tracking your company's financial health.
The ratio that needs to be followed is the debt-to-equity ratio or the D/E ratio. It shows your company’s long-term sustainability as it measures the debt you have against your equity.
The lower this ratio, the more trustworthy your company is, and investors and others can have more confidence in it. When the rate is low, it's a good indication that the company is financed by shareholders and not by creditors. That's naturally a good image because shareholders don't charge interest like creditors.
You can probably assume that profitability ratios are one of the most important metrics your company needs to follow. They are not only vital for the evaluation of the financial viability of a company, but also for comparing your firm to the competitors. Through profitability ratios, you can also follow the development trends of your company over a few years or more.
Your company should follow several profitability ratios:
- Net margin – the rate of profits compared to total revenues. The larger the number, the higher the margin of financial safety. In turn, higher financial safety shows that the company has room for expansion and growth.
- Operating profit margin – earnings before interest and taxes. It shows your ability for expansion while having debt and other investments.
- Return on assets and return on equity – the first shows how the company is utilizing the various resources it has. The latter shows how well the company is doing when compared to the investments made by the shareholders.
The Bottom Line
These ratios are the best indicators of your company's financial health. They enable you to track and even improve your finances over time. Naturally, they differ from industry to industry. Each industry needs different figures within ratios, and it's vital to adjust your expectations from them according to the standards your industry has.
When you require help with tracking your financial health, it’s best to turn to third-party finance and accounting services instead of putting it all on the shoulders of your CFO. By doing that, they will have more time to focus on ensuring the right strategies are implemented that lead to sustained growth and expansion.
Whatever you decide to do, one thing remains clear – it’s vital to track the right ratios and numbers to ensure your company’s financial health is stable.