Management of many companies, SMEs and even some publicly listed companies, often associate the company’s bottom-line (net profits) with financial health. While this perception is not completely misaligned, financial health provides a more holistic overview of the company.
One story that adequately illustrates this notion is that of a relative of mine who was a regular Singapore Armed Forces (SAF) officer. Known for his speed and stamina, he was someone who jogged on a regular basis and often participated in marathons. One day, while taking his Individual Physical Proficiency Test (IPPT), he suddenly collapsed and passed away at the age of 49. It later became apparent that he had an unknown heart deficiency. Though he had great physical performance, his key asset – his heart, was not as strong as we perceived it to be.
Companies are similar. They may have strong financial performance (income statement), generating annual profits that are growing year on year, but have a weak financial position (balance sheet). Conversely, a company with strong financial position and weak financial performance also cannot be considered financially healthy.
In general, there are four aspects to financial health: liquidity, financial sustainability, efficiency of business activities and profitability. Therefore, a typical financial analysis would use ratios to evaluate both the financial position and financial performance with respect to these four aspects.
A company’s financial position or balance sheet is a snapshot of its assets and liabilities at a particular point in time. The assets and liabilities are then further classified as current (within a year) and non-current (more than a year).
A more significant emphasis is placed on the financial position than the financial performance in the evaluation of the company’s financial health. One reason is that the financial position is a result of the accumulation of the company’s financial performance to date. This accumulation portrays a more accurate picture of the company’s health as it smooths out fluctuations in the financial performance. For example, liabilities such as a five years loan taken from a bank during financial adversity would be reflected on five years of the financial position. While, retained earnings sums up all the fluctuations in the company’s earnings and losses through the years since incorporation. Therefore, it gives an indication of the company’s past records of long term sustainability.
The other reason is that a company’s operational sustainability depends not just purely on its financial performance, but also on the amount of outstanding liabilities. Of which the company’s ability to make the necessary repayments, when liabilities fall due, is highly dependent upon. The failure to meet the financial obligations could be as a result of the company taking on excessive liabilities when the financial performance is not able to support or purely as a result of cash flow problems. Both of which are recurring themes that are considered in the aspects of financial health.
Liquidity: Liquidity refers to the ability of the company to meet the financial obligations as they fall due without hurting the normal operations of the business. In other words, it measures the business’s ability to repay current liabilities with the conversion of current assets to cash. Therefore, the larger the cash reserves, the more liquid the company is said to be. However, on the flip side, large amounts of cash and cash equivalents are not advisable as cash in general are the least efficient means of generating returns for a company.
Financial Sustainability: Financial sustainability as compared to liquidity, is a long run concept. This measure is an indicator of the company’s ability to repay all of its financial obligations with the present assets. It can also indicate the ability of the company to sustain its operations in an event of a financial adversity, which might result in increment in debt or reduction in equity.
Efficiency of Business Activities: Evaluation of the efficiency of business activities gives a measure of how effectively the company utilise its resources to generate revenue. This is measured by inventory turnover days, receivables turnover days, payable turnover days amongst many others. In fact, this aspect is closely linked to the business’s cash flow. For example, a high receivables turnover days might mean that a significant proportion of the year’s revenue has yet to be realised in cash. Cash flow wise, giving customers generous credit terms might not necessarily be a problem if the company’s payment credit comparatively long. This aspect might not be as useful for companies that operate on cash basis.
Financial performance portrayed from the company income statement that measures the company’s profitability. It essentially gives an overarching summary of the company’s profit breakdown; from revenue, cost of goods sold to operating expenses. Financial performance covers the last aspect of financial health: profitability.
Profitability: As identified by many corporate management, the bottom line of the Income Statement (Net profit) is arguably the most important line item in the income statement to monitor. After all, profitability is the primary purpose of all businesses with exception to non-profit organisations. Profitability can be measured by gross margins and profit margins, for example. These two ratios can give an indication of which items are of significant cost to the business operations and possible inefficient usage of resources.
The financial ratios computed can differ greatly between industries and time periods. For example, a high debt to equity ratio maybe common for businesses in the financial industry or during times of financial crisis. Therefore, the analysis of the financial ratios must be benchmarked against the performance of fellow industry peers in the same time period. This would give a context to the ratios, such that the understanding of the company’s performance would be more accurate.
While all these aspects of financial health are important for every company, the relevance of aspects are highly dependent upon the business model of the firm. For example, a measure of inventory turnover would not be useful for a consulting firm that does not hold onto inventories. Nevertheless, it is important that all aspects are considered in tandem for the analysis to be comprehensive.