Business financial strength is of vital concern to business owners, corporate managers, investors and lenders. Efficiency and cost control are keys to success in many companies throughout the United States and the world. There are many ways to measure the financial strength of a company. The key is identifying the right measurement tools for the company, taking into consideration: the industry, stage of life cycle, time horizon, business objectives, and economic conditions. It is also important to understand your company’s financial performance relative to its industry as all companies compete in the marketplace on a local, regional, national or international level. In general, the financial strength of a company can be measured in three key areas: profitability, liquidity and solvency.
Profitability measures a company’s ability to generate profit or positive net income for a given level of sales or investment. If a company is not profitable it eventually becomes insolvent and may require reorganization or liquidation. The greater a company’s ratio of net income to sales or investment, the stronger it is. One example of a financial ratio that measures a firm’s profitability is the profit margin ratio which measures the amount of net income a company generates relative to the amount of sales it generates. Another example of a financial ratio that measures profitability is return on investment or ‘ROI’ which measures a firm’s profitability relative to the amount of capital invested to generate that profitability.
Liquidity measures a company’s ability to utilize its resources available to meet its short term commitments. If a company cannot meet its short term commitments on time, it eventually becomes insolvent and may require reorganization or liquidation. The greater the ratio of resources available to short term commitments, the stronger the company. One example of a financial ratio that measures liquidity is the current ratio. The current ratio measures the size of a company’s current assets (i.e. assets that can be converted into cash in less than 12 months) to the size of its current liabilities (debts that have to be paid in less than 12 months). Other liquidity ratios measure the company’s working capital required for the level of sales generated. One example of a financial ratio that measures this characteristic is the accounts receivable turnover ratio, which measures the size of sales relative to the size of average accounts receivable.
Solvency measures a company’s ability to meet its interest and principal payments on long term debt and similar obligations as they come due. If a company cannot make payments on time, it becomes insolvent and may require reorganization or liquidation. One example of a financial ratio which measures a firm’s long term solvency is the debt ratio. This ratio measures the amount of long term debt financing as a proportion of its overall capital structure. In this case the greater the ratio of long term debt to overall capital the great the solvency risk and the weaker the company.
Key Drivers of Your Business
As we mentioned above, there are many ways to measure the financial strength of a company. The financial metrics mentioned above are a few of the key metrics used to measure performance. The key is to identify the right metrics for your business. One way to identify these metrics is to identify the key drivers of your business and then identify those financial metrics that will help you track these key drivers. For example, in one industry one of the key drivers may be sales growth and profitability, while for another industry the key drivers might be cost control and liquidity. The former may want to utilize more profitability metrics to track performance, while the latter may want to utilize more liquidity metrics to track performance.
Keep It In Context
It’s important to measure financial performance in some context. Understand how your financial performance compares to your industry average and best in class. Are you doing better or worse you’re your competition? Understand how your financial performance compares to historical trends. Is your company gaining financial strength or losing financial strength over time? Understand how your financial performance compares to your long range plan. Is your company on-track to achieving its long term financial goals or do you need to make some course corrections to get back on track? By making these comparisons you will clearly understand how your company is performing in the marketplace. You will also be better able to identify those changes you need to make to be successful.
In addition to increased profitability, liquidity and solvency, companies that put programs in place to aggressively measure and improve financial strength can benefit tremendously. These benefits can include greater access to debt and equity capital, lower cost of capital, increased growth, increased market share, increased flexibility and ability to respond faster to changes in the market.
Business owners can no longer afford to manage by gut feel. Business owners need to monitor the financial strength of their companies relative to their marketplace on an ongoing basis. Placing increased focus on the key areas of business profitability, liquidity and solvency can really have a positive impact on your financial strength and bottom line!
Note: The information contained in this material represents a general overview of accounting and should not be relied upon without an independent, professional analysis of how any of these provisions apply to a specific situation.