When you want to understand the true value of a company, you need to look to its financial position. Although this sounds difficult and complicated, it really isn’t; most companies openly list their financial accounts for public viewing.
Evaluating the financial situation of a company is quite like evaluating the financial situation of a private individual – total value of assets minus total value of liabilities – however, investors also need to consider the market value of a company in addition to the above.
There are several financial ratios which can be looked at to figure out a company’s financial health and suss out whether or not a company is likely to continue operating as a profitable and viable business.
Financial ratios look at and compare the various numbers found on a balance sheet and are more valuable than standalone numbers such as net profit, total liabilities or debt. Additionally, it is important to look at any trends associated with these financial ratios and see whether they are improving or declining over time.
Here are the ratios you need to look at when analysing a company’s finances –
1.Profitability
The bottom line is its net profitability. Although companies can survive, for many years in some cases, without being profitable, you can only operate for so long off of the back of creditors and investors. To survive in the long-term, a company must attain and maintain net profitability.
Measuring a company’s profitability is done by looking at its net margin – its ratio of profits to total revenues – which is much more reliable than looking at a simple figure for profitability. A company’s net profit may show as $15,000,000, but if the net margin is only 0.5% then even a marginal increase in operating costs or competition from other industry actors could push the company towards failure.
The larger a net margin, the healthier a company’s finances.
2. Liquidity
Liquidity refers to the amount of cash on-hand and the number of assets which can easily be converted to cash. Liquidity is used to assess how a company can manage any short-term debt it may run into. Before a company can prosper in the long-term, it must first survive the short-term.
To measure liquidity, the “acid test” is used. The acid test divides current assets by current liabilities to provide a reliable indication of a company’s inherent ability to manage their short-term debt with cash and assets which they have available on-hand. The acid test excludes inventory and long-term debt to provide this indicator. This is known as the “quick ratio” and anything below 1.0 can be a signal of danger.
3. Solvency
Solvency measures a company’s ability to settle its long-term debt obligations on an ongoing basis, not merely over the short-term. A solvency ratio is used to measure this metric and it is done by calculating long-term debt relative to its equity and assets.
Using the debt-to-equity ratio (D:E), a solid figure is provided which measures debt against shareholder equity, and it is also a strong indicator of investor confidence. A low D:E ratio is an indicator that a company is relying on finance more from shareholders rather than creditors who do not charge interest.
When measuring solvency, look out for a downward trend over the long-term for a D:E ratio – the lower this ratio the more solid a company’s finances.
4. Operating Efficiency
An operating margin is the metric used to measure operating efficiency, something which is crucial for financial success. Operating efficiency shows a company’s operational profit margin after deducting variable costs and shows how well (or how badly) a company’s management controls costs.
Essentially, operating efficiency demonstrates how well (or how badly) a company is managed and, since good management is crucial for success, it is an important way to gauge how well a company’s finances are going to perform in future.
It is important to figure out how well a company is performing financially if you are considering an investment. Together, these four metrics paint a clear picture of how well a company is currently performing financially, and how well it is likely to perform in the future. Using all this data together can help you make important decisions with regard to investments.
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