What Is Financial Health and Why Is It Important to Your Business?

January 14, 2022

Financial health is somewhat a common buzzword nowadays. Most people have become alert to the importance of financial health. Just as much as every individual is supposed to have their finances in order, every business must also regulate their financial well-being. If finances are not regulated well, it’s easy to descend to a place of failure, and business failure isn’t fun. Failure for a business may result in closure or liquidation. Therefore, for your business to survive in the long run, you need to keep it financially healthy.

Different businesses will have slightly different goals, and consequently, their operations will be different. The metrics needed to assess financial health will differ from industry to industry.

That being said, here’s a short guide on how financial health affects business and why it is important:

 

 

1. What Is Financial Health?

 

Financial health refers to the financial well-being of a business. Everybody knows that the end goal of business is to make profits. Without profit, a business cannot survive, so businesses are a vehicle for cash generation, in a sense. There’s usually a system in place that facilitates the smooth running of a business’s operations.

Financial health considers the volumes of money coming in versus money going out. It also considers other aspects such as debts, creditors, and expenses. Ideally, a business should keep its liabilities in check. It should also ensure the proper management of expenses to avoid loss. If the business is managed poorly for a long time, profits will deteriorate. Therefore, every business should manage finances to optimize profitability. For more information and tips about business financial health, visit https://www.michigancfo.com/fractional-cfo.

Furthermore, since businesses are technically a going concern, they will incur operational costs. But the money that goes in should outweigh the money that goes out.

 

2. Why Is It Important?

 

The main reason why financial health is important is that it affects a business’s capacity to generate profits and grow. A business needs to be profitable to survive in the long run. An unprofitable business is not sustainable. Also, since finances are a big part of business, managing them is paramount to success. You need to be financially stable if you wish to engage in business with the world. Mind you, credit ratings are very important. They can be the difference between receiving the loan or being rejected. So, if you have massive debt in your name, it will be hard to secure loan financing or even investor finance because of a poor credit rating. Nobody wants to invest in a risky business. Even if you do secure a loan, you’re likely to pay higher interest rates because of your risk profile.

Therefore, financially healthy businesses are attractive to lenders such as banks. The financial health of the business positively contributes to its viability too.

Also, you need to keep track of your credit before it’s too late. The consequences of poor financial management could slow you down. It’s better to keep track of your business’s financial performance diligently.

 

3. How Is It Determined?

 

Businesses use financial ratios to measure the financial health of their business. Big or small, finance is perhaps the most measurable aspect of a business. Ratios are very informative and aid in financial planning and decision-making. Every ratio reveals the status of your business’s financial health, so you have to understand what the ratios mean to derive utility from them.

But here’s an important point to note: businesses operate within different industries and not all industries prioritize the same key performance indicators or financial metrics. Therefore, when utilizing ratios, you need to stick to one industry. Here is a brief outline of the most common ratios that are used in business:

 

 

a. Debt-Equity Ratio

 

Debt isn’t always a bad thing. Companies can leverage debt to bring a greater return for their shareholders. When a business can flip debt into earnings for its shareholders, it creates value from borrowing. The debt-to-equity ratio calculates total liabilities divided by total assets. A ratio of less than one signifies that the company can cover its debts. If it’s above one, the company is highly leveraged.

 

b. Profitability Ratios

 

The net profit margin is perhaps the ratio that investors consider most. It measures the efficiency with which a business generates profits. Higher margins or good bottom lines are positive. Having a low margin doesn’t necessarily equate to poor performance. For example, companies like Tesla have low-profit margins, yet they are still high-value businesses. Nonetheless, the net profit margin is still is a useful indicator to use in assessing the financial health of a business. If you’re an investor, you want to put your money where the profits are likely to come.

 

c. Liquidity Ratios

 

These ratios measure a business’s accessibility to cash. This is especially important in the event of a crisis. It also measures how quickly a company can convert its assets into cash on demand. Therefore, a liquid business is preferable. It’s also more likely to survive in a time of crisis than an illiquid one.

The most common liquidity ratios are the cash ratio, quick ratio, and acid test ratio. These ratios are similar in that they all try to measure how much a company will pay off its current liabilities. The higher the ratio, the better.

 

4. How Can You Improve Your Business’s Financial Health?

 

Benchmarking – It’s always good to keep up with what the competition. Businesses can use the ratios to check whether they’re falling behind. If so, they have to rectify some things to get back on track.

Budgeting – A budget is a useful tool in terms of decision-making. It has to be realistic Also given the fact that the business landscape always changes. You need to have a flexible budget in place.

Automation – Try to automate as many parts of the business as possible. Automation offers the opportunity to optimize business processes and accessibility. Automation is the key to unlocking efficiency in your business.

Pay your debts on time – If you can, pay off your debts promptly. You don’t want your credit score to be impacted negatively due to your inability to pay off debts on time.

Asset disposal  – This can be an option if you have some assets that are no longer in use or are way past their useful life. You can dispose of these assets to improve your business’s liquidity.

 

Conclusion

 

Just as much as individual financial health is important, so is a business’s financial health. Financial health affects the ease with which it can conduct business. It also affects its credit rating. Poor credit ratings are bad news for big corporations, but more so for startups and smaller enterprises. Therefore, in the interest of running a business as a viable going concern, it’s best to have a healthy financial record. When dealing with investors and lenders, you need it to work in your favor.

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