How to run a financial health check for your business

Keeping an accurate balance sheet and income statement is important for any business. But what do you do with your financial documents once they’re in your hands? Analysing your financial data is just as important as collecting it.

You should run a business financial health check periodically. Once a year is a sensible minimum; check quarterly, or even monthly, if you are growing quickly or cash is tight.

Not sure where to begin? Let’s talk about the steps to taking your financial reporting and turning it into meaningful insights about the direction of your business.

Steps to determine your business’s financial health

A financial health check helps you determine if your business is meeting its financial performance expectations. To do the job thoroughly, you need to analyse several reports and a handful of financial ratios. You can’t simply look at your bank balance to tell if you’re doing well.

To run a complete financial health check for a business, you should look at your balance sheet and income statement, analyse your current cash flow, and look at common financial ratios related to your debt and equity.

Analyse your balance sheet

A balance sheet is an important bookkeeping document. This report shows your business’s position at a single date, including its liquidity (could you pay the debts due in the next 12 months?). It also shows your working capital: current assets minus current liabilities, the buffer that funds day-to-day operations.

Your business’s balance sheet lists assets on one side and liabilities and owners’ equity on the other side. In short: Assets = Liabilities + Equity. The two sides of a balance sheet must balance. A healthy business usually sees its equity (net assets) hold steady or grow over time.

A balance sheet with errors, or a series of balance sheets in which liabilities grow faster than assets, may be red flags about your financial health. If liabilities exceed assets, or you cannot pay debts as they fall due, get professional advice promptly.

Analyse your income statement

An income statement covers a period rather than a single date. It shows your income and expenses for that period, often a month, quarter or financial year.

This report reveals whether you have experienced profit or loss during the time period covered in the document. In fact, the report is often called a profit and loss statement. Your gross profit is determined by taking your revenue and subtracting the cost of goods sold.

If revenue and profit trend upward, you are likely in good shape. If expenses keep growing faster than revenue, that is a warning sign. Profit is not cash, so read the income statement alongside the cash flow statement.

Analyse your cash flow statement

A cash flow statement measures the cash coming in and going out of your business. It records cash when it is received or paid, not when revenue is earned, and answers the question: where is our money going?

You can use a cash flow statement to identify seasonal trends. For instance, you may notice that costs are higher during certain periods of time. The sale of your goods and services may also wax and wane over the course of a year. Comparing cash flow statements can help you identify when to buy materials and when to market certain products.

There are several main components that should go into your cash flow analysis:

1. Opening balance. How much cash and cash equivalent do you have on hand at the start of the analysed period?
2. Cash incoming. How much money came in from sales, grants, tax refunds, and other sources? You should calculate your total cash incoming.
3. Cash outgoing. What did you spend on purchases, rents, marketing, payroll, and other expenditures? Calculate your total outgoing cash.
4. Closing balance. Opening balance plus cash incoming minus cash outgoing. Is the net movement for the period positive or negative, and is the closing balance enough to cover the next few months of commitments?

Look at financial ratios

There are several key ratios often used during a business financial health check.

• Profit margins: Gross profit margin is gross profit (revenue minus cost of sales) divided by revenue. Net profit margin is net profit (after all expenses) divided by revenue. Both are usually shown as percentages for the same period.
• Coverage ratio: Broadly, a coverage ratio measures whether your business can meet its debt costs. The most common is the interest coverage ratio (also called times interest earned): earnings before interest and tax (EBIT) divided by interest expense for the same period. The higher the ratio, the more comfortably you can pay interest; lenders often set a minimum in loan covenants.
• Current ratio: This tells you whether you can pay the debts due in the next 12 months. Divide total current assets by total current liabilities. Below 1:1 means current debts exceed current assets and needs attention; what counts as comfortable above that depends on your industry and how quickly your debtors pay.
• Debt-to-equity ratio: Total liabilities (some analysts use interest-bearing debt only) divided by total equity. It shows how much of the business is funded by borrowing compared with the owners’ stake. A higher ratio means more financial risk, though some borrowing to fund growth is normal.
• Return on equity (ROE): This formula measures how efficient you are at generating profits. ROE is net profit for the year divided by average equity over the year.
• Return on assets (ROA): Similarly, ROA shows how well you use assets to create profit. Net profit is divided by total (or average) assets.

Need help determining your business’s financial health?

A self-check like this is a useful start, but it is easy to make honest mistakes, especially if the books aren’t up to date. As income streams evolve and the expenses of your business change, it can be hard to make heads or tails of whether you’re on the right track.

Visory runs bookkeeping, payroll, accounts payable and receivable for growing businesses, and Visory Insights turns those numbers into a plain-English monthly read with your Business Performance Partner. If you’d like a second opinion, a senior member of the Visory team will analyse your financials for you. Get your free financial health check. If you are in Queensland, Visory’s bookkeepers in Brisbane work to Queensland payroll tax, long service leave and show holiday rules.