Which ratio is used to determine a companys ability to meet its debt obligations?

Knowing how to determine the financial health of a company is a vital business skill.

If you’re an entrepreneur or business owner, you need to know how your company is performing for several reasons. Having a clear picture of financial health can help you make more informed decisions about your organization’s direction and how resources are allocated. Similarly, if you plan to attract investors or seek financing, you need to speak to your business’s financial health.

If you’re a manager, you need to understand the financial health of your organization so you can better direct your team. Without that understanding, it can be all too easy to chase projects with no clearly defined return on investment or initiatives that don’t contribute to the wellbeing of your company.

Knowledge of your company’s financial health can also benefit you as an employee. By understanding when your employer is doing well, you can ask for a promotion or raise at the right time. When you recognize your employer is struggling, you can take steps to either demonstrate your worth or seek employment elsewhere.

While there are many metrics you can use to evaluate financial health, one of the surest means is through financial statement analysis. Here’s a look at the different types of analyses you can conduct to gain a better understanding of your company’s financial health.

How to Determine the Financial Health of a Company

1. Analyze the Balance Sheet

The balance sheet is a statement that shows a company’s financial position at a specific point in time. It provides a snapshot of its assets, liabilities, and owners’ equity.

Assets are what a company uses to operate its business. Liabilities refer to money that’s borrowed from other sources and needs to be repaid by the company. Owners’ equity represents the financing that owners, whether private or public, put into the business. It’s important to note that assets should always be equal to the sum of liabilities and owners’ equity. This relationship is the basis of the accounting equation: Assets = Liabilities + Owners’ Equity

Both assets and liabilities are displayed as either current or non-current on the balance sheet, indicating whether they’re short- or long-term. Short-term assets are those expected to be converted to cash within a year, while long-term assets are those not expected to be converted into cash within a year. Short-term liabilities, on the other hand, are those which are due within a year; long-term liabilities are not due within a year.

The balance sheet provides information on a company’s financial health by helping you analyze the following:

• How much debt the company has relative to equity
• How liquid the business is in the short term (less than one year)
• What percentage of assets are tangible and what percentage comes from financial transactions
• How long it takes to receive outstanding payments from customers and repay suppliers
• How long it takes to sell inventory the business keeps on hand

2. Analyze the Income Statement

The income statement shows a company’s financial position and performance over a period by looking at revenue, expenses, and profits earned. It can be created for any period using a trial balance of transactions from any two points in time.

The income statement generally starts with the revenue earned for the period minus the cost of production for goods sold to determine the gross profit. It then subtracts all other expenses, including staff salaries, rent, electricity, and non-cash expenses, such as depreciation, to determine the earnings before interest and tax (EBIT). Finally, it deducts money paid for interest and tax to determine the net profit that remains for owners. This money can be paid out as dividends or reinvested back into the company.

The income statement provides information on a company’s financial health by helping you analyze the following:

• How much revenue is growing over certain accounting periods
• The gross profit margin for goods sold
• What percentage of revenue results in net profit after all expenses
• If the business can cover its interest repayments on debt
• How much the business repays to shareholders versus how much it reinvests

3. Analyze the Cash Flow Statement

The cash flow statement provides detailed insights into how a company used its cash during an accounting period. It shows the sources of cash flow and different areas where money was spent, categorized into operations, investing, and financing activities. Finally, it reconciles the beginning and ending cash balance over the period.

The cash flow statement is one of the most important documents used to analyze a company’s finances, as it provides key insights into the generation and use of cash. The income statement and balance sheet are based around accrual accounting, which doesn’t necessarily match the actual cash movements of the business. That’s why the cash flow statement exists—to remove the impacts of non-cash transactions and provide a clearer financial picture to managers, owners, and investors.

The cash flow statement provides information on a company’s financial health by helping you analyze the following:

• The liquidity situation of the company
• The company’s sources of cash
• The free cash flow the company generates to further invest in assets or operations
• Whether overall cash has increased or decreased

4. Financial Ratio Analysis

Financial ratios help you make sense of the numbers presented in financial statements, and are powerful tools for determining the overall financial health of your company. Ratios fall under a variety of categories, including profitability, liquidity, solvency, efficiency, and valuation.

Some of the financial ratios you should know include:

• Gross profit margin: The percentage of profit the company generates after direct cost of sales expenses have been deducted from the revenue
• Net profit margin: The percentage of profit the company generates after all expenses have been deducted from revenue, including interest and tax from revenue
• Coverage ratio: The company’s ability to meet its financial obligations, specifically to cover its debt and related interest payments
• Current ratio: The company’s ability to meet short-term obligations of less than one year
• Quick ratio: The company’s ability to meet short-term obligations of less than one year using only highly liquid assets
• Debt-to-equity ratio: The percentage of debt versus equity that the company uses to finance itself
• Inventory turnover: How many times per period the entire inventory was sold
• Total asset turnover: How efficiently the company generates revenue from total assets
• Return on equity (ROE): The company’s ability to use equity investments to earn profit
• Return on assets (ROA): The company’s ability to manage and use its assets to earn profit

Financial ratios should be compared across periods and against competitors to see whether your company is improving or declining, and how it’s faring against direct and indirect competitors in the industry. No single ratio or statement is sufficient to analyze the overall financial health of your organization. Instead, a combination of ratio analyses across all statements should be used.

Turn Insights into Actions

Understanding the financial health of a company is critical for all professionals: business owners, entrepreneurs, employees, and investors. By analyzing the information in financial statements, you can learn about your company’s fiscal health and turn insights gleaned from data into actions that benefit your business and career.

Do you want to develop or hone your understanding of finance? Explore our online finance and accounting courses to build your toolkit for making and understanding financial decisions. If you aren't sure which course is the right fit, download our free course flowchart to determine which best aligns with your goals.

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