Course Project

Business Financial Health

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Many investors today are more concerned about a company’s profit margins as the only indicator to its financial health. However, to accurately evaluate the financial health of a given company, one has to consider the following metrics: liquidity, solvency, and, profitability.

1. Liquidity

The first thing investors start by looking at when evaluating a company’s bear minimum financial health, is the look at its liquidity. By definition, liquidity is the volume of cash and easy to sell assets that a business holds to tackle instant financial responsibilities. Therefore, before the company can prosper in the long-term, it has to be able to endure short-term financial glitches. The following metric can be used to measure liquidity:

Quick ratio or acid test

Quick are is derived the following formula:

Liquidity = cash + temporary marketable investments + receivables/current liabilities.

The above formula implies that a higher quick ration indicates a higher level of liquidity or ability to meet short-term and agent financial responsibilities. It is a more precise measure of liquidity compared to the current ratio, which achieved by the following formula:

Liquidity = cash + temporary marketable investments /current liabilities

The above formula implies that ratio is among the reliable measure of liquidity in a crisis. However, if one divides current assets by current liabilities while at the same time excluding inventory from assets and eliminates the long-term debt from liabilities. As a result, it gives a more realistic sign of the company’s capacity to address short-term responsibilities with cash as well as assets. Therefore, a quick ratio below one means that the existing liabilities surpass assets present (Dahiyat, 2016).

2. Solvency

This is similar to liquidity, but solvency implies a company’s capability address debts responsibilities on a routine basis, as opposed to short-term basis. On the other hand, solvency ratios determine a business’s long-term debt management concerning assets and equity.

The (D/E) debt to equity ratio the primary pointer of a business’s long-term sustainability, since it determines the liability against investors’ equity, it is also a gauges the level of investors’ interest in a business. The lower debt to equity ratio means that more of an organization’s operation is being financed by stockholders rather than debtors, which is a good thing since the company will save on interest cost accrued on financing (Hermawan, et al, 2016).

3. Profitability

In some cases, a company may survive for years without being profitable, that is, it can survive on debtors and investors goodwill. However, in the long run, for the company to survive it needs to attain and maintain profitability. Hence, the best metrics to assess a company’s profitability is net margins, that is, the ratio of profit to total revenues. It does not matter the gain is in large figures if the net margin is said 1% or less. This implies that an increase in either operating costs or marketplace competition, the business start making losses (Kajananthan, & Velnampy, 2014).

Reference

Dahiyat, A. (2016). Does Liquidity and Solvency Affect Banks Profitability? Evidence from

Listed Banks in Jordan. International Journal of Academic Research in Accounting, Finance and Management Sciences, 6(1), 35-40.

Hermawan, U., Amboningtyas, D., Syaifuddin, T., & Paramita, P. D. (2016). THE IMPACT OF

LIQUIDITY, SOLVENCY, AND PROFITABILITY RATIOS TO COMPANY PROFITS (STUDY ON PT. SSB TAHUN 2013-2016). Journal of Management, 3(3).

Hutabarat, F. M., & Tarigan, D. (2015). Financial Performance Based on Profitability, Liquidity,

Solvency and Its Impact on the Stock Price of Companies Listed in Consumer Goods Sector at Indonesia Stock Exchange from Year 2008-2014.

Kajananthan, R., & Velnampy, T. (2014). Liquidity, Solvency and Profitability Analysis Using

Cash Flow Ratios and Traditional Ratios: The Telecommunication Sector in Sri Lanka. Research Journal of Finance and Accounting, 5(23), 163-171.