While a company’s profit margin is an excellent indicator of its financial health, it’s important to consider several other factors for the most accurate picture. At Aura Wealth, we recommend that clients consider the liquidity, operating efficiency, profitability, and solvency when determining if the company’s current status is good or it could benefit from some changes. We examine each of these four areas below.
The amount of cash your company has on hand and the number of assets it could quickly convert to cash, if necessary, creates its liquidity factor. Positive liquidity ensures that a business can meet its short-term obligations while still remaining profitable. The current ratio and the quick ratio are two methods used to determine the liquidity of a business. To determine your company’s current ratio, divide its present assets by its liabilities. The total will be a numeric value rather than a decimal.
The quick ratio, sometimes referred to as the acid test since it typically produces a more accurate picture of financial health, goes a bit further than dividing assets by liabilities. With this method, you also need to exclude long-term debt as part of liabilities and inventory from your company’s total assets. A figure above 1.0 indicates a high likelihood of the company managing short-term financial obligations with the assets and cash it has on hand, while a lower score indicates liabilities higher than assets.
The operating margin of your company is a good way to determine its operating efficiency. The first metric indicates the percentage of profit margin after accounting for the cost of production and marketing for the company’s goods or services. This proves the presence or absence of financial health by showing how well the business manages its costs. Effective management is an essential component of success and can help the company overcome numerous problems.
It’s true that a business can remain open for several years even when it’s not profitable. This is typically due to the actions of investors and creditors. However, all businesses must reach a point of sustained profitability for long-term success. Determining the net margin of a company is a good way to show whether it’s currently profitable. This figure represents the ratio of total revenues to total profit. The higher the net margin percentage, the easier it is for a company to absorb unexpected operating costs without the threat of becoming non-profitable.
Solvency and liquidity are closely related. The primary difference is that solvency is the ability to meet financial obligations on a long-term rather than a short-term basis. A practical method to determine solvency is to use the debt-to-equity ratio. If your company has a lower percentage, it means that shareholders finance your company more than creditors do. This is a positive indicator of financial health, especially when you consider that shareholders help to finance business operations without charging interest.
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