It’s important to analyze a company’s financial health to understand how it’s doing. To do this, it’s common to use financial indicators to identify areas for improvement. These indicators provide an overview of the SME and help to position the company with bankers and investors in the event of a loan application. In this article, our experts present the six key financial indicators for assessing your company’s financial health.
Why should you assess your SME’s financial health?
Analyzing the financial health of an SME is necessary for entrepreneurs and business owners to assess their company’s profitability and monitor its positive evolution. Bankers can also use this analysis to assess the company’s financial situation and decide whether they can trust their client. Finally, your potential investors will use the accounts to make informed investment decisions.
There are many financial indicators for assessing a company’s financial health, but we’re going to focus on six in particular. By cross-referencing them, we can get a complete and accurate picture of a company’s performance. The first, sales, is an important indicator, as it represents the company’s level of activity. It is useful to monitor its evolution from one year to the next, and to calculate its percentage growth to measure the company’s progress. It is also interesting to compare sales with those of the sector in which the company operates, to see how it compares with the competition. However, sales alone are not enough to provide meaningful information. As a reminder, sales are calculated by multiplying the selling price by the quantities sold.
The SME’s debt situation
The debt-to-equity ratio of an SME is a financial criterion used to assess its solvency, i.e. its ability to repay its debts. This criterion is calculated by dividing shareholders’ equity (funds contributed by shareholders and investors, plus earnings) by total indebtedness (all debts). Ideally, this ratio should be 1, meaning that shareholders’ equity covers all debts. However, this is rarely the case, and we recommend getting as close as possible. The closer the ratio is to 1, the better the company’s ability to repay its debts.
A company’s profit is a financial indicator that measures the wealth generated by all its activities. It is calculated by subtracting company expenses from sales. Expenses include operating expenses, financial expenses and non-recurring expenses. Earnings are used to determine whether a company is profitable by creating value and making a profit. If the company has made a profit, it is important to examine its growth from one year to the next, and to compare profit with sales to assess the rate of profitability or net margin. To interpret this rate correctly, it is advisable to compare it over several years and with the average for the company’s sector of activity. A profitability rate is considered good if it is at least equal to the industry average, and if it increases from one year to the next.
Working capital requirements
Working capital requirement is a financial indicator linked to cash flow, representing the need for financing from operations. Depending on the operating cycle, there may be a time lag between cash inflows and outflows. The WCR therefore makes it possible to anticipate these discrepancies and forecast the cash required to finance them. However, it is important not to have too high a WCR, as this can lead to difficulties in finding sufficient sources of financing to cover it. To optimize WCR, it is advisable to focus on the average payment terms of customers and suppliers. If customers are slow to pay, this can be reduced by facilitating payment or granting cash discounts. Secondly, it is important to negotiate with suppliers to extend payment terms, since a supplier debt represents a cash resource for the company until it is settled.
Your SME’s gross operating surplus
We had discussed the use of a company’s comprehensive income as a financial indicator. This result is made up of several financial elements, including those from operations, financial items and exceptional items. The most important and interesting element is current operations, which must be examined in detail to determine whether the company is creating profits or wealth. EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) is used to measure the wealth created by a company’s current operations. EBITDA is calculated by subtracting purchases, third-party consumption, personnel costs, taxes and similar payments from sales, and adding operating subsidies. Although operating income also includes depreciation and amortization, it is more relevant to focus on EBITDA to analyze the company’s financial health. In fact, depreciation and amortization only correspond to accounting entries.
Cash flow statement
It’s important to study a company’s cash flow, which is directly linked to its EBITDA. EBITDA represents the cash flow generated by the SME’s activity and its capacity to generate cash resources from its operations. To assess the cash position, we add cash and marketable securities, and subtract bank overdrafts. Without cash, a company cannot maintain and grow. To analyze cash flow and its evolution, we need to ask the right questions about how it has progressed, identifying how it is fed and whether operations have contributed to generating liquidity.
Assessing the financial health of an SME is essential to understanding its performance and viability. The six key financial indicators presented in this article measure different aspects of the company’s activity, such as profitability, cash flow and debt. By using these indicators consistently, entrepreneurs and investors can make informed decisions to improve the company’s financial health.