How to Analyze Financial Health in a Company

You are being requested by your chief executive officer/president to make an analysis of the financial health in the company. What financial information will you give to your CEO/President that will be needed to make him efficient and effective financial manager? Explain.

Raine from Philippines 
Raine ! As financial manager, it is your duty to analyze financial health in a company and to provide its information to CEO. Suppose, you are doctor and a patient (who can not speak) comes to you. How to analyze his diseases and health weakness? Like this you do your duty. I am explaining it in following ways:

1st Step : To Analyze the Blood Pressure of Company : { Analyze the Flow of Cash and Working Capital }

When a person goes to doctor, he check the blood pressure and see whether it is high or low. Both high and low blood pressure are the sign of health weakness of person. But you know that company's blood is cash and its flow is just like blood pressure. Flow of cash should be normal. It has also two parts, one is cash inflow and other is cash outflow. Financial manager should check which cash is used where. Whether company misuse cash in useless schemes or not. He should analyze whole cash flow statement and see deeply the applications of cash in operation and in investment.

With analysis of Cash flow, you can get following information

1. # Information of total cash after all the usages of cash. Compare it with future liabilities and give the fact whether company have sufficient cash or not.

2.# Provide information of different sources of cash which may be useful for stockholders because they are interested to know if the company is generating enough cash to pay dividends and for suppliers who are interested to know if their customers will be able to pay if offered credit and for other interested parties.

We also check the flow of working capital. Working capital is the excess of current assets over current liabilities. Only optimum working capital is useful for company. We should have always enough working capital for doing day to day operational activities of business. 

2nd Step : To Check the Temperature of Company : { Analyze the Risk of Company }

 It is general knowledge that normal human body temperature is 37.0 °C (98.6 °F). Both over and less temperature is the sign of weakness of health. For healthy company's temperature can be easily calculate by analysis of risk. Risk is not loss of business but probability of future loss. As financial manager, you have to calculate economic capital and  risk adjusted rate of return on your company's investment and compare it with your paid up capital and your normal rate of return. After this, you have to provide information to your CEO.

We are also giving you one example of risk analysis by taking a bank's balance sheet. In following screen-shoot, you are seeing that banking company has 1000$ total liabilities and total assets. Out of total liabilities, $ 950 is just debt which has been taken by bank for business. Bank's own capital is $ 50. It means banking is operating on high leverage and bank may face high leverage risk, if company's return on investment is less than rate of interest on taken loan. Core capital leverage is 5% which we have calculated capital / total assets X 100. Risk based regulatory tier 1 ratio is 3% which we have calculated by paid up capital/ risk weighted assets X 100. Both ratios are helpful for risk assessment. 

Risk Analysis through Bank's Balance Sheet


3rd Step : Take Some Drops of Company's Blood and Test : { Accounting Ratio Analysis }

As financial manager, it is also your duty to calculate accounting ratio and to analyze them. It is just like test of small drops of patient to see the position of different organs. You can calculate

a) Current and liquid ratio

b) Working capital turnover ratio

c) Debt - equity ratio

d) Debtor and creditor turnover ratio

e) Profitability ratios

f) Return on capital employed

d) Cost of Capital

4th Step : Check the Past History of Company's Health : { Analyze Past Financial Statements }

Financial manager should also check last 10 years financial statements and analyze them. With this, he can explain sales and profit trend. He can also analyze financial data with statistical tools like moving average and trend analysis.

Related : Balance Sheet Analysis

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Accounting Education: How to Analyze Financial Health in a Company
How to Analyze Financial Health in a Company
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