How to effectively identify signs of poor financial health in a company?
Determining whether a company is financially healthy is one of the most important tasks for a potential buyer before deciding to invest their funds in a company. As the title of this article suggests, financial health refers to a satisfactory financial condition of the company.
The financial health of a company is most commonly assessed through financial analysis. This analysis focuses on several key indicators that can significantly indicate whether the company is truly financially healthy:
Financial Indicators
Liquidity. Liquidity indicates the ease of converting assets into cash or tradable assets. If a company has high liquidity, it means that it can quickly obtain financial resources, enabling it to easily meet its short-term financial obligations and thus be easily tradable.
Profitability. Profitability focuses on the company's ability to generate profit based on invested resources and, in connection with this, on the efficiency of utilizing both its own and external financial resources.
Activity. Activity focuses on the success and efficiency of the company's management of its assets (property, receivables, etc.).
Debt. Debt indicates the extent to which the company is financed by external sources, i.e., the relationship between its own and external resources.
We have outlined the basic indicators of financial analysis, yet we still do not have an answer to the question of how to identify poor financial health of a company. However, financial analysis can reveal many issues that a particular company may have.
Key Indicators for Investors
The key indicator of financial health is not profit, as one might think, but the company’s cash flow, which refers to the flow of finances coming in and out of the company. If cash flow is negative, the likelihood of long-term sustainability of this company's business is very low. Negative cash flow is thus an indicator that the company is not entirely financially healthy, especially when compared to positive cash flow.
Cash flow (or cash flow statement) is typically not part of the standard financial statements. For this reason, investors commonly use the so-called EBITDA indicator. This indicator should provide basic insights into how much the invested business can generate from operating revenues and can also be used for company valuation.
Another guideline for determining a company's financial health is its reserves, i.e., a part of liabilities created for a specific purpose. It is important for a company to maintain reserves that are neither too low nor too high. It is evident that low reserves can cause significant problems in the event of an unexpected crisis (and we have experienced more than enough of those in recent years!) or the need for a large or critical investment. However, many may wonder about the issues associated with high reserves. Funds allocated to reserves cannot be invested, which significantly reduces the company's potential. Both extremes can, and often do, indicate financial instability of the company.
The financial health of a company can also be assessed by the multitude of obligations and the approach to them and all documentation. However, this is more difficult for a third party, such as an investor, to uncover, as we usually do not have insight into the company and whether it has chaos or order in its obligations and documents. However, through the company's financial statements or liquidity and debt indicators, we can at least reveal poor management of the company's obligations, and consequently, financial instability of the company.
Before proceeding with the transaction itself (investment in the company), we strongly recommend conducting a thorough due diligence of the company. You can learn more about due diligence here.