Question

How can one access the financial solvency(health) of an organization,?

Substantiate the findings and make recommendations for improvement

Answer 1

Financial health of a Company refers to its ability to generate sufficient profits to take care of its operating needs (short term as well as long term needs) so as to survive in the long run. To accurately assess the financial health of a Company, investors should carry out a thorough analysis of various profitability, liquidity and solvency ratios and then make a prudent decision as to whether to go for investment or not.

Profitability ratios: To survive in the long run, companies must generate a reasonable level of net profit and maintain the same through fair means.

1) Net Profit margin= the ratio of net profit (Profot after taxes) to Net Sales, the higher the ratio, the better.

2) Gross Profit Margin= the ratio of gross profit to Net Sales, the higher the ratio, the better

3) Operating profit margin= EBIT/Net Sales, higher the better

Liquidity Ratios: Liquidity refers to the presence of adequate cash and highly liquid marketable securities to take care of the short term needs of an Organization.

1) Current Ratio: Current assets/ Current liabilities (ideal ratio- 2:1; however ratios 1.33:1 and above are acceptable); it shows how much liquid assets an organization holds to serve short term liabilities.

2) Quick Ratio: (Current assets-inventory)/ Current liabilities; (1.33:1 is a good ratio). This ratio is more effective than current ratios as it excludes inventory from assets which are not very liquid so as to help serve current liabilities.

Solvecy Ratios: Company's capability to pay off its ongoing liabilities, both short term as well as long term, without going bankrupt.

1) Debt to Equity Ratio: Long term debt/ Equity; Higher debt equity ratio suggests that the Company has high financial risk due to presence of high amount of debt.

2) Interest Service Coverage Ratio: (Profit before tax+Interest+Depreciation)/ Interest; the ability of a company to service its interest payments on time, the higher the better

3) Debt Service Coverage ratio: (PAT+Depreciation+Interest)/ (Instalment+Interest on loan); shows the ability of an organization to repay the principal debt as well as interest on time. The higher the ratio, the better.