Most business owners would agree that regularly assessing their company's financial health is critical, yet often overlooked when caught up in day-to-day operations.
Luckily, Xero offers powerful yet easy-to-use tools for conducting thorough financial checkups to evaluate profitability, liquidity, leverage, and more - providing actionable insights to help guide your business decisions.
In this post, you'll discover step-by-step how to conduct a financial health check in Xero to accurately assess and forecast your business's vitality. We'll cover evaluating earnings, liquidity, debt levels, industry benchmarking, and scenarios for future performance.
Understanding Business Financial Health
Financial health is critical for any business to achieve long-term growth and sustainability. Assessing key metrics in Xero can provide insight into a company's financial vitality.
Some key aspects to evaluate regularly include:
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Profitability - Analyze net profit margins over time to detect positive or negative trends. Compare against industry benchmarks.
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Liquidity - Review the current ratio by comparing current assets to current liabilities. Aim for at least 1:1 to meet short-term obligations.
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Leverage - Calculate debt-to-equity and debt-to-EBITDA ratios. Higher leverage can signal risk, while low leverage provides flexibility.
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Cash Flow - Running out of cash is a top reason businesses fail. Forecast cash flow needs and monitor performance.
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Benchmarks - Compare financial ratios against industry averages to gauge business health.
Regularly monitoring these vital signs in Xero can help diagnose weaknesses early and highlight opportunities to improve operational and financial performance. Addressing problems proactively is key for long-term viability.
Partnering with accounting professionals can also help accurately assess business financials and chart a course toward growth and profitability. Their expertise and insights are invaluable.
What is a xero health check?
A Xero Health Check is an independent review of your Xero account conducted by Xero certified advisors. It serves several key purposes:
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Identifies errors or issues in your Xero setup, chart of accounts, transactions, reconciliations, and reporting. Experts will spot problems you may have overlooked.
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Provides specific fixes and recommendations to address errors and improve processes. You will gain actionable insights on how to resolve problems and streamline financial workflows in Xero.
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Highlights optimization opportunities such as automations to save time, customizations to get more value from Xero, and ways to enhance reporting. The review helps uncover areas where you can get more out of Xero to support business growth.
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Validates that key processes align to best practices so you can have confidence in the accuracy of financial data and compliance with accounting standards/regulations. It serves as an audit to ensure proper controls are in place.
In summary, a Xero Health Check gives you an independent set of eyes reviewing your books to help uncover issues, reduce risks, apply fixes, and realize more value from your Xero investment. It is a proactive way to check the "vital signs" of your business's financial health.
Can Xero produce statutory accounts?
Yes, Xero Tax has robust capabilities for generating company statutory accounts and tax returns. Here are the key features:
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Statutory Accounts Generation: Xero Tax enables automated production of statutory accounts per UK company law, including profit and loss statements, balance sheets, notes to the accounts, directors' reports, and more.
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Corporation Tax Return Filing: Once statutory accounts are finalized in Xero Tax, the platform allows one-click corporation tax return filing directly with HMRC. This includes current year and amended returns.
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Companies House Filing: Finalized statutory accounts can be directly filed with Companies House through Xero Tax's integration. You can file new and amended accounts and confirm filing status.
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HMRC Integration: Xero Tax connects with HMRC for streamlined tax return filing, receiving return status updates, and more. This simplifies compliance.
So in summary, Xero Tax has robust statutory accounts and tax compliance features to meet all your company reporting and filing needs with HMRC and Companies House. The automated generation and one-click filing capabilities make the process smooth and efficient.
Does Xero produce iXBRL accounts?
Xero Tax has built-in support for iXBRL (Inline eXtensible Business Reporting Language) tagging to streamline filing UK company tax returns. This feature automatically tags any chart of accounts set up in Xero with the appropriate iXBRL tags required by HMRC.
When you generate a set of statutory accounts in Xero, it will embed the iXBRL tags directly into the accounts file. This saves you from having to manually tag accounts or use an external iXBRL tagging solution.
Some key benefits of Xero's integrated iXBRL tagging include:
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Automatic tagging - Once the chart of accounts is set up, Xero automatically handles tagging financial data with the correct iXBRL tags. No manual work needed.
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HMRC-compliant - The iXBRL tags applied conform to HMRC's official taxonomy requirements for company accounts.
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Simplified filing - With the accounts pre-tagged, you can directly submit them to HMRC alongside the company tax return. No further iXBRL formatting needed.
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Cost-effective - Comes bundled with Xero Tax at no extra charge, saving on an external iXBRL tool.
So in summary, Xero Tax eliminates the iXBRL headache by baking compliant tagging directly into the accounts production process. This makes filing annual returns smooth, efficient and hassle-free for UK companies.
What is Xero HQ?
Xero HQ is an online platform designed specifically for accounting and bookkeeping professionals to manage their practices efficiently. It connects the various software tools needed to run a financial services business in one centralized dashboard.
Some key features of Xero HQ include:
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Practice management tools: Xero HQ provides tools to manage clients, track time and projects, create invoices, collect payments online, and automate workflows. This streamlines practice operations.
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Accounting software integrations: It seamlessly integrates with leading accounting platforms like Xero to enable easy financial data access and reporting across client accounts.
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Client collaboration portals: The platform offers customizable client portals to securely share financial documents and communicate with clients.
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Data analytics: Insightful reports and dashboards provide real-time visibility into the performance and profitability of the practice.
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App ecosystem: Xero HQ connects with 350+ apps covering everything from payroll to proposal generation, allowing businesses to customize their tech stack through an open API.
In summary, Xero HQ gives accounting and bookkeeping professionals a centralized platform to manage clients, access essential software tools, and gain data-driven insights to enhance productivity and growth. Its comprehensive feature set and open ecosystem make practice management simpler.
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Evaluating Profitability and Earnings
Using Xero's Profit & Loss Report
The Profit & Loss report in Xero provides key insights into a business's profitability over time. Here are some tips for analyzing this report:
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Gross profit margin - This metric shows the percentage of revenue that remains after accounting for the direct costs associated with producing goods and services. A higher percentage indicates greater efficiency in managing production costs.
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Net profit margin - This shows what percentage of revenue turns into net profit. Track this metric over time to assess profitability trends. Declining margins may indicate rising expenses or the need to adjust pricing.
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To view the report, navigate to Reports > Profit & Loss in Xero. Filter by date range and compare periods to analyze fluctuations.
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Click on report line items to display underlying transactions. This helps reveal what's driving changes in costs of goods sold, operating expenses, and margins over time.
Evaluating Earnings Per Share (EPS)
Earnings per share (EPS) measures net profit allocated to each outstanding share of common stock. Monitoring EPS helps assess business profitability and shareholder value over time.
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Navigate to Reports > Balance Sheet in Xero. Scroll down to the Equity section to find common shares issued and EPS.
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Compare EPS over multiple periods. Increasing EPS generally indicates greater value creation for shareholders.
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Click into report line items to analyze drivers behind EPS changes, like net profit fluctuations or share issuances. This helps determine if business performance or financial structure is impacting value per share.
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Use EPS alongside other profitability metrics when evaluating business financial health over both short and long-term periods.
Assessing Liquidity and Working Capital
Evaluating a company's liquidity and working capital provides insight into its financial health and ability to meet its short-term obligations. Within Xero, business owners can analyze key liquidity metrics over time to identify any areas of concern.
Interpreting the Cash Flow Statement
The Cash Flow report in Xero breaks down inflows and outflows into three categories:
- Operating activities: Cash generated or spent on day-to-day operations
- Investing activities: Cash used to acquire assets or received from asset sales
- Financing activities: Cash from financing received or cash spent on loan repayments
Monitoring changes in cash from operations indicates whether core business activities are producing positive cash flow. Consistently negative operational cash flow could signal deeper issues with profitability or the timing of receivables/payables.
Comparing cash inflows and outflows over prior periods also highlights seasonal fluctuations or broader trends affecting liquidity. For example, rapid inventory build-up could explain higher cash outflows in a growth phase.
Using Current and Quick Ratios
Two key liquidity ratios to assess in Xero are:
- Current ratio = Current Assets / Current Liabilities
- Indicates ability to cover short-term obligations
- Quick ratio = (Current Assets - Inventory) / Current Liabilities
- More conservative view of liquidity by excluding inventory
A current ratio below 1 suggests insufficient working capital to pay upcoming bills. Meanwhile, a declining quick ratio over time could reflect difficulties converting assets to cash.
Regularly monitoring liquidity ratios provides an early warning for potential cash crunches. Dipping ratios may warrant closer inspection of customer collections, inventory levels, payment terms, and other working capital drivers.
Analyzing Business Debt and Leverage
Balance Sheet Debt Analysis
Navigate to the Balance Sheet report in Xero to analyze key debt accounts and compare them to assets and equity. This provides visibility into total debt obligations and allows you to track changes over time.
Specifically look at:
- Current liabilities - Debt due within 12 months
- Non-current liabilities - Long-term debt
- Track total liabilities compared to total assets and equity
Monitoring the mix of debt and equity financing on your balance sheet is an important way to assess financial health and risk.
Debt and Leverage Ratio Analysis
Two key ratios to analyze:
- Debt-to-Equity Ratio - Measures degree of financial leverage by comparing total liabilities to shareholder equity. Higher ratio = more debt financing relative to equity. Benchmark against industry averages.
- Interest Coverage Ratio - Evaluates ability to meet interest payments on debt. Divide EBIT (earnings before interest & taxes) by interest expense. Higher ratio = greater cushion for making interest payments.
Analyze changes in these ratios over time in Xero to assess whether financial leverage and risk are increasing or decreasing. Unexpected shifts may indicate problems with cash flow or taking on too much debt and warrant further investigation.
Benchmarking Against Industry Averages
Comparing your company's financial ratios and metrics to industry averages can provide valuable insights into your business's financial health and areas for improvement. Here are some tips for effective benchmarking:
Gather Relevant Industry Data
The first step is finding industry average ratios to compare against. Good sources include:
- Industry research reports
- Trade association data
- Government economic census figures
- Financial database aggregators like Bloomberg or S&P Capital IQ
Focus on averages for your specific industry and business model. An online retailer would compare against ecommerce industry benchmarks rather than brick-and-mortar retail, for example.
Calculate Key Ratios
With Xero, you can easily extract the numbers required to compute key financial ratios like:
- Profitability - Gross profit margin, net profit margin, ROA, ROE
- Liquidity - Current ratio, quick ratio
- Leverage - Debt-to-equity ratio
- Efficiency - Inventory turnover, receivables turnover
Compare these to industry averages to gauge your company's financial fitness.
Identify Strengths and Weaknesses
Look at any major differences between your company's ratios and relevant industry benchmarks. Areas where you significantly trail the industry likely represent weaknesses and risks, while ratios that exceed the average highlight competitive strengths.
For example, a lower gross margin than industry peers could indicate production inefficiencies or issues with pricing strategy and product positioning.
Set Targets and Develop Initiatives
For underperforming ratios, set clear targets for reaching at least industry average levels within a realistic timeframe. Define initiatives to address the underlying issues, like:
- Production process improvements to increase gross margin
- Inventory management changes to improve turnover
- New credit policies to shorten the receivables cycle
Regularly benchmarking against updated industry data will help monitor your progress over time.
Comparing your company's financial metrics to industry averages benchmarks your business against peers, highlights problem areas, and informs strategy and performance improvement initiatives. This helps ensure long-term competitiveness and financial health.
Forecasting Future Performance
Setting Up Forecasting in Xero
Xero's forecasting feature allows businesses to model future revenues and expenses. To set up forecasting in Xero:
- Navigate to the Accounts tab and click on Budgets
- Create a new budget
- Name the budget and assign it to the appropriate cost centers
- Enter the budget time period, such as the next fiscal year
- Input revenue and expense forecasts for each month
Some tips when setting up forecasts in Xero:
- Break down forecasts by cost center or department to model performance
- Use historical data to estimate future performance
- Factor in growth rates and business goals
- Consider potential new hires or initiatives that could impact budgets
With the budgets set up, Xero will track actuals against forecasts to monitor performance over time.
Modeling Future Performance Scenarios
In addition to the main forecast in Xero, it can be helpful to model best-case and worst-case scenarios. This provides a range of possible outcomes to aid in cash flow, profit and loss, and ratio analysis.
To build forecast scenarios:
- Clone the original forecast budget
- Name the cloned budget appropriately, e.g. "Pessimistic Forecast"
- Adjust revenue and expense assumptions higher or lower depending on the scenario
- Consider impacts to payroll, operating expenses, tax obligations, loan repayments and other cash flows
- Assess how ratio analysis changes under different scenarios, including liquidity ratios, solvency ratios, and profitability ratios
Modeling scenarios helps businesses prepare for different environments. The optimistic scenario shows the highest profit potential while the pessimistic scenario accounts for risks and uncertainty that could negatively impact financial performance. Comparing all scenarios side-by-side allows for contingency planning and quick responses to changing conditions.
Conclusion and Next Steps
In summary, conducting regular financial health checks in Xero provides vital insights into the current state and ongoing viability of your business. By assessing key metrics around profitability, liquidity, solvency, and efficiency, you can identify areas of strength to leverage as well as spots of weakness requiring attention.
Some recommended next steps based on this analysis include:
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Review expenses and identify opportunities to cut costs or improve spending efficiency. Controlling expenses has a direct impact on profit margins. Assess if any costs can be reduced without negatively impacting operations.
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Consider adjusting prices or product/service offerings to boost sales revenue. Growing the top line through strategic moves to capture more business can offset issues with the bottom line.
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Renegotiate payment terms with suppliers to ease short-term cash flow issues. Extending accounts payable days gives you more breathing room managing working capital.
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Develop a cash flow projection and put controls on discretionary spending. Tighter cash management ensures you can cover near-term obligations.
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Explore financing options to provide a capital buffer if liquidity is tight. Lines of credit or loans can help bridge gaps in cash availability.
Regular financial reviews, paired with decisive actions around identified opportunities, will help ensure your business remains financially sound. Consistent monitoring also enables you to catch problems early before they escalate. Leverage Xero's reporting tools to stay on top of your numbers and quickly adapt to evolving conditions for sustained success.
