Curious about the financial health of your enterprise? You don't necessarily need to delve deeply into your accounts. By monitoring three essential financial ratios, you can quickly assess the stability of your business and identify areas for improvement. We explain how to calculate liquidity, solvency, and profitability ratios—and, crucially, how to enhance them.
1. Liquidity: Can your business pay its bills on time?
The liquidity ratio (also known as the current ratio) indicates whether your business has sufficient short-term assets to cover its short-term liabilities. Maintaining healthy liquidity is vital to prevent cash flow issues and ensure stable operations.
How to calculate the liquidity ratio:
Formula:
(Receivables ≤ 1 year + inventories + work in progress + cash + short-term investments) ÷ liabilities ≤ 1 year
(Receivables ≤ 1 year + inventories + work in progress + cash + short-term investments) ÷ liabilities ≤ 1 year
- Healthy: A ratio of 1.5 or higher suggests a comfortable buffer.
- Risky: A ratio below 1 may lead to payment delays, reduced creditworthiness, and even bankruptcy if unaddressed.
- A ratio above 1 indicates that your business has sufficient means to meet its short-term obligations.
Since inventories can be challenging to convert quickly into cash, it's also beneficial to calculate the quick ratio:
Formula:
(Receivables ≤ 1 year + cash + short-term investments) ÷ liabilities ≤ 1 year
(Receivables ≤ 1 year + cash + short-term investments) ÷ liabilities ≤ 1 year
How to improve your business's liquidity:
- Extend payment terms with suppliers and encourage customers to pay more promptly.
- Convert short-term shareholder loans into long-term financing.
- Sell redundant assets and optimise inventory management.
- Negotiate better payment terms with suppliers.
2. Solvency: How financially stable is your business?
The solvency ratio reveals how independent your company is from external financing. A higher solvency ratio means your business is better equipped to withstand financial setbacks. Banks also scrutinise this ratio closely when assessing loan applications.
How to calculate the solvency ratio:
Formula:
Equity ÷ total assets
Equity ÷ total assets
- Good: At least 25%, but ideally, your fixed assets should be financed with at least 66% equity.
- Risky: A low solvency ratio indicates reliance on external financing, which can be hazardous during economic fluctuations.
How to improve your business's solvency:
- Retain profits within the company instead of distributing them as dividends.
- Attract additional capital from investors or shareholders.
- Convert shareholder loans into equity.
- Limit total debts and avoid excessive external financing.
3. Profitability: Is your business generating sufficient profit?
Profitability ratios demonstrate how efficiently your business operates and how much profit it retains. These metrics assist in making informed decisions and seizing growth opportunities.
We examine three key profitability ratios:
Gross margin: How much do you retain after direct costs?
Formula:
(Revenue - direct costs) ÷ turnover
(Revenue - direct costs) ÷ turnover
- Provides insight into pricing and cost structure.
- Enables benchmarking against competitors.
EBITDA margin: How profitable is your core activity?
Formula:
EBITDA ÷ turnover
EBITDA ÷ turnover
- Indicates profitability excluding financing costs and depreciation.
- Important for investors and lenders.
Return on Equity: What does your investment yield?
Formula:
Net profit after tax ÷ equity
Net profit after tax ÷ equity
- For example, a return of 14% means you earn €14 for every €100 of equity.
- This percentage should exceed the return on a risk-free investment.
How to improve your business's profitability:
- Analyse expenses and eliminate unnecessary costs.
- Enhance gross margin by increasing efficiency.
- Boost turnover, focusing on profitable growth.
- Optimise pricing strategies and negotiate better terms.
Maintain control over your financial health with our experts
Aiming to grow your business while keeping it financially sound? Regularly monitoring your liquidity, solvency, and profitability is essential. By analysing these ratios with our experts, you can swiftly identify potential issues and make timely adjustments. Don't hesitate to contact us—we're here to assist you.
Learn more about our services
We love to help you.
Subscribe to our newsletter