Understanding your business’s liquidity is essential, as it’s a key factor for small and medium-sized businesses and the self-employed.
In this regard, financial ratios are valuable indicators for assessing your company’s health.
They also help you manage your business based on its current situation and results.
Therefore, calculating these ratios and using them as benchmarks enables you to make strategic management decisions.
Although uncertainty is inherent in your business, this data allows you to better understand your situation and anticipate potential challenges.
In the business world, it’s not enough to simply want to use these ratios to improve the organization’s management.
You also need to choose wisely which ones to calculate and how to interpret them.
To that end, we present a selection of the most insightful and useful ratios for analyzing a company’s economic and financial situation.
This ratio compares your business’s debts—both short-term and long-term—to its available equity.
It is calculated by dividing equity by debt.
The result shows the company’s financial autonomy and provides insight into the structure of its funding sources.
It depends on both the industry and the company’s age:
Equity / (Non-Current Liabilities + Current Liabilities)
This ratio tells you whether your company will be able to meet its short-term financial obligations.
To calculate it, divide current assets by current liabilities.
If the result is greater than one, you can rest assured, although it’s a good idea to compare it with other ratios.
Its value will depend on the industry, as some companies with a liquidity ratio below one are still solvent.
Current Assets / Current Liabilities
Also known as the quick ratio, it indicates whether your company is able to meet its short-term payment obligations.
The formula is the sum of available assets (temporary financial investments and cash) and realizable assets, divided by current liabilities.
Ideally, this ratio should tend toward zero (between 0.1 and 0.3), since the return on cash is very low or nonexistent.
Cash and Other Liquid Assets / Current Liabilities
Do you want to know how well your assets generate profits?
In other words, how much profit you earn for every euro you invest in the company.
To calculate this, simply divide earnings before interest, taxes, depreciation, and amortization by total assets.
It is important that this figure be higher than the cost of financing.
EBITDA / Total Assets
This ratio, also known by the acronym ROE (Return on Equity), indicates the organization’s ability to reward its shareholders.
It compares financial profit with the resources required to achieve it.
Want to calculate it?
Perform this calculation: net income divided by shareholders’ equity.
Its value should be sufficient to satisfy shareholders, though this is subjective as it depends on the investor’s profile.
Net Income / Equity
How long does it take you to pay your suppliers?
In other words, what is the relationship between the average balance of accounts payable and your daily purchases?
The higher the result, the more you are financing your operations through them.
The calculation is the ratio of the average balance of accounts payable to purchases, multiplied by 365 days.
It is desirable for this figure to be in line with the average collection period or, if possible, to be higher.
365 * (Suppliers + Miscellaneous Creditors) / Purchases
This reflects how long it takes, on average, to collect payment from your customers.
In other words, it’s the number of days that pass from the time you sell a product until you receive payment.
The formula is similar to the previous one: it is the ratio of the average customer balance to sales, multiplied by 365 days.
The lower this value, the less capital you need to invest to finance your customers, although it must always be in line with the company’s sales policy.
365 * (Trade receivables and other accounts receivable – Advances from customers) / Net sales
Although the liquidity ratio is one of the most revealing, there are many variations that can help us understand the true state of a company’s liquidity.
We will therefore list some of the most effective ones for conducting this financial analysis:
This reflects the extent to which a company can pay its current liabilities (those due within one year) with its current assets. It is calculated by dividing current assets (consisting of cash, accounts receivable, and inventory) by current liabilities.
Current Assets / Current Liabilities
Measures short-term liquidity—excluding inventory—relative to short-term liabilities. This version of the liquidity ratio penalizes inventory in current assets because, as a general rule, it is illiquid. However, for a correct interpretation, the company’s industry must be taken into account, as there are sectors where a minimum level of inventory is inherent.
(Current assets – Inventory) / Current liabilities
It is easily calculated by simply subtracting current liabilities from current assets. It indicates the company’s ability to meet short-term debt obligations. It is useful for determining whether the assets that will remain with the company for a period of up to one fiscal year are sufficient to meet all payment obligations.
Current assets – Current liabilities
After listing all the reasons why liquidity should be a constant focus in your analyses, we hope you now have a clearer understanding of how to approach this and which indicators to use.
This will allow you to plan ahead and take the appropriate economic or financial measures.
At Workcapital, we provide the necessary liquidity for small and medium-sized businesses and self-employed individuals.
Discover all the benefits you can get with Workcapital’s business financing