A busy order book can make a business feel secure. So can a healthy bank balance. Yet neither tells you how much of the company is supported by its own capital and how much depends on money owed to others.
That is where the equity ratio helps. It shows the share of business assets financed by equity. In the Netherlands, this calculation is commonly used to measure solvency. It is a useful view of financial resilience, provided you do not mistake it for a complete health check.
Start with a small business balance sheet
A balance sheet records what a business owns and owes at a particular date. Assets include equipment, stock, money customers owe and cash. Liabilities include bank borrowing, unpaid supplier bills and other amounts the business must settle.
Equity is what remains after liabilities are subtracted from the recorded value of assets. It can include capital put in by the owner and profits kept in the business. Losses and distributions to owners can reduce it.
For a simple example, imagine a small design and manufacturing studio. It has € 200,000 in recorded assets and € 130,000 in liabilities. The difference, € 70,000, is equity. The assets have been financed partly by that equity and partly by the people and organisations the business owes.
Equity does not mean € 70,000 is sitting untouched in a savings account. Much of it may be tied up in equipment or stock. It is an accounting measure of the owners’ interest in the business, not a separate pile of spending money.
The calculation is short
Divide equity by total assets, then multiply by 100. For the studio, € 70,000 divided by € 200,000 gives an equity ratio of 35%. In other words, 35 cents of every euro in recorded assets are financed by equity.
| Item | Amount |
|---|---|
| Total recorded assets | € 200,000 |
| Total liabilities | € 130,000 |
| Equity | € 70,000 |
| Equity divided by assets | 35% |
This is not the profit margin. It does not mean that 35% of each sale becomes profit. Nor does it show the return that the owner earned on an investment. Those are different calculations answering different questions.
You may encounter other measures under the heading of solvency or financial strength. A debt-to-equity ratio, for example, compares liabilities or a defined category of debt with equity. Always check the formula before comparing numbers. The same label can hide a different calculation, particularly across countries or lenders.
How equity absorbs a loss
Suppose the studio discovers that € 20,000 of its recorded stock has no remaining value. In this simplified example, ignoring tax effects, assets fall from € 200,000 to € 180,000. Liabilities remain € 130,000. Equity falls to € 50,000.
The ratio is now about 27.8%. The loss has reduced the owners’ recorded stake before changing what the business owes its creditors. That is why equity can be described as a cushion against losses.
But the cushion is only as reliable as the accounts. If stock is worth less than recorded, customers will not pay, or equipment has lost value, an old balance sheet may overstate the room available. Review the quality of the assets as well as their total.
A ratio is not a promise about what creditors would recover if the business closed. A rushed sale can raise less than the recorded asset values. Selling costs, security held by lenders and legal priorities can also affect the outcome. A 35% ratio is not a 35% probability of anything.
Cash answers a different question
Imagine the studio still has the original € 70,000 of equity but only € 8,000 in the bank. Payroll and suppliers require € 22,000 next week. There may be plenty of value in equipment and customer invoices, but the business has a payment problem unless cash arrives in time.
Liquidity is the ability to meet payments when they fall due. Solvency concerns the broader ability to meet obligations, with the equity ratio offering one view of the financial structure. Profitability concerns whether revenue exceeds expenses. A company can look strong on one measure and weak on another.
My article on making a profit but running out of cash explains the timing problem in more detail. A new loan can make the bank balance look healthier overnight while adding another repayment commitment. The cash position improves immediately; the underlying business may still need work.
There is no universal passing score
A lender may set a minimum ratio, and an industry may have a typical range. Neither creates a universal line between safe and unsafe. The type of assets, stability of earnings, repayment timetable and exposure to setbacks all matter.
A consultant who needs a laptop and a small office has a different balance sheet from a manufacturer running expensive machinery. A retailer holding seasonal stock faces risks that differ from those of a service business with long contracts. Even two similar firms may have very different dependence on one customer.
Compare the business with itself over time and with similar businesses where reliable information is available. If a bank requires a particular ratio, ask which liabilities and adjustments it includes. The number used in a loan agreement may differ from the simplest calculation in your bookkeeping software.
Also check the date. A year-end statement may not reflect a recent loss, a large distribution or a new borrowing commitment. Decisions made today need figures that are current enough to describe today’s business.
Growth can lower the ratio without being a mistake
Return to the studio with € 200,000 of assets and € 70,000 of equity. It borrows € 50,000 and uses the money to buy a machine. Immediately after the transaction, before fees or other effects, assets rise to € 250,000 and liabilities to € 180,000. Equity stays at € 70,000.
The equity ratio falls from 35% to 28%. That does not prove the machine was a bad purchase. The investment may increase capacity and future profit. It does show that the business now relies more heavily on creditors and has additional payments to support.
Test the plan with slower sales or a delayed launch. Can the business still cover wages, suppliers and loan payments? A forecast that works only if everything happens on schedule gives you little room to adjust.
The opposite trade-off occurs when debt is repaid from cash. Assets and liabilities both fall while equity initially stays the same, so the ratio can rise. Available cash falls too. Improving one number by emptying the bank account may leave the business less able to handle a short-term interruption.
Improve the business behind the number
Keeping some profits in the business can build equity. An owner can also contribute new capital. But capital alone does not repair weak pricing, unprofitable work or costs that consistently exceed revenue. Repeatedly adding personal savings may postpone a decision rather than solve the underlying problem.
Collecting invoices faster usually improves cash availability first. A customer payment replaces an amount owed with money in the bank; it does not create fresh profit or equity by itself. That can still be a major improvement in day-to-day resilience.
Good records make these distinctions visible. Reconcile the bank, review unpaid invoices and keep track of supplier and tax liabilities. A simple bookkeeping routine gives you better inputs for the balance sheet and fewer surprises when the accounts are prepared.
For a business in the Netherlands, I can prepare annual accounts and explain what the figures show. If the statements are needed for finance, tell me what the lender has requested so the requirements can be assessed first.
The point of the equity ratio is to make business decisions clearer. Use it alongside a cash forecast and a realistic view of future earnings. Then ask what would happen if a customer paid late, a machine failed or sales slowed. Those answers tell you more about resilience than a percentage viewed on its own.