Every business owner needs a financial dashboard to make informed business decisions. Accounting software can provide dozens of metrics to measure financial results. To keep your firm on track, you need to identify the most important metrics for your company.

This article explains the difference between liquidity and solvency, two concepts that managers use to assess business results. Many financial ratios measure either liquidity or solvency. You’ll also read about six common financial ratios that are used to make financial decisions.

First, let’s define liquidity and solvency.

Understanding liquidity and solvency

When you consider liquidity, think about your company checkbook.

Liquidity refers to the ability to generate sufficient current assets to pay current liabilities. If you can’t generate enough current assets, you may need to borrow money to fund your business operations and to pay current liabilities.

Current assets include cash, and assets that will be converted into cash within a year. Accounts receivable and inventory are often a firm’s largest current asset balances. Current liabilities include accounts payable, and the current portion of long-term debt that must be paid within a year.

Liquidity has a short-term focus, while solvency measures long-term financial health. Solvency is the ability to generate profits over a number of years, in order to purchase expensive assets and to make payments on long-term debt.

Successful business owners have to focus on both liquidity and solvency. You need to get cash in the door over the next several months, and generate profits to repay bank loans.

You can use financial ratios to assess your firm’s liquidity, solvency, and other factors.

Using the current ratio

The current ratio is defined as (current assets divided by current liabilities). This ratio determines if your firm has sufficient current assets to pay current liabilities.

Financially sound companies will have a ratio of greater than one. If a company has $1.20 current assets for every $1 of current liabilities, the current ratio is 1.2.

How much debt is too much? The debt-to-equity ratio provides an answer.

Why the debit-to-equity ratio is important

The formula for this ratio is:

(Total liabilities / total equity)

This ratio tracks increases and decreases in liabilities, as a percentage of equity. Total liabilities include current liabilities (such as accounts payable), and long-term debt. If liabilities are increasing at a faster rate than equity, your firm is taking on more debt. Can you afford to make the payments?

For many businesses, cash flow is more important than generating a profit. Use the accounts receivable turnover ratio to monitor cash collections.

Collect more cash using the accounts receivable turnover ratio

It’s a common business problem: your sales are growing, but you’re not collecting payments fast enough. Eventually, you may run short on cash. Monitor the accounts receivable turnover ratio to manage cash, using this ratio:

(Net annual credit sales) / (average accounts receivable)

Let’s define each component of the formula:

  • Credit sales: Sales to customers who don’t pay immediately
  • Net credit sales: Credit sales less any uncollectable balances
  • Average accounts receivable: (Beginning plus ending balance for a month or year), divided by two

A well-managed business can increase credit sales, and keep the accounts receivable balance at reasonable level. If you can increase the turnover ratio, you’ll collect cash at a faster rate.

Accounts receivable and inventory may be the two largest current asset balances. If you carry inventory, take a look at the inventory turnover ratio.

Inventory turnover ratio: a tool to manage inventory levels

This ratio is (cost of goods sold) divided by (average inventory). The average is computed using the same formula as the accounts receivable turnover ratio above.

Your goal is to increase sales (which increases cost of goods sold) and to minimize the investment in inventory. Assume that a firm generates $2,000,000 in sales, and that the average inventory balance is $200,000. The turnover ratio is 10 ($2,000,000 / $200,000).

If the business can produce the same $2,000,000 in sales with a $100,000 inventory investment, the ratio increases to 20.

The most common measure of profitability is earnings per share.

What earnings per share tells business owners

Earnings per share (EPS) is defined as:

(Net income available to common shareholders) / (average common stock shares outstanding)

EPS measures how much profit a business generates for each share of common stock. If you can produce more earnings per share, the common stock is more valuable.

If a company must pay dividends to preferred shareholders, the net income used to pay the preferred stock dividends is subtracted from the net income total.

Every business uses assets to generate revenue, and the return on assets ratio measures how efficiently a firm uses assets.

Monitoring return on assets

The return on assets (ROA) formula is: (Net income) / (average total assets). Well-managed companies are able to increase the profit generated from each dollar of assets.

Let’s say that a tree service business uses a $20,000 truck that carries $5,000 in equipment. If the company can increase the profit generated from using the truck by $10,000, the firm increases ROA.

Decide what works for you

Review the financial ratios listed above, and decide which metrics are the most useful for you. Talk to your CPA and other people in your industry, and find out what financial information they use. Create a financial dashboard with some key ratios, so you can operate your business with confidence.