Liquidity Ratios: Definition, Calculator, Formula, Examples, & More

What Is a Liquidity Ratio?

Liquidity ratios measure a company’s assets against its financial obligations. They tell you whether your liquid assets are enough to cover what you owe in the short term. Owners and stakeholders can use these calculations to guide business decisions.

To understand how liquidity ratios can guide business decisions, you first need to understand how each ratio is formatted. To calculate a liquidity ratio, divide a company’s liquid assets (and, in some cases, those that are easily liquidated) by its liabilities. 

If the result is at least 1, the company has at least enough assets to cover its current expenses.

If it’s less than 1, the company can’t pay its current liabilities with its current assets. Essentially, the greater the liquidity ratio, the easier it is for a company to pay its current obligations.

Important: While a higher number is generally better, it doesn’t mean that a company with a lower ratio is necessarily doing any better or worse. 

Pro Tip: Maximize the accuracy of your financial analysis by using our liquidity ratio calculator. It’s designed to quickly evaluate your company’s ability to cover short-term obligations, providing crucial insights for informed decision-making.

The Importance of the Liquidity Ratio

A company’s liquidity ratio can serve as a measure of its financial health, so it can be used in a variety of different ways:

• By business owners and executives to determine overall financial stability (and to determine whether the business should liquidate more of its assets)
• By investors to determine whether investing in a company is worth the risk
• By lenders to determine whether a company should be approved for credit

To further learn how to use liquidity ratios, it’s important to first understand their various types.

Fun Fact: The highest ever recorded current ratio in the Fortune 500 was over 30. This unusually high ratio was due to a company holding massive cash reserves, illustrating how industry-specific factors can significantly skew financial ratios.

The 3 Main Types of Liquidity Ratios

There are three main types of liquidity ratios. Each type tells you something different about your company. Here’s a rundown of the three main types of liquidity ratios and when to use them.

1. Current Ratio

The current ratio is the most straightforward, at least in terms of calculation.

It shows a company’s ability to pay off its current liabilities (debts payable within a year) with its current assets (including inventory, accounts receivable, and cash). If you want to get straight to calculating, just scroll down to our current ratio calculator below.

Here’s the formula:

You would use this calculation when you need to get a general idea of a company’s liquidity as it stands right now.

2. Quick Ratio

You may have heard the quick ratio referred to as the “acid-test” ratio.

It’s somewhat similar to the current ratio but only factors in a company’s most liquid assets when assessing its ability to cover short-term obligations. This means that when you total current assets, you exclude the value of any inventory.

To calculate a quick ratio, you add up a company’s marketable securities, accounts receivable, and cash (plus cash equivalents). You then divide the total by current liabilities.

Here’s a more straightforward way to write that equation:

This is a good calculation to use if you want to measure a company’s liquidity more stringently.

If your company needs to pay off its current liabilities, it’s usually not feasible (or advisable) to liquidate all inventory completely in a short period. Essentially, a quick ratio gives you a more practical idea of liquidity.

3. Cash Ratio

A company’s cash ratio measures its ability to cover short-term debts using only cash and cash equivalents. That means it excludes inventory, accounts receivable, and other assets from the equation.

The equation itself is pretty simple:

This is the ratio to use when calculating a company’s cash position.

If you run a business and are considering applying for a business loan or another type of credit, pay close attention to your cash ratio — it’s commonly used by lenders to assess a given company’s short-term risk.

Did you know? During the 2008 financial crisis, companies with strong liquidity ratios were more likely to navigate the economic turmoil successfully? This underscores the importance of maintaining good liquidity management practices.

Liquidity Ratio Calculator

Already have the data you need and just want to get to calculating? Just plug in your data in the fields below and hit calculate.

Current Ratio Calculator

What is a Good Current Ratio?

A good current ratio is one that indicates a company’s ability to cover its short-term obligations with its short-term assets. Generally, a current ratio of 2:1 is considered healthy.

This means the company has twice as many current assets as it does current liabilities.

A ratio of 2:1 suggests that the company is well-positioned to meet its debts and other financial commitments within the year without facing liquidity issues.

However, the “ideal” current ratio can vary depending on the industry and the specific operating requirements of a business.

For instance: Industries that require more inventory management, such as retail, might operate safely with a lower ratio. Conversely, in industries where assets are less liquid, a higher current ratio might be necessary to ensure financial stability.

How to Use the Liquidity Ratios [Step-by-Step]

While all of the aforementioned ratios are useful, each one tells you something different. Before you start calculating your company’s liquidity ratios, make sure you know which one to use (and how).

Step 1: Choose the Appropriate Type of Ratio

Begin by choosing which ratio will best answer your questions.

Here’s a brief guide to making an informed selection:

• Choose a current ratio if you need long-term insights and a general idea of a company’s liquidity
• Choose a quick ratio if you want shorter-term insights and a more stringent picture of liquidity
• Choose a cash ratio if you want the most conservative view of a company’s liquidity (or if you’re applying for a line of credit)

Once you’ve determined the right metric for your needs, you can gather the relevant financial data and start calculating. If you want as strong of an understanding of your business’ financial position, you might as well calculate all 3 liquidity ratios.

Step 2: Calculate the Ratio

Here’s what you’ll need to calculate each ratio:

• Current Ratio: The value of all current assets (meaning assets you can turn into cash within a year), including inventory, accounts receivable, and cash
• Quick Ratio: The value of your company’s “quick” (most liquid) assets, including accounts receivable, marketable securities, cash, and cash equivalents
• Cash Ratio: The value of your company’s cash reserves and easily marketable (“near-cash”) securities

You’ll also need to total your current liabilities for each of these ratios. Current liabilities are financial obligations you have during each operating cycle (or, in some cases, every year).

Many businesses have a range of current liabilities. Here are some of the most common:

• Employee compensation and benefits
• Notes payable
• Accounts payable
• Income taxes
• Short-term loans 
• Income taxes 
• The current portion of any long-term debt you have

Take your time gathering the information you need. Many companies base business decisions at least partly on liquidity ratios, so you want to verify that your data points are as complete and accurate as possible.

Step 3: Examples of Calculating Liquidity Ratios

The best way to understand liquidity ratios and how they work is to apply them in practice. Let’s look at a couple of real-world examples.

Example 1

Snow Line Metals has historically enjoyed steady revenue, but a new mega-corporation has begun eating into its profits.

Snow Line’s executives are worried that the company is headed for disaster, and they want to ensure that the company has enough money to pay off its short-term debts if business slows dramatically. 

Which ratio is best in this situation? The executives are worried about a very near-term financial disaster, so they need to see if Snow Line can pay its debts quickly if needed. In this case, a quick ratio is ideal.

The executives would gather the following values:

• Current Liabilities: $50,000
• Cash: $100,000
• Easily Marketable Securities: $10,000
• Accounts Receivable: $100,000

Here’s a review of the quick ratio formula:

As you’ve seen, that formula can also be written this way:

Quick ratio = (marketable securities + accounts receivable + cash and cash equivalents)/(current liabilities)

When you plug in the values above, you get the following:

Quick ratio = ($10,000 + $100,000 + $100,000)/($50,000) = 4.2

Generally, a quick ratio of more than one is considered “good,” so Snow Line looks very secure for the short term.

Example 2

Joe, a small business owner, wants to hire another employee. However, his company’s finances have been getting tighter, and he wants to make sure he can comfortably afford to pay another worker.

Because Joe needs to see beyond the short term, his best bet is to calculate a current ratio. He gathers the following data points:

• Inventory: $100,000
• Accounts Receivable: $50,000
• Cash: $50,000
• Marketable Securities: $10,000
• Current Liabilities: $200,000

Here’s the current ratio formula:

Joe would then enter the values above to get this figure:

Current ratio = ($100,000 + $50,000 + $50,000 + $10,000)/$200,000 = 1.05

Pro Tip: Many experts believe that a current ratio of two or higher is good. Joe’s company has a ratio of 1.05, which shows there could be trouble paying expenses in the next year. This means Joe should likely avoid hiring another employee and should also consider reducing costs in other areas.

Implementing Liquidity Ratios in Business Decisions

Liquidity ratios should be applied thoughtfully within the context of your company’s operational needs and industry norms:

• Strategic Planning: Use liquidity ratios to assess the feasibility of major purchases, expansions, or other investments. Ensure that these activities do not compromise your ability to meet short-term obligations.
• Risk Management: Regular monitoring of liquidity ratios can help identify potential financial stress early, allowing for timely adjustments to financial strategies.
• Investor and Lender Communications: Present these ratios during discussions with potential investors and lenders to demonstrate your company’s financial health and creditworthiness.

Recommendation: Use the quick ratio for a more conservative assessment of your liquidity, especially if your industry experiences seasonal fluctuations or if the market is volatile. This can give you a clearer picture of your financial cushion.

Our Top Tips for Liquidity Ratios

Here are a few other things to keep in mind when it comes to liquidity ratios.

Importance of Liquidity

Liquidity isn’t the only thing that matters when evaluating a company’s financial health. However, a certain degree of liquidity is essential for stability.

Debt and Its Role

All else being equal, greater debt means lower liquidity. If you have a considerable amount of debt, make sure you have enough liquidity to comfortably cover it (and any other financial obligations) if need be.

Special Considerations for Using Liquidity Ratios

• Industry Standards: Always consider industry standards when evaluating your liquidity ratios. Comparing your ratios against industry averages can provide more nuanced insights into your financial position relative to competitors.
• Economic Conditions: Be aware of how broader economic conditions affect your liquidity. For example, during an economic downturn, maintaining a higher current ratio may be prudent.
• Financial Flexibility: While maintaining good liquidity is essential, overly conservative liquidity management can hinder growth. Find a balance that allows for financial security without limiting your company’s growth potential.

Other Metrics to Watch: Cash Flow and Working Capital

These two metrics don’t directly measure liquidity, but they can add important context to liquidity measurements.

“Cash flow” is the difference between a company’s opening and closing balances for a given revenue cycle. Greater liquidity often (but not always) leads to greater cash flow.

“Working capital” is the money your company has tied up in accounts receivable and inventory (minus accounts payable, accrued expenses, etc.).

For lenders and investors, a company with high working capital (even if it also has high liquidity) usually appears riskier because so much of its cash flow is held in accounts like these.

Wrapping Up: Why Liquidity Ratios Matter

When you’re running a business, there’s little room for error.

Saying your company can comfortably cover its liabilities is one thing, but when you can definitively quantify a business’s ability to pay, you will have the precise numbers you need to make confident decisions.

Liquidity ratios are essential for determining these precise numbers.

Whether you need to get a sense of the company’s long-term outlook, understand its short-term financial health, or see how likely you are to be approved for credit, there’s a liquidity ratio that can help. 

When you understand which liquidity ratios to use and when, you can spot potential risks, remedy them, and keep your business running smoothly.