Liquidity Ratio

What is a liquidity ratio?

Liquidity ratios are the financial equivalent of a pulse check. They give you a sense of whether a company is healthy enough to pay its bills. That’s what investors, lenders, and business owners want to know.
A business with strong liquidity can ride out financial challenges. One with a low liquidity ratio might struggle to pay its suppliers or employees on time. That’s where liquidity ratios come in.

Key Point

They measure a company’s ability to pay short-term debts using the assets it has available. That’s what financial health is all about.
There are three main types of liquidity ratios. The current ratio gives you a broad view. The quick ratio takes inventory out of the equation (because it might not be easily converted to cash). The cash ratio focuses only on cash and cash equivalents.

How to calculate liquidity ratio

You calculate liquidity ratios by dividing current assets by current liabilities. The three most common ratios are the current ratio, quick ratio, and cash ratio.

1. Current Ratio

The current ratio = current assets divided by current liabilities. That’s whether a company has enough short-term assets to cover its short-term debts.

2. Quick Ratio

The quick ratio = (current assets minus inventory) divided by current liabilities. That’s a stricter test.

3. Cash Ratio

The cash ratio = (cash plus cash equivalents) divided by current liabilities. That’s the most conservative liquidity measure.

What is a good liquidity ratio?

What constitutes a good liquidity ratio varies by industry and business. Generally, you’re looking for:

A current ratio above 1.0 (ideally between 1.5 and 3.0)
A quick ratio above 1.0
A cash ratio above 0.5 (higher is better, but too high might indicate underutilized cash)

If a ratio is below 1.0, that could signal financial risk. But a ratio that’s too high might mean a business isn’t reinvesting its resources effectively.