Liquidity ratio

Key takeaways

Short-term solvency indicator

Liquidity ratios measure how easily a company can convert assets into cash to cover immediate liabilities, reflecting its short-term financial strength.

Common liquidity ratios

Current ratio = Current assets / Current liabilities
Quick ratio (Acid-test ratio) = (Current assets – inventories) / Current liabilities
Cash ratio = Cash and cash equivalents / Current liabilities

Industry benchmarking

Ideal liquidity ratio values vary by industry, but generally, a ratio above 1 indicates that a company can cover its short-term obligations.

Early warning signal

Regular monitoring of liquidity ratios helps businesses spot potential cash flow problems before they escalate.

Strong liquidity ratios provide companies with financial stability by assuring creditors and investors that short-term commitments can be met, thus reducing default risk. These ratios are key indicators of creditworthiness, as banks and suppliers often rely on them to decide whether to extend credit or favorable payment terms. Additionally, companies with healthy liquidity enjoy greater operational flexibility, enabling them to seize new opportunities or handle unexpected expenses without financial strain.

The liquidity ratio calculation process

Gather financial data

Use the company’s balance sheet to obtain current assets, current liabilities, and cash equivalents.

Apply the formulas

Current ratio: Divide total current assets by total current liabilities.
Quick ratio: Subtract inventories from current assets, then divide by current liabilities.
Cash ratio: Divide cash and cash equivalents by current liabilities.

Interpret the results

Compare the ratios to industry benchmarks and historical trends to assess financial health.

Frequently asked questions about liquidity ratio?

1) What is a good liquidity ratio?

Generally, a current ratio above 1 is considered healthy, but the ideal value depends on the industry and business model.

2) Can a company have too high a liquidity ratio?

Yes. Excessively high ratios may indicate underutilized assets or overly conservative cash management.

3) What’s the difference between liquidity and solvency?

Liquidity focuses on short-term obligations, while solvency measures a company’s ability to meet long-term debts.

4) How can a business improve its liquidity ratios?

By speeding up receivables, reducing inventory, delaying payables (within reason), or increasing cash reserves.