While you may be familiar with looking at profit and turnover, one of the most useful ways to measure financial health is by looking at liquidity. But what exactly is a liquidity ratio and why does it matter?

Whether a large or small business, running a company always requires keeping a close eye on the numbers.

In simple terms, a liquidity ratio shows whether a company can pay its short-term bills without running into trouble. In this blog, we explain what liquidity ratios are, the different types, why they’re useful, and, crucially, how to interpret them.

Key takeaways: What is a liquidity ratio?

  • A liquidity ratio shows how easily a business can cover short-term debts using current assets.
  • The three main types are the current ratio, quick ratio and cash ratio.
  • Liquidity ratios are important for investors, lenders and managers to assess financial health.
  • Ratios vary by industry, but in general a higher ratio suggests stronger short-term stability.
  • Liquidity ratios have limitations, as they only provide a snapshot in time.

What is a liquidity ratio?

A liquidity ratio is a financial metric that compares a company’s current assets — things like cash, accounts receivable and inventory — to its current liabilities, which are bills and obligations due within a year.

To put it in simple terms, it answers the question: “If all my short-term debts had to be paid today, could I afford them?”

Liquidity is not the same as profitability. A company may make a profit on paper but still struggle with cash flow. Liquidity ratios focus only on short-term survival: do you have enough on hand to pay suppliers, staff and other immediate costs?

A good analogy is your own household budget. Looking at your current account balance and savings against your rent, utilities and credit card payments gives you a sense of whether you can cover the next month comfortably. 

Liquidity ratios work in a similar way for businesses.

credit cards on a laptop

Types of liquidity ratios

Each ratio type interprets financial health in a slightly different manner.

Current ratio

The current ratio is considered the simplest measure. Here’s the formula:

Current assets ÷ current liabilities

So, if a company has £200,000 in current assets and £100,000 in current liabilities, its current ratio is 2.0. This means it has £2 available for every £1 owed.

Quick ratio (acid test)

The quick ratio excludes inventory, which can take longer to convert into cash. See the formula below:

(Current assets – inventory) ÷ current liabilities

This ratio is considered a stricter test when compared to the current ratio.

It focuses on assets that can be turned into cash quickly, such as bank balances and receivables.

Cash ratio

The cash ratio looks only at cash and cash equivalents:

Cash and equivalents ÷ current liabilities

This is the most conservative measure of liquidity, showing whether a company could pay all its short-term obligations immediately, without selling anything or waiting for invoices to be paid.

Why liquidity ratios matter

Liquidity ratios are a valuable business tool as they show whether a business can stay afloat in the short term. 

  • Even the most profitable companies can run into trouble if they don’t have enough cash to hand to pay bills.
  • Even if not part of your day-to-day financial process, external investors and lenders will often look to liquidity ratios in order to assess financial risk. 
  • A business with weak liquidity may struggle to secure funding or credit. 
  • On the other hand, strong liquidity can reassure stakeholders that the company is well-managed and financially stable.
  • For managers, these ratios are a useful internal tool. They highlight potential cash flow problems early and help with planning.

It’s worth noting that extremely high liquidity isn’t always positive. Holding too much cash may mean the business is missing opportunities to invest in growth.

Liquidity ratio examples and benchmarks

You’ve done your calculations – now you’re wondering what would be considered a “good” liquidity ratio.

For the current ratio, we generally consider a figure between 1.5 and 3.0 to be healthy. A ratio below 1.0 suggests the company may struggle to cover short-term debts. On the other hand, a very high ratio may indicate inefficiency.

With the quick ratio, a figure over 1.0 is usually seen as safe. It shows the company can pay off liabilities without selling stock.

Cash ratios do tend to be lower. Businesses rarely aim for more than 1.0 here, as holding too much idle cash is not efficient.

It’s important to remember that these benchmarks vary by industry. 

A supermarket, for example, sells inventory quickly and may be fine with a lower quick ratio. 

A construction company, which holds more stock for longer periods, might need a stronger liquidity position.

Once again, getting input from a chartered accountant will be valuable in interpreting the data for your business’ particular situation.

using a calculator and writing, accounting errors

Limitations of liquidity ratios

While useful, liquidity ratios are not the full picture.

  • They are a snapshot in time. A ratio may look healthy at the end of the financial year but not reflect cash flow challenges at other points.
  • They don’t measure profitability. A business might have solid liquidity but still lose money overall.
  • Seasonal businesses may show distorted figures, depending on when the calculation is made.

For these reasons, liquidity ratios should be viewed alongside other measures like profitability ratios, debt ratios and cash flow statements.

FAQs: What is a liquidity ratio?

What is the meaning of liquidity ratio?

It measures a company’s ability to cover its short-term debts with its current assets, such as cash, receivables and inventory.

What does a liquidity ratio of 1.5 mean?

It means the company has £1.50 in current assets for every £1.00 of short-term liabilities. This is generally seen as a healthy balance.

What does a 30% liquidity ratio mean?

A liquidity ratio of 30% (0.3) means the company has only 30p of liquid assets for every £1 of liabilities — which may indicate financial strain.

Is a liquidity ratio of 2 good?

Often yes. A current ratio of 2.0 means the company has twice as many assets as liabilities. In many industries this is considered strong, though very high ratios can also signal inefficiency.

What are the 3 types of liquidity ratios?

The main ones are the current ratio, quick (acid test) ratio and cash ratio.

Why are liquidity ratios important?

They show if a business can pay its bills in the short term and help investors, lenders and managers assess financial health.

Final thoughts: What is a liquidity ratio?

We hope you found this article useful. Our blog is full of helpful guides and information – some of our most popular articles include:

Liquidity ratios are one of the simplest and most useful tools for checking a business’s short-term financial health. 

In placing current assets alongside current liabilities, they provide a clear picture of whether a company can cover its immediate debts.

It’s true, they’re not a perfect measure. Liquidity ratios should always be considered alongside other financial indicators. However, they are a valuable starting point for assessing stability.

If you’d like expert guidance on understanding your business’s liquidity or improving your financial position, the team at Accountants East London is here to help. Get in touch today to learn more.