Liquidity Ratio (2024)

A type of financial ratio used to determine a company's ability to pay its short-term debt obligations

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What is a Liquidity Ratio?

A liquidity ratio is a type of financial ratio used to determine a company’s ability to pay its short-term debt obligations. The metric helps determine if a company can use its current, or liquid, assets to cover its current liabilities.

Liquidity Ratio (1)

Three liquidity ratios are commonly used – the current ratio, quick ratio, and cash ratio. In each of the liquidity ratios, the current liabilities amount is placed in the denominator of the equation, and the liquid assets amount is placed in the numerator.

Given the structure of the ratio, with assets on top and liabilities on the bottom, ratios above 1.0 are sought after. A ratio of 1 means that a company can exactly pay off all its current liabilities with its current assets. A ratio of less than 1 (e.g., 0.75) would imply that a company is not able to satisfy its current liabilities.

A ratio greater than 1 (e.g., 2.0) would imply that a company is able to satisfy its current bills. In fact, a ratio of 2.0 means that a company can cover its current liabilities two times over. A ratio of 3.0 would mean they could cover their current liabilities three times over, and so forth.

Summary

  • A liquidity ratio is used to determine a company’s ability to pay its short-term debt obligations.
  • The three main liquidity ratios are the current ratio, quick ratio, and cash ratio.
  • When analyzing a company, investors and creditors want to see a company with liquidity ratios above 1.0. A company with healthy liquidity ratios is more likely to be approved for credit.

Types of Liquidity Ratios

1. Current Ratio

Current Ratio = Current Assets / Current Liabilities

The current ratio is the simplest liquidity ratio to calculate and interpret. Anyone can easily find the current assets and current liabilities line items on a company’s balance sheet. Divide current assets by current liabilities, and you will arrive at the current ratio.

2. Quick Ratio

Quick Ratio = (Cash + Accounts Receivables + Marketable Securities) / Current Liabilities

The quick ratio is a stricter test of liquidity than the current ratio. Both are similar in the sense that current assets is the numerator, and current liabilities is the denominator.

However, the quick ratio only considers certain current assets. It considers more liquid assets such as cash, accounts receivables, and marketable securities. It leaves out current assets such as inventory and prepaid expenses because the two are less liquid. So, the quick ratio is more of a true test of a company’s ability to cover its short-term obligations.

3. Cash Ratio

Cash Ratio = (Cash + Marketable Securities) / Current Liabilities

The cash ratio takes the test of liquidity even further. This ratio only considers a company’s most liquid assets – cash and marketable securities. They are the assets that are most readily available to a company to pay short-term obligations.

In terms of how strict the tests of liquidity are, you can view the current ratio, quick ratio, and cash ratio as easy, medium, and hard.

Important Notes

Since the three ratios vary by what is used in the numerator of the equation, an acceptable ratio will differ between the three. It is logical because the cash ratio only considers cash and marketable securities in the numerator, whereas the current ratio considers all current assets.

Therefore, an acceptable current ratio will be higher than an acceptable quick ratio. Both will be higher than an acceptable cash ratio. For example, a company may have a current ratio of 3.9, a quick ratio of 1.9, and a cash ratio of 0.94. All three may be considered healthy by analysts and investors, depending on the company.

Liquidity Ratio (2)

Importance of Liquidity Ratios

1. Determine the ability to cover short-term obligations

Liquidity ratios are important to investors and creditors to determine if a company can cover their short-term obligations, and to what degree. A ratio of 1 is better than a ratio of less than 1, but it isn’t ideal.

Creditors and investors like to see higher liquidity ratios, such as 2 or 3. The higher the ratio is, the more likely a company is able to pay its short-term bills. A ratio of less than 1 means the company faces a negative working capital and can be experiencing a liquidity crisis.

2. Determine creditworthiness

Creditors analyze liquidity ratios when deciding whether or not they should extend credit to a company. They want to be sure that the company they lend to has the ability to pay them back. Any hint of financial instability may disqualify a company from obtaining loans.

3. Determine investment worthiness

For investors, they will analyze a company using liquidity ratios to ensure that a company is financially healthy and worthy of their investment. Working capital issues will put restraints on the rest of the business as well. A company needs to be able to pay its short-term bills with some leeway.

Low liquidity ratios raise a red flag, but “the higher, the better” is only true to a certain extent. At some point, investors will question why a company’s liquidity ratios are so high. Yes, a company with a liquidity ratio of 8.5 will be able to confidently pay its short-term bills, but investors may deem such a ratio excessive. An abnormally high ratio means the company holds a large amount of liquid assets.

For example, if a company’s cash ratio was 8.5, investors and analysts may consider that too high. The company holds too much cash on hand, which isn’t earning anything more than the interest the bank offers to hold their cash. It can be argued that the company should allocate the cash amount towards other initiatives and investments that can achieve a higher return.

With liquidity ratios, there is a balance between a company being able to safely cover its bills and improper capital allocation. Capital should be allocated in the best way to increase the value of the firm for shareholders.

More Resources

This has been CFI’s guide to Liquidity Ratio. To keep advancing your career, the additional CFI resources below will be useful:

Liquidity Ratio (2024)

FAQs

What are the 5 liquidity ratios? ›

There are following types of liquidity ratios:
  • Current Ratio or Working Capital Ratio.
  • Quick Ratio also known as Acid Test Ratio.
  • Cash Ratio also known Cash Asset Ratio or Absolute Liquidity Ratio.
  • Net Working Capital Ratio.

How to calculate liquid ratio? ›

The current ratio is the simplest liquidity ratio to calculate and interpret. Anyone can easily find the current assets and current liabilities line items on a company's balance sheet. Divide current assets by current liabilities, and you will arrive at the current ratio.

What does it mean if liquidity ratio is high? ›

A higher liquidity ratio means that your business has a more significant margin of safety with regard to your ability to pay off debt obligations.

Is 0.8 a good liquidity ratio? ›

A good range for the current ratio to fall within is typically 1.5 to 3. If the current ratio is 3, that means the company has enough current assets to pay for its current liabilities threefold. If the ratio is less than 1, the company does not have enough current assets on hand to pay for its current liabilities.

What does a liquidity ratio of 1.5 mean? ›

A Liquidity Ratio of 1.5 means that a company has $1.50 in liquid assets for every $1 of its current liabilities, indicating that the company can cover its short-term obligations.

What is a good basic liquidity ratio? ›

A good current ratio is between 1.2 to 2, which means that the business has 2 times more current assets than liabilities to covers its debts. A current ratio below 1 means that the company doesn't have enough liquid assets to cover its short-term liabilities.

What is a bad liquidity ratio? ›

Low current ratio: A ratio lower than 1.0 can result in a business having trouble paying short-term obligations. As such, it may make the business look like a bigger risk for lenders and investors.

What is the ideal liquid ratio? ›

Ideal Liquid Ratio is 1 : 1.

How do banks calculate liquidity ratio? ›

The LCR is calculated by dividing a bank's high-quality liquid assets by its total net cash flows, over a 30-day stress period. The high-quality liquid assets include only those with a high potential to be converted easily and quickly into cash.

What is the ideal cash ratio? ›

Interpretation of the Cash Ratio

Although there is no ideal figure, a ratio of not lower than 0.5 to 1 is usually preferred. The cash ratio figure provides the most conservative insight into a company's liquidity since only cash and cash equivalents are taken into consideration.

How to measure liquidity? ›

Types of liquidity ratios
  1. Current Ratio = Current Assets / Current Liabilities.
  2. Quick Ratio = (Cash + Accounts Receivable) / Current Liabilities.
  3. Cash Ratio = (Cash + Marketable Securities) / Current Liabilities.
  4. Net Working Capital = Current Assets – Current Liabilities.

How do you fix low liquidity ratio? ›

Ways in which a company can increase its liquidity ratios include paying off liabilities, using long-term financing, optimally managing receivables and payables, and cutting back on certain costs.

How do I comment on liquidity ratios? ›

The higher the current ratio, the more funds the company has available and the better its liquid situation. If the current ratio is greater than 100%, it means that the company has more current assets available than it has current liabilities. This is the standard case for a healthy company.

What is the ideal liquidity quick ratio? ›

Generally speaking, a good quick ratio is anything above 1 or 1:1. A ratio of 1:1 would mean the company has the same amount of liquid assets as current liabilities. A higher ratio indicates the company could pay off current liabilities several times over.

What is the difference between current ratio and liquid ratio? ›

The Current Ratio includes all the Current Assets of the business. The Liquid Ratio includes only those Current Assets that the firm can liquidate to cash within the next ninety days. The Current Ratio includes the inventory stock of a firm. The Liquid Ratio excludes the inventory stock of a firm.

References

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