Liquidity ratios explained: How to measure yours and improve your small business cash flow

Published Friday 5 December 2025

Table of contents

• What is liquidity?
• What are liquidity ratios?
• Types of liquidity ratios
• Cash ratio
• Quick (acid test) ratio
• Current (working capital) ratio
• How to improve liquidity
• Another metric for liquidity: Days sales outstanding
• Using liquidity ratios
• Manage your business finances with confidence
• FAQs on liquidity ratios

Key takeaways

• Calculate your liquidity ratios monthly using the three main types: cash ratio (most conservative, using only cash), quick ratio (includes easily convertible assets within 90 days), and current ratio (includes all assets convertible within 12 months).

• Maintain benchmark ratios to ensure financial health: aim for a cash ratio of 0.2 or higher, a quick ratio between 0.8-1.0, and a current ratio between 1.5-2.0 for most small businesses.

• Improve liquidity by speeding up cash inflow through automated invoicing and early payment discounts, while managing outflow by negotiating extended supplier payment terms and cutting unnecessary expenses.

• Interpret ratios alongside other financial metrics and industry benchmarks rather than relying on single measurements, as each ratio has limitations and seasonal business cycles can affect accuracy.

What is liquidity?

Liquidity is how much cash your business has available to pay bills immediately. This includes cash in the bank plus anything you can quickly convert to cash.

Why liquidity matters:

• Cash flow problems cause 82% of business failures
• Poor liquidity management leads to overspending or missed growth opportunities
• Liquidity ratios help you assess your short-term financial health (12 months or less)

Understanding your liquidity helps you decide how to manage operations, expenses and investments.

What are liquidity ratios?

Liquidity ratios measure your business's ability to pay short-term debts using available cash and near-cash assets. These ratios show the gap between what you have and what you owe.

The three main liquidity ratios are:

• Cash ratio: Most conservative measure using only cash
• Quick ratio: Includes cash plus easily convertible assets
• Current ratio: Broadest measure including all current assets

If you use accounting software like Xero, you can click to view your quick ratio at any time.

Types of liquidity ratios

Liquidity ratios fall into three categories, each measuring different levels of financial flexibility. Understanding which ratio to use depends on how quickly you need to assess your ability to pay bills.

Conservative measurement:

• Cash ratio: Uses only cash and cash equivalents

Moderate measurement:

• Quick ratio: Includes cash plus assets convertible within 90 days

Comprehensive measurement:

• Current ratio: Includes all assets convertible within 12 months

Cash ratio

Here's a breakdown of how cash ratio works for your small business.

Cash ratio calculation

Cash ratio measures your ability to pay short-term debts using only cash and cash equivalents. This is the most conservative liquidity measure because it only counts money you can access immediately.

What it tells you:

• Can you cover payroll with cash on hand?
• Can you pay immediate expenses without selling assets?
• How much financial cushion do you have for emergencies?

This ratio includes the fewest assets and is the fastest to calculate.

Cash ratio calculation includes:

• Bank account balances: All business checking and savings accounts
• Cash equivalents: Securities you can convert to cash within 24–48 hours

Cash ratio calculation excludes:

• Inventory: Products waiting to be sold
• Accounts receivable: Money customers owe you
• Expected revenue: Future sales or payments

Cash ratio example

Imagine you have $50,000 in cash and $50,000 in stocks. Add them together to get $100,000. Now find the 'short-term liabilities' line on your balance sheet. This includes all of your upcoming expenses, like your loan payments, monthly bills, taxes due, and payroll.

• If this number is $250,000, your ratio is: $100,000/$250,000 = 0.4
• If your short-term liabilities are $25,000, your ratio is: $100,000/$25,000 = 4.0

What's a good cash ratio?

Good cash ratio benchmarks:

• 0.2 or higher: Adequate cash reserves for most small businesses
• 0.5 or higher: Strong cash position with good financial cushion
• Below 0.2: May struggle to pay immediate bills

If your ratio is low:

• Speed up collections: Offer early payment discounts
• Extend payment terms: Negotiate longer periods with suppliers
• Build cash reserves: Set aside more revenue before spending

When to use the cash ratio

As with the other ratios, the cash ratio doesn't reflect every situation your business is facing. If you've just invested lots of cash into a new product line, your cash ratio may be low – but that doesn't necessarily mean your business will suffer. It simply means you've decided to reduce your cash on hand to earn more revenue with your new product.

When you're making decisions about expenses, liquidity ratios can help you judge when you're going too low with your cash on hand.

The cash ratio:

• is easy to calculate
• provides quick insights on a business's cash utilisation rates
• shows a realistic ability to cover short-term expenses because it only takes into account cash and cash equivalents, not inventory or other assets

But:

• the cash ratio doesn't include any operating income
• it doesn't take into account how long-term credit with suppliers or accounts receivables cycles affect cash on hand
• it doesn't take consider long-term expenses or challenges

Quick (acid test) ratio

Quick ratio calculation

Quick ratio measures your ability to pay short-term debts within 90 days using cash and near-cash assets. This ratio excludes inventory because it can take time to sell.

What it measures:

• Can you cover 3 months of expenses without selling inventory?
• Can you pay bills using only liquid assets?
• How financially flexible is your business in the short term?

There are two ways to calculate the quick ratio:

• The first method is to add up your cash, securities such as shares and bonds that you can easily convert to cash, and accounts receivable (the money owed to you). Then divide that by the total of what you owe and have to pay in the next three months.
• The alternative is to start with the total current assets listed on your balance sheet, and then subtract inventory and prepaid expenses. Then divide by your current liabilities.

Both options should lead you to the same ratio.

Quick ratio example

So, if you've got $30,000 in the bank, $15,000 in securities, and $60,000 in costs over the next three months, your quick liquidity ratio is 0.75. That's $30,000 plus $15,000, divided by $60,000.

The quick ratio is also called an acid test ratio because acid tests are quick and easy to do. Your balance sheet should have all the numbers you need to calculate this ratio.

What's a good quick ratio?

Quick ratio benchmarks:

• 1.0 or higher: ideal position – you can cover all short-term debts
• 0.8 to 1.0: Adequate liquidity for most situations
• Below 0.8: May struggle with unexpected expenses

How to interpret your ratio:

• 1.5 ratio: You have $1.50 for every $1 of upcoming expenses
• 1.0 ratio: You have exactly enough to cover short-term debts
• 0.3 ratio: You have only 30 cents for every $1 of bills due

When to use the quick ratio

Use this ratio to compare different companies if you're thinking about investing in a new company. You can also use it to compare your business's financial health to other companies in your industry, or to look at your business's liquidity over different periods.

Although you can use this ratio as a quick guide when you're thinking about taking on new expenses, don't use it to assess the long-term health of your company. For instance, you might be sitting on a stack of cash after a great launch—and a very high quick ratio can indicate you have excess cash—but if your product or service doesn't have staying power, you won't be able to maintain your cash flow. The quick ratio isn't going to show you that.

The quick ratio:

• is easy to calculate
• gives you a good idea of whether you can cover your expenses over the short term
• helps you compare differences in cash flow between periods, so you can plan ahead for shortages
• lets you see liquidity to determine if you can afford more expenses or investments

But:

• the quick ratio doesn't take operating income into account
• it only considers a short-term (three-month) period
• it's tricky to estimate whether you have lots of marketable securities during times of economic stability, or if you have lots of volatile stocks that change value quickly
• the quick ratio may be inaccurate if you overstate the value of your accounts receivables – be realistic about the percentage of these bills that won't get paid

Current (working capital) ratio

Here are the basics of how current (working capital) ratio works for your small business.

Current ratio calculation

Current ratio measures your ability to pay debts due within 12 months using all current assets. This includes cash, inventory, accounts receivable, and other assets you can convert to cash within a year.

Why it's called the :

• Working capital = Current assets minus current liabilities
• Shows long-term sustainability over the next 12 months
• Includes inventory unlike the quick ratio

You can find the numbers for this calculation on your balance sheet. Look for your total current assets near the top of the report and total current liabilities near the middle. Don't worry about your long-term assets or liabilities. You can use the free Xero balance sheet template.

Unlike the quick ratio, the current ratio includes your inventory. It accounts for the inventory based on its value on your balance sheet – typically, this means the cost you paid for the inventory, not the price you're going to sell it for.

Note that if your inventory is worth less than it cost (such as out-of-season holiday inventory), you should adjust its value on the balance sheet so you get a more accurate current ratio.

Generally, your current liabilities include all bills due within 12 months or less. But keep in mind that the way you do your bookkeeping affects how your liabilities appear on your balance sheet.

For instance, if you don't record monthly bills until they go through your bank account they won't appear on your balance sheet, and you therefore won't be able to calculate this ratio easily. An accountant or the support team for your bookkeeping software can help you set up your books so you can calculate this ratio.

Current ratio example

Say you have $25,000 in inventory, $30,000 in your bank account, $10,000 in accounts receivables, $5,000 in prepaid expenses, and $2,000 in short-term investments.

When you add up these numbers, you get $72,000. Your balance sheet groups these assets in the current assets section, so you don't have to add them up yourself. The total will be labeled as 'current assets' on your balance sheet.

Now, find the current liabilities on your balance sheet. This section includes accounts payable, payroll, sales tax, income tax payable, and short-term loans. If your short-term liabilities add up to $100,000, your ratio is 0.72. On the other hand, if your short-term liabilities are $72,000, you have a ratio of 1.0.

As your bills get lower (in relation to your short-term assets), your ratio gets higher, meaning you have plenty of money to cover costs.

What's a good current ratio?

Current ratio benchmarks:

• 1.5 to 2.0: Ideal range for most small businesses
• 1.0 to 1.5: Acceptable but monitor closely, as a ratio over 1.0 is generally considered to be comfortable.
• Below 1.0: Immediate attention needed, as a ratio under 1.0 can result in reduced opportunities or even deregistration in some cases.
• Above 3.0: May be missing growth opportunities

When to use the current ratio

You can use the current ratio to make decisions about your expenses and cash on hand. For instance, if you have a low working capital ratio, you may need to cut expenses. A low ratio also indicates that if you're buying equipment, you probably shouldn't use your cash on hand – consider a loan to spread the cost over time, instead.

On the other hand, if your ratio is 3.0 or higher, you may be missing out on opportunities – you probably have cash, investments, or inventory lying around that should be reinvested into growing the company.

While this ratio is useful, it's not the only number you need to consider. Don't rely on this ratio to assess your ability to cover your short-term bills if you run a seasonal business. And keep in mind that this ratio really only looks at your current assets and liabilities; it doesn't take into account the long-term profitability of your business, the types of loans you have, or other factors that contribute to your business.

The current ratio:

• is easy to calculate – it requires just two numbers from the balance sheet
• allows business owners to quickly assess cash flow issues
• is helpful for assessing your ability to cover expenses
• can help you identify when you need to take out loans
• can help you identify when you should think about expanding or investing

But:

• because the current ratio only uses two numbers, it is easily skewed when one of those numbers changes for any reason
• it hides seasonal trends and doesn't reflect seasonal cash flow issues
• it only shows short-term financial health, and doesn't take into account future challenges (beyond 12 months)
• it doesn't show insights on the company's long-term financial health
• it lacks insights into the business's loans and profitability

How to improve liquidity

Speed up cash inflow:

• Use accounting software: Automate invoicing and payment reminders
• Offer early payment discounts: Encourage faster customer payments
• Improve collections: Send automated payment reminders

Manage cash outflow:

• Negotiate payment terms: Extend supplier payment periods
• Cut unnecessary expenses: Eliminate non-essential spending
• Lease instead of buy: Preserve cash for operations

Optimise operations:

• Manage inventory levels: Keep stock at industry standards
• Sell unproductive assets: Convert unused equipment to cash
• Increase sales efficiency: Focus on high-margin products

Your accountant can help you make these decisions. Find experienced accountants and bookkeepers in the Xero advisor directory.

Another metric for liquidity: Days sales outstanding

This ratio is most useful if you sell on credit or rely heavily on customer invoices.

The days sales outstanding formula

Days sales outstanding is the average number of days it takes you to get paid after a sale. To calculate it, divide your average accounts receivables by your revenue per day. If your number is too high, figure out how to get your clients to pay you faster because they're tying up your cash.

Using liquidity ratios

How to use liquidity ratios effectively:

Calculate consistently:

• Monthly calculations: Check ratios at the same time each month
• Track trends: Look at changes over time, not just single measurements
• Consider business cycles: Account for seasonal fluctuations

Interpret wisely:

• Know each ratio's limitations: No single ratio tells the complete story
• Compare with industry benchmarks: Understand what's normal for your sector
• Analyse alongside other metrics: Include profitability and efficiency ratios

Get professional guidance:

• Work with financial advisors: The stakes are high for liquidity decisions
• Use accounting software: Automate calculations and tracking

Manage your business finances with confidence

Understanding your liquidity ratios is a crucial step toward making smarter financial decisions. By regularly calculating and analysing these numbers, you get a clear picture of your ability to cover short-term debts, which empowers you to manage cash flow with confidence.

With Xero, you can generate the reports you need to calculate these ratios, so you can stay on top of your finances and focus on running your business. See how Xero can simplify your financial management.

Try Xero for free

FAQs on liquidity ratios

Here are some common questions small business owners have about liquidity ratios.

What are the 5 liquidity ratios?

While the three most common are the cash, quick, and current ratios, some analyses include others like the operating cash flow ratio (cash flow from operations / current liabilities) and the days sales outstanding (DSO) ratio. For most small businesses, focusing on the main three provides a solid understanding of liquidity.

Is 2 a good liquidity ratio?

For the current ratio, a value of 2 is often considered healthy. It suggests you have $2 of current assets for every $1 of current liabilities. However, a 'good' ratio depends on your industry and business model. A very high ratio might even suggest you're not using your assets efficiently.

What does a liquidity ratio of 2.5 mean?

A current ratio of 2.5 means your business has 2.5 times more current assets than current liabilities. This is generally seen as a strong, healthy position, indicating you have a significant cushion to cover your short-term obligations.

How often should I calculate liquidity ratios?

It's a good practice to calculate your liquidity ratios monthly. This allows you to track trends over time and spot potential cash flow issues before they become serious problems. Calculating them at the same time each month provides the most consistent view.

Can liquidity ratios predict cash flow problems?

Yes, they can be an early warning system. A declining trend in your liquidity ratios, especially the quick or cash ratio, can signal that you might face trouble paying your bills in the near future. They help you proactively manage your finances rather than reacting to a crisis.