Liquidity ratios: formulas, examples and how to use them

Published Friday 13 February 2026

Table of contents

• What are liquidity ratios?
• Why liquidity ratios matter for small businesses
• Current (working capital) ratio
• Quick (acid test) ratio
• Cash ratio
• Another metric for liquidity: Days sales outstanding
• Using liquidity ratios
• How to improve liquidity
• Track your liquidity with Xero
• FAQs on liquidity ratios

Key takeaways

• Calculate your current ratio monthly by dividing current assets by current liabilities, aiming for a healthy range of 1.5 to 2.0 to ensure you can cover short-term expenses without cash flow problems.
• Use the quick ratio to assess your ability to pay bills within three months without selling inventory, as it provides a stricter measure by excluding inventory and focusing only on cash, investments, and receivables.
• Improve low liquidity ratios by speeding up invoice collection, negotiating better payment terms with suppliers, and cutting non-essential spending to increase your available cash.
• Track liquidity trends over time rather than relying on single snapshots, as monthly monitoring helps you spot potential cash flow issues early and make informed decisions about spending and growth.

What are liquidity ratios?

Liquidity ratios measure your business's ability to pay short-term bills using cash or assets you can quickly convert to cash. These ratios help you understand whether you have enough money on hand to cover expenses over the next 12 months.

Cash flow issues are one of the biggest reasons small businesses fail. Liquidity ratios give you a clear picture of your short-term financial health so you can make informed decisions about spending, growth, and investments.

There are three widely used liquidity ratios:

• Current ratio: compares all current assets to current liabilities
• Quick ratio: excludes inventory for a stricter measure
• Cash ratio: only counts cash and cash equivalents

When you use accounting software like Xero, you can view your quick ratio at any time. Here's how each ratio works.

Why liquidity ratios matter for small businesses

Liquidity ratios help you avoid cash flow surprises and make confident financial decisions. Here's why they matter:

• Business survival: cash flow problems are a leading cause of small business failure; liquidity ratios give you early warning signs
• Smarter spending: knowing your ratios helps you decide when to invest, hire, or hold back
• Lender and investor confidence: banks and investors often review liquidity ratios before approving loans or funding
• Benchmarking: compare your ratios to industry standards to see how your business stacks up
• Short-term planning: track your ability to cover payroll, bills, and loan payments over the next 3 to 12 months

Understanding your liquidity puts you in control. Without it, you risk spending too much, growing too fast, or missing opportunities to reinvest.

Current (working capital) ratio

The current ratio (also called the working capital ratio) measures whether your total current assets can cover all current liabilities over the next 12 months. It's the most comprehensive liquidity ratio because it includes all short-term assets, including inventory. Accurately calculating inventory value can be a challenge since 43% of small businesses don't track inventory or use a manual process.

Use this formula: current assets ÷ current liabilities = current ratio.

Current ratio liquidity formula

Current ratio liquidity formula

Current ratio calculation

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. You can ignore your long-term assets or liabilities for this calculation. You can use our free 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. 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

Here's an example using typical small business numbers:

Current assets:

• Inventory: $25,000
• Bank account: $30,000
• Accounts receivable: $10,000
• Prepaid expenses: $5,000
• Short-term investments: $2,000
• Total current assets: $72,000

Your balance sheet groups these together, so you can find the total under "current assets."

Current liabilities include accounts payable, payroll, sales tax, income tax payable, and short-term loans.

Example calculations:

• If current liabilities = $100,000: $72,000 ÷ $100,000 = 0.72 ratio
• If current liabilities = $72,000: $72,000 ÷ $72,000 = 1.0 ratio

The lower your liabilities relative to assets, the higher your ratio and the stronger your ability to cover costs.

What's a good current ratio?

While a current ratio between 1.5 and 2.0 is ideal, a broader view is that any liquidity ratio above one is usually considered healthy for most businesses. This means you have $1.50 to $2.00 in current assets for every $1 of current liabilities.

Here's how to interpret your current ratio:

• 2.0 or higher: Strong liquidity, though very high ratios may indicate underused assets.
• 1.5 to 2.0: Healthy range for most small businesses.
• Below 1.5: May indicate cash flow risk; a slow sales month could make it hard to pay bills.
• 3.0 or higher: Consider reinvesting excess cash into 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, consider it alongside other financial metrics. If you run a seasonal business, use additional metrics alongside this ratio to assess your ability to cover short-term bills. This ratio 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.

Strengths of the current ratio:

• Calculates easily with just two numbers from the balance sheet
• Allows business owners to quickly assess cash flow issues
• Helps assess your ability to cover expenses
• Identifies when you need to take out loans
• Identifies when you should think about expanding or investing

Limitations of the current ratio:

• Easily skewed when one of the two numbers changes for any reason
• Hides seasonal trends and doesn't reflect seasonal cash flow issues
• Only shows short-term financial health, not future challenges beyond 12 months
• Lacks insights into the company's long-term financial health
• Provides no insights into the business's loans and profitability

Quick (acid test) ratio

The quick ratio (also called the acid test ratio) measures whether you can pay expenses over the next three months without selling inventory or borrowing money. It includes cash, cash equivalents, short-term investments, and accounts receivable.

This ratio answers a critical question: do you have enough liquid assets to cover payroll, bills, and loan payments in the short term?

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Quick ratio liquidity formula Version 1

Quick ratio liquidity formula Version 1

Quick ratio calculation

Calculate the quick ratio using either method:

Method 1: (cash + cash equivalents + short-term investments + accounts receivable) ÷ current liabilities = quick ratio

Method 2: (current assets − inventory − prepaid expenses) ÷ current liabilities = quick ratio

Both methods produce the same result. Use whichever works best with the data you have available.

Quick ratio example

If you have $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. Your balance sheet should have all the numbers you need to calculate this ratio.

What's a good quick ratio?

A quick ratio of 1.0 or higher is generally healthy. This means you have at least $1 in liquid assets for every $1 of short-term liabilities.

Here's how to interpret your quick ratio:

• 1.5 or higher: Strong liquidity; you have $1.50 for every $1 of expenses.
• 1.0: Adequate liquidity; you can cover upcoming bills.
• Below 1.0: Potential cash flow concerns; a ratio of 0.3 means only 30 cents for every $1 of bills.

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.

You can use this ratio as a quick guide when you're thinking about taking on new expenses. For long-term health assessments, use additional metrics. For instance, you might be sitting on a stack of cash because you've had a great launch, but the quick ratio alone can't predict whether your product or service will sustain that cash flow. The quick ratio measures current liquidity only.

Strengths of the quick ratio:

• Calculates easily with readily available numbers
• 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

Limitations of the quick ratio:

• Excludes operating income from the calculation
• Only considers a short-term (three-month) period
• Can be tricky to estimate if you have lots of marketable securities during times of economic instability
• 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

Cash ratio

The cash ratio measures whether you can cover short-term bills using only cash and cash equivalents. It's the strictest liquidity ratio because it excludes inventory, accounts receivable, and other assets.

Use this formula: cash and cash equivalents ÷ current liabilities = cash ratio.

This ratio tells you if you can pay your payroll, expenses, and loan payments over the next year without selling inventory or collecting receivables.

Cash ratio liquidity formula

Cash ratio liquidity formula

Cash ratio calculation

The cash ratio calculation includes:

• bank account balances: cash you can access immediately
• cash equivalents: securities you can convert to cash quickly

The cash ratio excludes:

• inventory: products you haven't sold yet
• accounts receivable: money customers owe you
• expected revenue: income you haven't received yet

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 short-term liabilities are $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?

A cash ratio of 1.0 or higher means you have enough cash to cover all short-term liabilities. A ratio below 1.0 suggests you may struggle to pay upcoming bills without selling assets or collecting receivables.

If your ratio is low, consider getting clients to pay invoices faster or reducing short-term expenses.

When to use the cash ratio

The cash ratio works best when you need a quick snapshot of your ability to pay bills with cash on hand. A low ratio after a major investment doesn't always signal trouble; it may simply reflect a strategic decision to deploy cash for growth.

Strengths of the cash ratio:

• Calculates quickly with just two numbers
• Provides immediate insight into cash availability
• Shows your most conservative ability to cover short-term expenses

Limitations of the cash ratio:

• Excludes operating income from the calculation
• Excludes supplier credit terms from the calculation
• Focuses only on short-term expenses, excluding long-term business challenges

Another metric for liquidity: Days sales outstanding

Days sales outstanding is another metric that may help you assess liquidity, depending on your industry and the way you operate your business.

The days sales outstanding formula

The days sales outstanding formula

Days sales outstanding (DSO) measures the average number of days it takes to collect payment after a sale. A lower DSO means faster cash collection and better liquidity.

Use this formula: (average accounts receivable ÷ net revenue) × 365 = DSO

What's a good DSO?

This varies by industry, but as a benchmark, the median DSO across industries was 56 days in 2024. Generally:

• 30 days or less: Excellent, you're collecting quickly.
• 30 to 45 days: Typical for many industries.
• 45 days or more: May indicate collection issues, though some sectors like consulting have higher DSOs because 90-day payment terms are common. For most businesses, tighten payment terms or follow up on overdue invoices.

Using liquidity ratios

Here's how to get the most from your liquidity ratios:

• Calculate monthly: Check your ratios at the same time each month for consistency.
• Track trends: Look at how ratios change over time, not just single snapshots.
• Know the limitations: Each ratio has blind spots; use multiple ratios together.
• Consider the full picture: Analyse liquidity alongside solvency and efficiency ratios.
• Get expert input: Work with an accountant or financial advisor for complex decisions.

How to improve liquidity

If your liquidity ratios are lower than you'd like, here are practical ways to improve them:

1. Speed up invoicing:Use accounting software like Xero to send invoices faster and collect payments more efficiently.
2. Collect receivables faster:Improve your accounts receivable by offering early payment discounts and sending automated reminders for overdue invoices.
3. Negotiate better payment terms: Extend supplier payment windows where possible while avoiding late fees.
4. Cut non-essential spending: Review operating costs and eliminate discretionary expenses.
5. Optimise inventory levels:Manage your inventory by using just-in-time ordering to avoid tying up cash in excess stock.
6. Sell unproductive assets: Convert unused equipment or inventory into cash.
7. Grow revenue strategically:Increase sales by expanding your customer base without proportionally increasing operating costs.
8. Refinance expensive debt: Consolidate high-interest short-term loans into lower-rate options.

Your accountant can help you prioritise these strategies. You may need to initiate the conversation, as research shows many small business owners find their accountant is more reactive than proactive. Find experienced accountants and bookkeepers in the Xero advisor directory.

Track your liquidity with Xero

Understanding your liquidity ratios helps you make confident decisions about spending, growth, and cash flow management. With the right tools, tracking these metrics becomes part of your regular routine rather than a time-consuming task.

Xero's accounting software lets you view your quick ratio at any time and generates the reports you need to calculate all three liquidity ratios. Automated bank feeds and real-time dashboards give you visibility into your cash position whenever you need it.

Ready to take control of your cash flow? Get one month free and see your financial health in real time.

FAQs on liquidity ratios

Here are answers to common questions about liquidity ratios and how to use them.

What is a healthy liquidity ratio?

A healthy current ratio is typically between 1.5–2.0, meaning you have $1.50–$2.00 in current assets for every $1 of liabilities. For the quick ratio, aim for 1.0 or higher.

What does a liquidity ratio of 2.5 mean?

A liquidity ratio of 2.5 means you have $2.50 in assets for every $1 of short-term liabilities. This indicates strong liquidity, though a very high ratio may suggest you could reinvest some cash into growth opportunities.

How often should I calculate my liquidity ratios?

Calculate your liquidity ratios monthly, ideally at the same point in your billing cycle each time. This helps you spot trends and catch potential cash flow issues early.

Can liquidity ratios be too high?

Yes. A very high ratio (above 3.0) may indicate you're holding too much cash or inventory that could be reinvested into the business. Balance liquidity with growth opportunities.

Which liquidity ratio is most important for small businesses?

The current ratio is most commonly used because it gives a comprehensive view of short-term financial health. However, the quick ratio provides a stricter measure if you want to exclude inventory from the calculation.