Liquidity ratios: types, formulas and how to use them

Published Friday 13 February 2026

Table of contents

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

Key takeaways

• Calculate your three key liquidity ratios monthly to monitor your business's ability to pay short-term bills: the current ratio (all current assets vs liabilities), quick ratio (excluding inventory), and cash ratio (only cash and equivalents).
• Target a current ratio between 1.5-2.0 and a quick ratio of 1.0 or higher to maintain healthy short-term financial position, as ratios below 1.0 indicate potential cash flow problems.
• Improve your liquidity by speeding up invoice collection, negotiating better supplier payment terms, reducing unnecessary expenses, and managing inventory levels efficiently to free up cash.
• Track trends over time rather than relying on single snapshots, as your ratios can shift based on billing cycles and seasonal factors that affect your business operations.

What is liquidity?

Liquidity is how much cash (or assets you can quickly convert to cash) your business has on hand to pay your bills.

Managing cash flow effectively helps new businesses stay open and thrive. Liquidity ratios help you gauge your short-term financial health over 12 months or less.

Understanding your liquidity helps you:

• make smart decisions about operations, expenses, and investments
• avoid spending too much or growing too fast
• identify underused resources you could put to work

Why liquidity ratios matter

You need to know if you have enough cash to cover your short-term debts. Liquidity ratios give you a clear picture of your financial health, helping you answer important questions like, 'Can you afford to pay your suppliers next month?' or 'Is this a good time to invest in new equipment?'.

Cash ratio liquidity formula

Tracking these ratios helps you spot potential cash flow problems before they become serious. It gives you the confidence to make informed decisions, manage your money effectively, and plan for growth.

What are liquidity ratios?

Liquidity ratios measure the gap between your available cash and your upcoming bills. They show whether your business can cover short-term expenses without taking on new debt.

There are three widely used liquidity ratios in accounting:

• Cash ratio: measures cash and cash equivalents against current liabilities
• Quick (acid test) ratio: includes receivables but excludes inventory
• Current (working capital) ratio: compares all current assets to current liabilities

If you use accounting software like Xero, you can check your quick ratio at any time. Here's what each ratio means and how to calculate it.

Cash ratio

The cash ratio is your cash and cash equivalents divided by your short-term liabilities. It shows whether you can cover payroll, expenses, and loan payments over the next year using only the cash you have on hand.

This ratio includes the fewest assets of the three liquidity ratios, making it the fastest to calculate and the most conservative measure of your ability to pay bills.

Cash ratio liquidity formula

Cash ratio calculation

The cash ratio calculation only includes cash in your bank accounts and cash equivalents, which are highly liquid investments with a maturity of three months or less.

The cash ratio excludes several types of assets that aren't immediately available as cash:

• Inventory: products you'd need to sell first
• Accounts receivables: money customers owe you but haven't paid
• Expected revenue: income you anticipate but haven't received

This makes the cash ratio a conservative measure of immediate liquidity.

Cash ratio example

Quick ratio liquidity formula Version 1

Say 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?

• High ratio (above 1.0): Your business can easily cover its expenses with cash on hand
• Low ratio (below 1.0): You'll want to improve cash flow and should consider getting clients to pay invoices faster

A cash ratio of 1.0 means you have exactly enough cash to cover your current liabilities.

When to use the cash ratio

The cash ratio reflects only part of your business situation. If you've just invested heavily in a new product line, your ratio may be low, and your business can still thrive. It simply means you've chosen to deploy cash for future revenue.

When making decisions about expenses, liquidity ratios help you judge when your cash on hand is getting too low.

The cash ratio offers several advantages:

• Calculates quickly with minimal data
• Provides immediate insights on cash utilisation
• Shows realistic ability to cover short-term expenses using only liquid assets

The cash ratio has some limitations:

• Excludes operating income from the calculation
• Ignores supplier credit terms and receivables cycles
• Focuses only on short-term expenses, excluding long-term factors

Quick (acid test) ratio

The quick ratio measures your ability to cover expenses over the next three months without selling inventory or taking out loans. It calculates whether your cash, securities, and accounts receivables can cover payroll, bills, loan payments, and other business essentials.

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Quick ratio liquidity formula Version 1

Quick ratio calculation

There are two ways to calculate the quick ratio:

Method 1: Add liquid assets

Current ratio liquidity formula

Follow these steps:

1. Add cash + securities + accounts receivables
2. Divide by current liabilities (what you owe in the next three months)

Method 2: Subtract from current assets

Follow these steps:

1. Start with total current assets from your balance sheet
2. Subtract inventory and prepaid expenses
3. Divide by current liabilities

Both methods produce the same result.

Quick ratio example

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?

Target quick ratio: 1.0 or higher

• 1.0: You have $1 to cover every $1 of expenses
• 1.5: You have $1.50 for every $1 of upcoming expenses
• Below 1.0: You'll want to improve cash flow to comfortably cover upcoming bills
• 0.3: You have only 30 cents for every $1 of bills over the next three months

A ratio above 1.0 indicates healthy short-term liquidity.

When to use the quick ratio

The quick ratio helps you make informed business decisions. Use it to:

• compare different companies before investing
• benchmark your business against others in your industry
• track your liquidity over different time periods
• guide decisions about taking on new expenses

The quick ratio only shows short-term health. A high ratio after a successful launch reflects current health; long-term cash flow depends on sustained product performance.

The quick ratio offers several advantages:

• Calculates easily with balance sheet data
• Shows whether you can cover short-term expenses
• Compares cash flow between periods for shortage planning
• Reveals whether you can afford new expenses or investments

The quick ratio has some limitations:

The days sales outstanding formula

• Excludes operating income from calculations
• Covers only a three-month period
• Works best with stable securities; volatile ones may affect accuracy
• May overstate liquidity if accounts receivables include debts unlikely to be paid, such as anything over 90 days old

Current (working capital) ratio

The current ratio is your current assets divided by your current liabilities. It shows whether you have enough working capital to cover your business's expenses over the next 12 months.

This ratio is also called the working capital ratio because it measures the relationship between what you own and what you owe in the short term.

Current ratio liquidity formula

Current ratio calculation

Find both numbers on your balance sheet:

• Current assets: listed near the top of the report
• Current liabilities: listed near the middle

You can use our free balance sheet template to organise your data.

How inventory affects this ratio: Unlike the quick ratio, the current ratio includes inventory valued at cost (not selling price). If your inventory is worth less than you paid (like out-of-season stock), adjust its balance sheet value for a more accurate ratio.

What counts as current liabilities: Current liabilities include all bills due within 12 months. Your bookkeeping method affects what appears on your balance sheet. If you don't record monthly bills until they clear your bank, they won't show up in your liabilities.

An accountant or your bookkeeping software support team can help you set up your books correctly.

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. Tip: the balance sheet groups all these assets together in your current assets section, so you don't have to add them up. 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. 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?

Target current ratio: While the ideal number varies by industry, a ratio between 1.5–2.0 is generally considered healthy.

• Below 1.0: Consider increasing assets or reducing liabilities
• 1.0–1.5: Adequate but leaves little margin for slow sales months
• 1.5–2.0: Healthy range with buffer for unexpected expenses
• Above 3.0: You may have idle cash that could be reinvested

A low ratio suggests you could benefit from reducing expenses or increasing available cash.

When to use the current ratio

Use the current ratio to guide decisions about expenses and cash:

If your ratio is low (below 1.5):

• consider cutting non-essential expenses
• finance equipment purchases with loans rather than cash
• focus on collecting receivables faster

If your ratio is high (above 3.0):

• look for reinvestment opportunities
• consider whether cash or inventory is sitting idle
• evaluate growth initiatives you may be delaying

Considerations:

• Seasonal businesses benefit from using multiple financial metrics
• The current ratio only shows short-term position, not long-term profitability
• It focuses on assets and liabilities, excluding loan types and other financial factors

The current ratio offers several advantages:

• Calculates easily with just two balance sheet numbers
• Assesses cash flow issues quickly
• Shows ability to cover upcoming expenses
• Identifies when you may need financing
• Signals when you're ready to expand or invest

The current ratio has some limitations:

• Skews easily when either number changes significantly
• Hides seasonal trends and cash flow fluctuations
• Covers only 12 months of financial health
• Excludes long-term profitability insights
• Ignores loan structures and debt composition

Days sales outstanding

Days sales outstanding (DSO) measures the average number of days it takes to collect payment after a sale. This metric helps you understand how quickly you're converting sales into cash.

The days sales outstanding formula

To calculate this metric, divide your average accounts receivables by your revenue per day, then multiply by 365.

Your DSO reveals important insights about your cash flow:

• Lower DSO: You collect payments quickly, improving cash flow
• Higher DSO: Customers take longer to pay, tying up your cash

If your DSO is too high, consider offering early payment discounts or tightening credit terms to speed up collections. What's considered high can depend on the industry standard.

Using liquidity ratios

Track your liquidity metrics regularly to understand your financial position. Calculate your ratios once a month, ideally at the same time each month. Your ratios can shift depending on where you are in your billing cycle.

Follow these practices when using liquidity ratios:

• Track trends over time, not just single snapshots
• Consider each ratio's limitations when making decisions
• Analyse liquidity alongside solvency and efficiency ratios
• Work with a financial advisor for high-stakes decisions

Understanding what each ratio can and can't tell you helps you make better business decisions.

How to improve liquidity

To improve your liquidity ratios, increase available cash and reduce short-term obligations. Take these practical steps to strengthen your position:

• Speed up invoicing: Use accounting software like Xero to send invoices faster and receive payments more efficiently
• Improve accounts receivable: Offer early payment discounts, send automated reminders, and follow up on overdue invoices
• Optimise accounts payable: Negotiate favourable supplier terms, use extended payment periods strategically, and cut non-essential spending
• Reduce operating costs: Lease equipment instead of buying, sell unproductive assets, and review expenses regularly
• Manage inventory efficiently: Keep stock at industry-standard levels and use just-in-time ordering to free up cash
• Grow revenue strategically: Expand your customer base or add products without proportionally increasing costs
• Refinance debt: Consolidate expensive short-term loans into lower-interest options when possible

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

Track your liquidity ratios with Xero

When you understand your liquidity ratios, you can make smarter financial decisions for your business. Xero makes it easy to see these numbers in real time, so you can stop guessing and start planning for a healthy financial future.

See how your business is performing and get one month free.

FAQs on liquidity ratios

Here are answers to common questions about liquidity ratios.

What are the main liquidity ratios I should track?

For most small businesses, the three key ratios to watch are the current ratio, quick ratio, and cash ratio. Each gives you a slightly different view of your ability to pay your bills, from a broad look (current ratio) to a very conservative one (cash ratio).

What does a liquidity ratio of 2.5 mean?

A ratio of 2.5 means your business has $2.50 of current assets for every $1 of current liabilities. This is generally considered a very healthy position, indicating you have more than enough liquid assets to cover your short-term obligations.

What's the difference between the current ratio and quick ratio?

The main difference is inventory. The current ratio includes inventory in your assets, while the quick ratio (or acid-test ratio) does not. The quick ratio provides a more conservative measure because it only includes assets that can be converted to cash very quickly.

How often should I calculate my liquidity ratios?

Calculate your liquidity ratios once a month. This allows you to monitor trends over time and make timely adjustments without getting bogged down in daily fluctuations.

Can a liquidity ratio be too high?

Yes. A low ratio signals room for improvement, and a very high ratio (like 4.0 or more) might suggest opportunities to put your assets to better use. It could mean you have cash available that could be reinvested into your business to fuel growth.