Liquidity Ratios: What They Are and How to Use Them

Published Monday 22 December 2025

Table of contents

• What is liquidity?
• What are liquidity ratios?
• Cash ratio
• Quick (acid test) ratio
• Current (working capital) ratio
• Using liquidity ratios in your business
• Another metric for liquidity: days sales outstanding
• How to improve your liquidity ratios
• Making liquidity ratios work for your business
• FAQs on liquidity ratios

Key takeaways

• Calculate your three main liquidity ratios monthly on the same date to track trends and identify cash flow issues early, focusing on the cash ratio (most conservative), quick ratio (excludes inventory), and current ratio (includes all current assets).
• Maintain target liquidity benchmarks of at least 0.2 for cash ratio, 0.7-1.0 for quick ratio, and 1.5-2.0 for current ratio to ensure adequate short-term financial health while avoiding inefficient use of assets.
• Accelerate cash inflows by automating invoicing, offering early payment discounts, and implementing systematic follow-up on overdue accounts to improve your liquidity position without requiring additional capital.
• Combine liquidity ratio analysis with other financial metrics and professional guidance to make informed decisions about expenses, growth investments, and debt management rather than relying on ratios alone.

What is liquidity?

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

Why liquidity matters: Cash flow problems cause 82% of small business failures, and signs of financial distress are growing. For example, data shows the accrual of tax debt for Australian businesses increased from A$26.5 billion to A$44.8 billion between 2019 and 2022. Liquidity ratios help you assess your short-term financial health over the next 12 months.

Understanding your liquidity helps you to:

• make informed spending decisions without risking cash shortages
• plan growth at a sustainable pace
• use extra cash instead of leaving it idle

What are liquidity ratios?

Liquidity ratios measure your business's ability to pay short-term debts with available cash and near-cash assets. They compare what you have versus what you owe.

Each ratio serves different purposes depending on your business needs and industry. You can use Xero accounting software to track these ratios from your financial reports.

Types of liquidity ratios

Small businesses use three main liquidity ratios to assess financial health:

• Cash ratio: Most conservative measure using only cash and cash equivalents
• Quick ratio: Includes cash plus easily convertible assets like accounts receivable
• Current ratio: Broadest measure including all current assets like inventory

Cash ratio

Cash ratio liquidity formula

The cash ratio measures your ability to pay short-term debts using only cash and cash equivalents. It answers the question: "Can I cover my bills with cash on hand right now?"

Formula: Cash + Cash Equivalents ÷ Current Liabilities = Cash Ratio

What it tells you: Whether you can cover payroll, expenses, and loan payments over the next 12 months using only your most liquid assets.

This ratio is the most conservative and fastest to use because it leaves out assets that are harder to turn into cash.

Cash ratio calculation

The cash ratio calculation only includes the cash in your bank accounts and any securities your business can cash out quickly. It doesn't consider:

• inventory or accounts receivables (money people owe your business)
• any revenue you're likely to receive

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 your 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?

Good cash ratio benchmarks:

• 0.2 or higher: Generally considered healthy for most small businesses
• Below 0.1: May indicate cash flow challenges requiring immediate attention
• Above 0.5: Strong liquidity position but may suggest underutilised cash

If your ratio is low: Focus on accelerating invoice payments or reducing short-term expenses to improve cash availability.

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 for you to calculate
• gives you quick insight into how you use your cash
• shows how well you can cover short-term expenses using only cash and cash equivalents

However, keep these limitations in mind:

• 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 long-term expenses or challenges into account

Quick (acid test) ratio

Quick ratio liquidity formula Version 1

The quick ratio measures your ability to pay short-term debts within three months using cash and near-cash assets, excluding inventory. It's also called the "acid test ratio."

• What it includes: Cash, cash equivalents, short-term investments, and accounts receivable (money owed to you)
• What it excludes: Inventory and prepaid expenses that can't be quickly converted to cash
• Key question answered: Can you cover payroll, bills, and loan payments for the next three months without selling inventory or borrowing money?

Quick ratio calculation

There are two ways to calculate the quick ratio:

• The first method is to add up your cash, securities (shares, bonds, etc that you can easily convert to cash), and accounts receivables (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.

People also call the quick ratio the acid test ratio because it’s quick and easy to calculate. 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: Excellent liquidity – you have $1 or more available for every $1 of short-term debt
• 0.7 to 0.9: Acceptable for most businesses – monitor your cash flow closely
• below 0.7: may signal cash flow issues, so review your cash collection and expenses

Example: A 0.3 ratio means you have only 30 cents available for every $1 of bills due in the next three months, indicating potential payment difficulties.

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 because you've had a great launch, 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
• shows whether you can cover short-term expenses
• helps you compare cash flow between periods so you can plan for shortages
• helps you see if you can afford extra expenses or investments

But it has limitations:

• 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

Current ratio liquidity formula

The current ratio measures your ability to pay short-term debts over the next 12 months using all current assets. It's also called the "working capital ratio."

Formula: Current Assets ÷ Current Liabilities = Current Ratio

• What it includes: All assets convertible to cash within 12 months - cash, accounts receivable, inventory, and prepaid expenses.
• Key insight: Shows whether your working capital is sufficient to cover all upcoming business expenses and obligations.

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. Don't worry about your long-term assets or liabilities. You can use this free balance sheet template to find these numbers quickly.

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. Tip: your balance sheet groups all these items together 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 fall compared to your short-term assets, your ratio rises. A higher ratio means you have more money to cover costs.

What's a good current ratio?

Current ratio benchmarks:

• 1.5 to 2.0: Ideal range for most small businesses, with a generally accepted ratio being 2.0 (or 2:1), where current assets are twice the value of current liabilities.
• Below 1.0: High risk - current liabilities exceed current assets
• 1.0 to 1.5: Acceptable but monitor cash flow closely
• Above 3.0: May indicate inefficient use of assets

Low ratio risks: Difficulty paying bills during slow sales periods or unexpected expenses.

High ratio considerations: Excess cash sitting idle that could be invested in business growth.

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, since you only need two numbers from your balance sheet
• helps you quickly spot cash flow issues
• shows how well you can cover your expenses
• shows when you may need to take out a loan
• shows when you might be ready to expand or invest

But keep these limitations in mind:

• 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

Using liquidity ratios in your business

Best practices for tracking liquidity ratios:

• Calculation frequency: Calculate ratios monthly on the same date to ensure consistency and account for billing cycle variations.
• Focus on trends: Track ratio changes over 3-6 months rather than single-point measurements for meaningful insights. Using these as early warning metrics is critical, as one report found nearly half of surveyed managers don't, increasing their risk of being unprepared for a liquidity event.
• Combine with other metrics: Analyze liquidity ratios alongside profitability and efficiency ratios for comprehensive business health assessment.
• Professional guidance: Work with accountants or financial advisors to interpret results and make strategic decisions, especially when ratios indicate potential problems.

Another metric for liquidity: days sales outstanding

The days sales outstanding formula

This ratio may also help you, depending on your industry and the way you operate your business.

Days sales outstanding (DSO) measures the average time between making a sale and receiving payment. It shows how quickly your customers pay you.

Formula: Average Accounts Receivable ÷ (Annual Revenue ÷ 365) = DSO

Industry benchmarks:

• Under 30 days: Customers pay very quickly
• 30–45 days: Acceptable for most business-to-business (B2B) businesses
• Over 60 days: May mean you need to review your invoicing and follow-up process

Impact of High DSO: Extended collection periods tie up working capital and reduce liquidity ratios.

How to improve your liquidity ratios

Use these practical ways to improve your liquidity ratios:

• Use accounting software like Xero to automate invoicing and shorten payment times
• Offer small early payment discounts (for example, 2–3%) to encourage faster payment
• Send automated payment reminders to reduce late payments
• Improve your accounts receivable process by setting clear terms and following up quickly on overdue invoices
• Tidy up your accounts payable by negotiating favourable payment terms, choosing cost-effective suppliers and cutting non-essential spending
• Review and reduce operating costs, and consider leasing equipment or selling unused assets to free up cash
• Manage your inventory so stock levels match demand and do not tie up extra cash
• Increase sales through new customers or products without adding large extra costs
• Consider refinancing expensive short-term debt into lower-interest loans if it improves your cash flow

Your accountant can help you make these decisions, as experts note that accountants help with financial restructuring through tools like cash flow forecasts. Find experienced accountants and bookkeepers in the Xero advisor directory.

Making liquidity ratios work for your business

Liquidity ratios provide essential insights into your business's short-term financial health. The three main ratios (cash, quick, and current) each serve different purposes in assessing your ability to meet financial obligations.

Key ways to use liquidity ratios:

• Monitor monthly: Track your ratios on the same date each month so you can spot trends early
• Set clear benchmarks: Compare your ratios to industry norms and to your own past results
• Act on what you see: Improve cash flow when ratios are low, and look for growth opportunities when they are high

Ready to simplify your financial management? Use Xero to get automated liquidity ratio tracking, plus tools to improve your cash flow through faster invoicing and better financial visibility. Try Xero for free.

FAQs on liquidity ratios

Here are answers to common questions you might have about liquidity ratios.

What are the 5 liquidity ratios?

While the three most common are the cash, quick, and current ratios, some analyses also include the operating cash flow ratio and the net working capital ratio. For most small businesses, focusing on the main three provides a clear picture of financial health.

What does a liquidity ratio of 2.5 mean?

A current ratio of 2.5 means your business has $2.50 of current assets for every $1.00 of current liabilities. This is generally a strong position, showing you have more than enough short-term assets to cover your short-term debts.

Is it better to have higher or lower liquidity ratios?

Generally, a higher ratio is better, as it shows you can easily cover your short-term debts. A ratio above 1.0 is a good sign. However, a ratio that is too high might suggest you're not using your assets efficiently to grow the business.

How often should I calculate my liquidity ratios?

It’s a good idea to review your liquidity ratios each month. This helps you track trends and spot cash flow issues early. Accounting software can make this a simple part of your monthly review.

Can liquidity ratios be too high?

Yes. While a high ratio is good, an extremely high ratio (like a current ratio of 4.0 or more) could mean your business has too much cash sitting idle or too much money tied up in inventory. These are assets that could be reinvested for growth.