Liquidity ratios: types, formulas and how to use them

Published Wednesday 25 February 2026

Table of contents

• What is liquidity?
• What are liquidity ratios?
• Current (working capital) ratio
• Quick (acid test) ratio
• Cash ratio
• Using liquidity ratios
• Days sales outstanding
• How to improve liquidity
• 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 expenses over the next 12 months without cash flow problems.
• Use the quick ratio to assess your ability to pay bills within three months using only your most liquid assets, excluding inventory and aiming for 1.0 or higher to avoid relying on inventory sales or borrowing.
• Track all three liquidity ratios together rather than relying on just one, as each tells a different part of your financial story and helps you make more informed decisions about expenses and investments.
• Improve low liquidity ratios by speeding up invoice collection, negotiating better supplier payment terms, reducing unnecessary expenses, and managing inventory levels more efficiently to free up cash.

What is liquidity?

Liquidity is how much cash (or assets you can quickly convert to cash) your business has on hand, and whether it's enough to pay your bills.

Cash flow issues are one of the biggest reasons new businesses shut their doors. 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. Without this insight, you may spend too much, grow too fast, or underuse your resources. Some studies show a negative relationship between liquidity and profitability, suggesting that mismanaging cash can hurt financial performance.

What are liquidity ratios?

Liquidity ratios measure the gap between your cash and your bills. They show whether you can cover short-term expenses without taking on debt or selling long-term assets.

There are three widely used liquidity ratios in accounting:

• 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 using accounting software like Xero, you can click to see your quick ratio at any time. Here's what each ratio means and how to calculate it.

Current (working capital) ratio

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

A current ratio above 1.0 means you have more assets than liabilities. Below 1.0 signals potential cash flow problems.

Current ratio calculation

Current ratio liquidity formula

You can find the numbers for this calculation on your balance sheet. Look for total current assets near the top and total current liabilities near the middle. You can use our free balance sheet template.

What the current ratio includes:

The current ratio calculation considers these elements:

• all current assets, including inventory
• inventory valued at cost (not selling price)
• all bills due within 12 months

Keep in mind:

Consider these factors when calculating your current ratio:

• adjust inventory value if it's worth less than you paid (such as out-of-season stock)
• your bookkeeping method affects how liabilities appear on your balance sheet
• an accountant or your bookkeeping software support team can help you set up accurate tracking

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
• $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 labelled 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?

A good current ratio is between 1.5 and 2.0 for most small businesses, though for some industrial companies, 1.5 may be acceptable.

• Below 1.0: you may struggle to pay bills, especially during slow sales months
• 1.0 to 1.5: adequate, but leaves little buffer for unexpected expenses
• 1.5 to 2.0: healthy range with enough cushion for most situations
• Above 3.0: you may have excess cash that could be reinvested

When to use the current ratio

You can use the current ratio to make decisions about your expenses and cash on hand. For example, 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.

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.

Benefits of the current ratio:

The current ratio offers several advantages for assessing your financial health:

• requires just two numbers from the balance sheet
• reveals cash flow issues quickly
• helps assess your ability to cover expenses
• identifies when you may need financing
• signals when you're ready to expand or invest

Limitations to keep in mind:

Be aware of these limitations when using the current ratio:

• skews easily when either number changes significantly
• hides seasonal trends and cash flow fluctuations
• reflects only short-term health (12 months or less)
• omits long-term financial challenges
• excludes insights on loans and profitability

Quick (acid test) ratio

The measures your company's ability to cover expenses over the next three months without selling inventory or taking out loans. It counts only cash and assets you can convert to cash quickly, such as accounts receivable and marketable securities.

This ratio answers a critical question: Can you pay payroll, bills, and loan payments with your most liquid assets?

Quick ratio calculation

Quick ratio liquidity formula Version 1

Quick ratio liquidity formula Version 2

There are two ways to calculate the quick ratio. Choose the method that works best with the data you have available:

• 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

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?

A good quick ratio is 1.0 or higher. Any liquidity ratio above one is usually considered healthy and indicates you have enough liquid assets to cover immediate obligations. This means you have at least $1 in liquid assets for every $1 of short-term expenses.

• 1.0: you can cover expenses dollar-for-dollar
• 1.5: you have $1.50 for every $1 in upcoming bills
• Below 1.0: you may struggle to pay bills without selling inventory or borrowing
• 0.3: you have only 30 cents for every $1 due in the next three months

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 example, 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 has several benefits. It:

• 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

However, the quick ratio 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.

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 right now.

This is the most conservative liquidity ratio because it includes the fewest assets. It excludes accounts receivable and inventory entirely.

Cash ratio calculation

Cash ratio liquidity formula

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 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?

A good cash ratio is typically between 0.5 and 1.0 for most small businesses.

• Above 1.0: you can cover all short-term liabilities with cash alone
• 0.5 to 1.0: healthy range for most businesses
• Below 0.5: you may struggle to cover bills and should focus on speeding up invoice payments or reducing expenses

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 has several benefits. It:

• 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

However, the cash ratio has limitations:

• 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 consider long-term expenses or challenges

Using liquidity ratios

Knowing your ratios is just the start. How you track and apply them over time is what makes the difference for your business.

Best practices for using liquidity ratios:

Follow these guidelines to get the most value from your liquidity analysis:

• Calculate monthly: Track at the same time each month for consistency
• Watch the trend: A single snapshot matters less than the direction over time
• Know the limitations: Each ratio tells part of the story, not the whole picture
• Combine with other metrics: Analyse alongside solvency and efficiency ratios for fuller insight
• Consult an expert: Work with a financial advisor when making major decisions

Track your liquidity ratios with real-time dashboards and automatic calculations in Xero. Get one month free and see your business's financial health at a glance.

Days sales outstanding

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

Days sales outstanding (DSO) is the average number of days it takes you to get paid after a sale. To calculate it, divide your average accounts receivable by your revenue per day.

The days sales outstanding formula

What your DSO tells you:

Your DSO indicates how efficiently you collect payments:

• Under 30 days: Excellent cash collection
• 30 to 45 days: Typical for most industries and seen as a good benchmark
• Over 45 days: Customers are tying up your cash. While this is a time to consider tightening payment terms, some sectors like construction and manufacturing often have longer DSOs due to project complexity.

How to improve liquidity

If your liquidity ratios are lower than you'd like, take these steps to improve them:

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

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

FAQs on liquidity ratios

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

What is a healthy liquidity ratio?

A healthy liquidity ratio depends on which ratio you're measuring. For the current ratio, aim for 1.5 to 2.0. For the quick ratio, 1.0 or higher is considered healthy. For the cash ratio, 0.5 to 1.0 works for most small businesses.

What does a liquidity ratio of 2.5 mean?

A liquidity ratio of 2.5 means you have $2.50 in assets for every $1.00 of short-term liabilities. This indicates a strong liquidity position, though a ratio this high may suggest you have excess cash that could be reinvested in your business.

How often should I calculate my liquidity ratios?

Calculate your liquidity ratios once a month, ideally at the same point in your billing cycle each time. This consistency helps you spot trends and catch potential cash flow problems early.

Can a liquidity ratio be too high?

Yes. A ratio above 3.0 often means you have cash, inventory, or investments sitting idle. Research supports this, showing that while some liquidity measures link to higher profits, holding too much cash can actually hurt your financial performance. This money could be reinvested to grow your business, pay down debt, or improve operations. Balance liquidity with opportunity.

Which liquidity ratio is most important for small businesses?

The current ratio is typically most useful for small businesses because it provides a broad view of your ability to cover expenses over the next 12 months. Use the quick ratio for a stricter assessment that excludes inventory.