Liquidity ratios: What they are and how to use them

Published Friday 9 January 2026

Table of contents

• Why liquidity ratios matter for small businesses
• Types of liquidity ratios
• Using liquidity ratios in your business
• How to improve your liquidity ratios
• Managing your business finances with confidence
• FAQs on liquidity ratios

Key takeaways

• Calculate your current ratio monthly by dividing current assets by current liabilities, aiming for a range of 1.5-2.0 to ensure you have adequate working capital to cover business expenses over the next 12 months.
• Use the quick ratio to assess your ability to cover three months of expenses using only cash, securities, and accounts receivable, targeting a ratio of 1.0 or higher for excellent liquidity.
• Improve your liquidity ratios by automating invoicing and offering early payment discounts to speed up cash collection, while negotiating better supplier payment terms to optimise cash outflow.
• Monitor liquidity ratio trends over time rather than focusing on single-month results, as these ratios provide insights into short-term financial health but should be analysed alongside other financial metrics for a complete business assessment.

Why liquidity ratios matter for small businesses

Liquidity ratios are financial metrics that measure your business's ability to pay short-term bills using available cash and easily convertible assets.

These ratios help you assess your financial health over the next 12 months. They reveal whether you have enough cash on hand to cover expenses, payroll, and loan payments.

Understanding your liquidity ratios helps you:

• Make informed spending decisions
• Avoid cash flow crises
• Identify investment opportunities
• Prevent business closure due to cash shortages

Types of liquidity ratios

Liquidity ratios measure the gap between your available cash and upcoming bills. They show whether your business can meet its short-term financial obligations.

The three main liquidity ratios are:

• Current ratio: Compares all current assets to current liabilities
• Quick ratio: Excludes inventory from current assets calculation
• Cash ratio: Uses only cash and cash equivalents

With accounting software like Xero, you can view these ratios instantly to make informed financial decisions.

1. Current ratio

The current ratio divides your current assets by current liabilities. This ratio shows whether you have enough working capital to cover business expenses over the next 12 months.

Why it's called the working capital ratio: It measures your available working capital, or the funds you need to operate your business day-to-day.

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 long-term assets and liabilities for this ratio. You can use the 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. Cheat code: 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. 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:

• 1.5-2.0: Ideal range for most small businesses, although certain sectors like manufacturing may require current ratios of 2 or more due to higher investments in inventory.
• Below 1.5: May indicate cash flow challenges, but this benchmark varies by industry. In some sectors like retail, a ratio of less than 1 might be considered acceptable.
• Above 2.0: Possible excess cash that could be invested

If your ratio is low: You may struggle during slow sales periods and should consider reducing expenses or improving cash collection.

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. While providing liquidity, excess cash generates little return and could be reinvested to grow 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 because 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

2. Quick ratio

The quick ratio measures your ability to cover expenses over the next three months using cash, securities, and accounts receivable without selling inventory or borrowing money.

This ratio answers a critical question: Can your most liquid assets cover three months of payroll, bills, and loan payments?

Quick ratio calculation

Method 1 - Addition approach:

Quick ratio liquidity formula Version 1

1. Add cash + securities + accounts receivable
2. Divide by current liabilities

Method 2 - Subtraction approach:

Quick ratio liquidity formula Version 2

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

Both methods produce identical results.

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: Excellent liquidity (£1+ for every £1 of expenses)
• 0.7-1.0: Good liquidity position
• Below 0.7: Potential cash flow challenges

Example: A 0.3 ratio means you have only 30p for every £1 of upcoming bills, indicating you may struggle to meet short-term obligations.

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. Use other measures, such as profitability and long-term cash flow forecasts, 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
• 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

3. Cash ratio

The cash ratio divides your cash and cash equivalents by short-term liabilities. This ratio shows whether you can cover payroll, expenses, and loan payments using only your most liquid assets.

Why it matters: The cash ratio provides the most conservative view of your liquidity because it excludes inventory and accounts receivable. It's the fastest ratio to calculate and gives you an immediate picture of your ability to handle financial emergencies.

Cash ratio liquidity formula

Cash ratio liquidity formula

Cash ratio calculation

What's included in cash ratio calculations:

• Cash in bank accounts
• Short-term securities you can convert to cash quickly

What's excluded from cash ratio calculations:

• Inventory or stock on hand
• Accounts receivable (money customers owe you)
• Expected future revenue

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:

• Above 0.5: Strong liquidity position
• 0.2-0.5: Adequate for most small businesses
• Below 0.2: May indicate cash flow challenges

If your ratio is low: Speed up invoice collection by offering early payment discounts or using automated payment reminders.

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 into consideration long-term expenses or challenges

Using liquidity ratios in your business

Whichever liquidity ratio you choose, calculate it once a month. Try to do this at the same time each month, because the numbers can change depending on where your business is in its billing cycle. Focus on how the ratio is trending over time, not just the result in one month.

Use the lists above to remember what liquidity ratios are good at telling you, and what they're not good at telling you. Keep in mind the limitations of each number as you look at it. And while you may now know what liquidity ratios are, it's a good idea to work with a financial advisor on matters like these. The stakes are high.

Liquidity ratios should also be analysed alongside other financial ratios such as solvency and efficiency for a fuller picture of business health.

How to improve your liquidity ratios

If you want to strengthen your liquidity, you can take these steps:

Speed up cash collection:

• Automate invoicing: Use accounting software like Xero for faster invoice processing
• Offer early payment discounts: Incentivise customers to pay sooner
• Send automated reminders: Prevent late payments with systematic follow-ups

Optimise cash outflow:

• Negotiate supplier terms: Secure favourable payment schedules
• Cut non-essential spending: Eliminate discretionary expenses
• Lease equipment: Preserve cash reserves instead of large purchases

Improve operational efficiency:

• Reduce inventory levels: Use just-in-time ordering to free up cash
• Sell unproductive assets: Convert unused assets to cash
• Increase sales: Expand customer base without increasing operating costs

Consider financing options:

• Refinance debt: Consolidate expensive short-term loans
• Secure growth funding: Access capital for expansion opportunities

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

Managing your business finances with confidence

Understanding your liquidity ratios is a big step towards financial clarity. It helps you move from worrying about bills to planning for growth. By regularly checking these numbers, you can run your business with more confidence, knowing you have the insights to stay on track.

Xero shows these figures in real time, so you can take the guesswork out of your finances. Try Xero for free to take control of your business's financial health.

FAQs on liquidity ratios

Here are answers to some common questions about liquidity ratios.

What are the two main liquidity ratios?

The two most commonly used liquidity ratios for small businesses are the current ratio and the quick ratio. The current ratio gives a broad overview of your ability to pay debts over the next year, while the quick ratio provides a more conservative measure by excluding inventory.

What is a good liquidity ratio?

A good liquidity ratio depends on the specific ratio and your industry. For the current ratio, a value between 1.5 and 2 is often seen as healthy, meaning you have £1.50 to £2.00 of current assets for every £1 of current liabilities. For the quick ratio, a value of 1.0 or higher is generally considered good.

What's the difference between liquidity and solvency ratios?

Liquidity ratios measure a business's ability to pay its short-term bills (due within a year). Solvency ratios, on the other hand, measure a business's ability to meet its long-term financial obligations. Both are important for understanding the overall financial health of your business.