Liquidity ratios: types, formulas and how to use them

Published Tuesday 21 April 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

• Use all three liquidity ratios together — current, quick, and cash — to get a complete picture of your short-term financial health, as each one measures a different level of strictness and covers a different time period.
• Calculate your chosen liquidity ratio at the same time each month and track how it changes over time, since a single result means less than the trend it forms across your billing cycle.
• Aim for a current ratio between 1.5 and 2.0 and a quick ratio of 1.0 or higher, but compare your results to businesses in your own industry, as acceptable benchmarks vary by sector.
• Improve a low liquidity ratio by speeding up cash collection through automated invoicing and payment reminders, or by reducing short-term liabilities through supplier negotiations and cutting non-essential spending.

Why liquidity ratios matter for small businesses

Liquidity ratios 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. They can also serve as a foundation for the forward-looking financial projections expected by regulatory bodies.

Understanding your liquidity ratios helps you:

• Make informed choices about expenses and investments
• Avoid crises before they happen
• Identify when you have capital to invest
• Prevent closure due to cash shortages

Types of liquidity ratios

Three main liquidity ratios help you measure the gap between your available cash and upcoming bills. Each shows whether your business can meet its short-term financial obligations, with varying levels of strictness.

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

Some businesses also track the operating cash flow ratio, but the three above are most relevant for small business owners.

Accounting software can display these ratios instantly, helping you make informed financial decisions.

1. Current ratio

The current ratio divides your current assets by current liabilities, showing whether you have enough working capital to cover business expenses over the next 12 months. It's also called the working capital ratio because it measures the funds you need to operate your business day-to-day.

Use this formula to calculate your current ratio:

Current ratio calculation

Current ratio liquidity formula

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 ignore long-term assets and liabilities for this ratio. The Xero balance sheet template can help.

What's included in the current ratio:

• Inventory: valued at cost on your balance sheet, not selling price
• Current liabilities: all bills due within 12 months or less

If your inventory is worth less than it cost (such as out-of-season stock), adjust its value on the balance sheet for a more accurate ratio. The way you do your bookkeeping affects how liabilities appear. Work with an accountant or your bookkeeping software support team to 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 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?

Current ratio benchmarks:

• 1.5–2.0: Ideal range for most small businesses. To safely meet liabilities, aim to exceed 2.0
• Below 1.5: May indicate cash flow challenges, though this varies by industry
• Above 2.0: Suggests excess cash that could be invested elsewhere

Manufacturing businesses may need ratios of 2 or higher due to significant working capital investment in raw materials and trade receivables. Retail businesses can sometimes operate below 1.0.

If your ratio is low: Consider reducing expenses or improving cash collection to avoid struggles during slow sales periods.

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 suggests you shouldn't use cash on hand for equipment purchases. Consider a loan to spread the cost over time.

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 your business.

This ratio isn't 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. This ratio only looks at your current assets and liabilities. It doesn't account for long-term profitability, the types of loans you have, or other factors that affect your business.

Strengths of the current ratio:

• Easy to calculate: requires just two numbers from the balance sheet
• Quick assessment: helps you spot cash flow issues fast
• Decision support: shows when to take out loans or consider expanding

Limitations of the current ratio:

• Easily skewed: Changing one number can distort the result
• Hides seasonality: doesn't reflect seasonal cash flow patterns
• Short-term focus: only shows financial health for the next 12 months
• Incomplete picture: Doesn't show loans, profitability, or long-term health

2. Quick ratio

The quick ratio measures your ability to cover expenses over the next three months using only cash, securities, and accounts receivable. It answers a critical question: can your most liquid assets cover three months of payroll, bills, and loan payments without selling inventory or borrowing money?

Quick ratio calculation

You can calculate the quick ratio using two methods:

Method 1 (addition approach):

Quick ratio liquidity formula Version 1

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

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Quick ratio liquidity formula Version 2

Method 2 (subtraction approach):

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

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Both methods produce identical results. Most small business owners find Method 1 simpler.

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?

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. As a general rule, any ratio under 1.0 indicates your business is illiquid and unable to meet liabilities from readily available funds.

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 have significant cash reserves after a successful launch, but if your product or service doesn't sell consistently, you won't be able to maintain your cash flow. The quick ratio isn't going to show you that.

Strengths of the quick ratio:

• Easy to calculate: uses readily available balance sheet figures
• Short-term clarity: shows whether you can cover expenses over three months
• Comparison tool: helps you spot cash flow differences between periods
• Decision support: reveals if you can afford new expenses or investments

Limitations of the quick ratio:

• Excludes operating income: doesn't account for money coming in from sales
• Short timeframe: only covers a three-month period
• Securities volatility: stock values can change quickly, affecting accuracy
• Receivables risk: may be inaccurate if you overstate how much customers will actually pay

3. Cash ratio

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

This 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

Use this formula to calculate your cash ratio:

Cash ratio calculation

What's included:

• Cash in bank accounts: funds available immediately
• Short-term securities: investments you can convert to cash quickly

What's excluded:

• Inventory: stock on hand that must be sold first
• Accounts receivable: money customers owe you
• Future revenue: expected income not yet received

Cash ratio example

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?

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

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

However, the cash ratio has limitations:

• It doesn't include any operating income
• It doesn't account for how long-term credit with suppliers or accounts receivable cycles affect cash on hand
• It doesn't consider long-term expenses or challenges

Using liquidity ratios in your business

Here are some tips for using liquidity ratios effectively:

Calculate monthly: Choose your preferred liquidity ratio and calculate it at the same time each month. Numbers can change depending on where your business is in its billing cycle.

Focus on trends: Look at how the ratio moves over time rather than fixating on a single month's result.

Understand the limitations: Each ratio tells you something specific, but none gives the complete picture. Analyse liquidity ratios alongside solvency and efficiency ratios for a fuller view of business health.

Work with an advisor: Financial decisions can significantly affect your business. Consider partnering with an accountant or financial advisor on these matters.

How to improve your liquidity ratios

To improve your liquidity ratios, you need to either increase your liquid assets or reduce your short-term liabilities. Here are practical steps organised by approach.

Speed up cash collection:

• Automate invoicing: Use accounting software for faster 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 making large purchases

Improve operational efficiency:

• Reduce inventory levels: Use just-in-time ordering to free up cash
• Sell unproductive assets: Convert unused items to cash
• Increase sales: Expand your 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

When you understand your liquidity ratios, you can move from worrying about bills to planning for growth. By checking these numbers regularly, 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 make informed decisions about your finances. Get one month free to manage your business's financial health.

FAQs on liquidity ratios

Here are answers to common questions about liquidity ratios, including which ones matter most and how they compare to other financial metrics.

What are the two main liquidity ratios?

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

What is a good liquidity ratio?

A good current ratio is 1.5–2.0, meaning you have £1.50 to £2.00 of current assets for every £1 of current liabilities. A good quick ratio is 1.0 or higher. Both benchmarks vary by industry, so compare your results to similar businesses in your sector.

What's the difference between liquidity and solvency ratios?

Liquidity ratios measure your ability to pay short-term bills due within a year. Solvency ratios measure your ability to meet long-term financial obligations. Both are important for understanding your overall financial health.