Liquidity ratios: What they are, types, and how to use them

Published Thursday 29 January 2026

Table of contents

• What are liquidity ratios?
• Why liquidity ratios matter
• Cash ratio
• Quick (acid test) ratio
• Current (working capital) ratio
• Using liquidity ratios
• Ways to improve liquidity
• FAQs on liquidity ratios

Key takeaways

• Calculate all three liquidity ratios monthly to get a complete picture of your business's financial health, as each ratio shows different aspects of your ability to pay short-term debts.
• Maintain a current ratio between 1.5 and 2.0 for optimal financial stability, as ratios below 1.0 indicate insufficient assets to cover debts while ratios above 3.0 suggest you're not using cash effectively for growth.
• Speed up your cash flow by automating invoicing, offering early payment discounts, and negotiating better payment terms with suppliers to improve your liquidity ratios without taking on additional debt.
• Track ratio trends over several months rather than relying on single calculations, since seasonal variations and billing cycles can temporarily skew your liquidity position and lead to poor financial decisions.

What are liquidity ratios?

Liquidity ratios are financial calculations that measure your business's ability to pay short-term debts with available cash and liquid assets. For example, public company filings show that MEDTOX Scientific, Inc. reported a Current Ratio of 210% for the period ending in 2006, indicating it had more than double the assets needed to cover its short-term liabilities.

There are three main liquidity ratios that small businesses use to measure their financial stability. These ratios show the gap between what you owe and what you can quickly convert to cash.

The three main liquidity ratios are:

• Cash ratio
• Quick (acid test) ratio
• Current ratio (see the working capital guide)

When you use Xero accounting software, you can see your quick ratio at any time. Here's what those liquidity ratios mean.

Why liquidity ratios matter

Understanding liquidity ratios is about more than just numbers on a page. It's about knowing if your business has the cash to survive and thrive. These ratios give you a clear picture of your financial health, helping you spot potential cash flow problems before they become critical.

Understanding your liquidity ratios helps you:

• Make informed spending decisions: Avoid overextending your cash reserves
• Plan growth safely: Scale your business without risking cash flow problems
• Use resources wisely: Put idle cash to work instead of letting it sit unused
• Prevent financial crises: Spot cash flow problems before they become critical

Each liquidity ratio offers a slightly different perspective on your ability to cover short-term obligations.

Cash ratio

Cash ratio measures your ability to pay short-term debts using only cash and cash equivalents. This ratio shows whether you can cover payroll, expenses, and loan payments over the next year with cash you currently have on hand.

This liquidity ratio includes the fewest assets and is the fastest to calculate.

Cash ratio liquidity formula

Cash ratio calculation

What the cash ratio includes:

• Cash in bank accounts
• Securities you can convert to cash quickly (stocks, bonds, money market funds)

What the cash ratio excludes:

• Inventory or accounts receivable
• Expected future revenue
• Assets that take time to convert to cash

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?

Cash ratio benchmarks:

• 0.2 or higher: Good cash position for most small businesses. However, benchmarks can vary by industry and company strategy; for example, MEDTOX Scientific, Inc. reported a Cash Ratio of 19% (0.19) at the end of 2007 while still maintaining strong overall liquidity.
• Below 0.2: May struggle to pay bills, consider accelerating invoice collection
• Above 1.0: Excellent liquidity, but may indicate underused cash resources

You may need to get your clients to pay your invoices faster.

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
• shows how effectively your business uses cash
• 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 account long-term expenses or challenges

Quick (acid test) ratio

Quick ratio (also called acid test ratio) measures your ability to pay short-term debts within three months using cash and near-cash assets, excluding inventory. This calculation shows whether your liquid assets can cover payroll, bills, and loan payments without selling inventory or borrowing money.

Quick ratio liquidity formula Version 1

Quick ratio calculation

Two methods to calculate quick ratio:

Method 1: (Cash + Securities + Accounts Receivable) ÷ Current Liabilities

Method 2: (Current Assets - Inventory - Prepaid Expenses) ÷ Current Liabilities

Both methods produce the same result and show your three-month liquidity position.

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.

Many people also call the quick ratio the acid test ratio because the test is 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, can cover all short-term debts
• 0.7 to 1.0: Good liquidity position for most businesses
• 0.5 to 0.7: Adequate but monitor cash flow closely
• Below 0.5: Poor liquidity, may struggle to pay bills on time

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. For instance, public company filings show MEDTOX Scientific, Inc. had a Quick Ratio of 83% at the end of 2004, a figure that can be tracked year-over-year to assess trends.

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
• 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

Current (working capital) ratio

Current ratio measures your ability to pay short-term debts over the next 12 months using all current assets, including inventory. This ratio shows whether you have enough working capital to cover business expenses without additional financing.

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. Don't worry about your long-term assets or liabilities. You can use the free Xero balance sheet template.

Unlike the quick ratio, the current ratio includes your inventory. It uses the value of inventory on your balance sheet, typically the cost you paid for the inventory, not the price you plan 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 to 2.0: Ideal range for most small businesses. As an example of a company operating within this range, MEDTOX Scientific, Inc. reported a Current Ratio of 196% (1.96) for the period ending in 2005.
• Below 1.0: Insufficient assets to cover debts, high financial risk
• 1.0 to 1.5: Adequate but limited cushion for slow sales periods
• Above 3.0: Excellent liquidity but may indicate underused resources

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. Use this ratio alongside other measures to assess your ability to cover 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 only requires 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

Using liquidity ratios

Best practices for tracking liquidity ratios:

• Calculate monthly: Check ratios at the same time each month for consistency
• Track trends: Monitor changes over several months or years, not just single calculations. For example, by tracking its ratios annually, a company can spot important shifts. MEDTOX Scientific Inc. reported a Current Ratio of 111% at the end of 2003, providing a baseline to compare against in subsequent years.
• Consider billing cycles: Account for seasonal variations and payment timing
• Use multiple ratios: Combine all three ratios for a complete liquidity picture

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 analyzed alongside other financial ratios such as solvency and efficiency for a fuller picture of business health.

Ways to improve liquidity

Improving your liquidity ratios strengthens cash flow, reduces financial risk, and supports business growth. Here are proven strategies:

• Speed up invoicing: Use Xero accounting software to automate billing and payment collection
• Improve accounts receivable: Offer early payment discounts and send automated payment reminders
• Optimize accounts payable: Negotiate favorable payment terms and eliminate non-essential spending
• Reduce operating costs: Lease equipment instead of buying and sell unproductive assets
• Manage inventory efficiently: Maintain optimal stock levels using just-in-time ordering
• Increase sales: Expand your customer base without proportionally increasing operating costs
• Consider refinancing: Consolidate expensive short-term debt into lower-interest loans

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

Get one month free and see how Xero accounting software can help you track your business's liquidity.

FAQs on liquidity ratios

Still have questions? Here are answers to some common queries about liquidity ratios.

What does a liquidity ratio of 2.5 mean?

A current ratio of 2.5 means your business has $2.50 in current assets for every $1.00 of current liabilities. This generally indicates a very healthy liquidity position, showing you can comfortably cover your short-term debts.

Why is a high liquidity ratio bad?

While good, a very high liquidity ratio can sometimes be a negative sign. It might mean your business has too much cash or inventory sitting idle instead of being invested back into the business to generate more revenue. It's about finding the right balance between safety and growth.

What are the five liquidity ratios?

The three most common liquidity ratios for small businesses are the current ratio, quick ratio, and cash ratio. Other related metrics include days sales outstanding (DSO), which measures how quickly you collect payments, and the operating cash flow ratio, which compares cash from operations to current liabilities.