Liquidity ratios: types, formulas and how to use them

Published Thursday 19 February 2026

Table of contents

• What are liquidity ratios?
• Why liquidity ratios matter
• Types of liquidity ratios
• How to use liquidity ratios
• How to improve liquidity
• Track your liquidity with Xero
• 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 short-term bills while avoiding excess cash sitting idle.
• Use the quick ratio to get a stricter view of your liquidity by excluding inventory from current assets, targeting a ratio of 1.0 or higher to confirm you can meet obligations without selling stock.
• Track all three ratios over time rather than relying on single snapshots, as consistent monthly monitoring reveals trends and helps you spot potential cash flow problems before they become critical.
• Improve low liquidity ratios by speeding up invoice collection, negotiating better supplier payment terms, reducing non-essential spending, and optimising inventory levels to free up cash tied up in excess stock.

What are liquidity ratios?

Liquidity ratios measure whether your business has enough cash and near-cash assets to cover short-term expenses. They help you answer a critical question: can your business pay its bills over the next 12 months?

Liquidity refers to how much cash, or anything you can quickly convert to cash, your business has on hand. Cash flow issues are one of the biggest reasons new businesses fail. Research shows that 82% of them fail due to cash flow problems, so understanding your liquidity helps you make confident decisions about spending, growth, and investments.

There are three widely used liquidity ratios:

• Current ratio: compares all current assets to current liabilities
• Quick ratio: excludes inventory for a stricter measure
• Cash ratio: uses only cash and cash equivalents

When using Xero accounting software, you can view your quick ratio at any time. Each ratio works differently and suits different situations.

Why liquidity ratios matter

Liquidity ratios give you a clear picture of your business's short-term financial health. They help you answer a critical question: can you pay your bills on time? Understanding this helps you avoid cash flow problems, a common challenge for small businesses.

Tracking liquidity ratios is important because it helps you:

• Make confident decisions: Know if you can afford to hire a new employee, buy equipment, or invest in marketing.
• Avoid cash crunches: Spot potential shortfalls before they happen so you can take action.
• Secure funding: Lenders and investors look at liquidity ratios to assess risk before approving loans.
• Plan for the future: Healthy ratios show you have the financial stability to handle unexpected costs or pursue growth opportunities.

Types of liquidity ratios

There are three main liquidity ratios. Each one provides a slightly different perspective by including or excluding certain assets. They move from the broadest view to the most conservative.

Current ratio (working capital ratio)

The current ratio measures whether your business has enough current assets to cover current liabilities over the next 12 months. It's the broadest liquidity measure and the most commonly used.

Formula: Current assets ÷ Current liabilities = Current ratio

This ratio includes all current assets, such as cash, inventory, accounts receivable, and prepaid expenses. It's called the working capital ratio because it shows whether you have enough working capital to cover your bills.

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.

Current assets include:

• cash and bank balances
• accounts receivable
• inventory (at cost, not selling price)
• prepaid expenses
• short-term investments

Current liabilities include:

• accounts payable
• payroll due
• sales tax and income tax payable
• short-term loans
• any bills due within 12 months

Unlike the quick ratio, the current ratio includes inventory. 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. If you don't record monthly bills until they clear your bank account, they won't show on your balance sheet. An accountant or your bookkeeping software's support team can help you set up your books correctly. You can use our free balance sheet template.

Current ratio example

Say you have R25,000 in inventory, R30,000 in your bank account, R10,000 in accounts receivable, R5,000 in prepaid expenses, and R2,000 in short-term investments. Your total current assets are R72,000.

Your balance sheet groups these assets together, so you can find the total labelled as "current assets" without adding them up yourself.

Now find your current liabilities. If your short-term liabilities total R100,000, your ratio is:

R72,000 ÷ R100,000 = 0.72

If your short-term liabilities are R72,000, your ratio is:

R72,000 ÷ R72,000 = 1.0

As your bills decrease relative to your assets, your ratio increases, meaning you have more money available to cover costs.

What's a good current ratio?

A current ratio between 1.5 and 2.0 is generally considered healthy, although some sources suggest a broader healthy range of 1.5 to 3.0, noting that what is considered "good" varies by industry.

If your ratio is below 1.0: You may not have enough assets to cover your short-term bills. A low sales month could leave you struggling to pay expenses.

If your ratio is between 1.0 and 1.5: You can cover your obligations, but you have limited cushion for unexpected expenses.

If your ratio is above 3.0: You may have excess cash or inventory that could be put to better use. A very high ratio often indicates asset inefficiency, meaning those resources aren't being used to grow the business.

When to use the current ratio

Use the current ratio to make decisions about expenses and cash on hand.

If your ratio is low: You may need to cut expenses or consider a loan for large purchases rather than using cash reserves.

If your ratio is 3.0 or higher: You may have cash, investments, or inventory that could be reinvested into growing your business.

This ratio is useful but not comprehensive. Don't rely on it alone if you run a seasonal business, as it won't reflect seasonal cash flow patterns. It also doesn't account for long-term profitability or the types of loans you have.

Strengths of the current ratio:

• requires just two numbers from the balance sheet
• provides a quick snapshot of cash flow health
• helps assess your ability to cover short-term expenses
• identifies when you may need financing
• signals when you have room to expand or invest

Limitations of the current ratio:

• skews easily when either number changes significantly
• hides seasonal trends and cash flow patterns
• shows only short-term health, not challenges beyond 12 months
• lacks insight into long-term financial health
• excludes loan terms and profitability factors

Quick ratio (acid test ratio)

The measures whether your business can cover short-term expenses without selling inventory or taking out loans. It's a stricter test than the current ratio, focusing on assets you can convert to cash within 90 days.

Formula: (Cash + Cash equivalents + Short-term investments + Accounts receivable) ÷ Current liabilities = Quick ratio

This ratio is also called the acid test ratio because it quickly and straightforwardly assesses your liquidity.

Quick ratio calculation

There are two ways to calculate the quick ratio. Both should give you the same result.

Method 1: Add up your liquid assets and divide by current liabilities.

(Cash + Securities + Accounts receivable) ÷ Current liabilities

Method 2: Start with total current assets, subtract inventory and prepaid expenses, then divide by current liabilities.

(Current assets − Inventory − Prepaid expenses) ÷ Current liabilities

Securities include shares, bonds, and other investments you can convert to cash quickly. Accounts receivable is the money customers owe you.

Quick ratio liquidity formula Version 1

Quick ratio example

If you've got R30,000 in the bank, R15,000 in securities, and R60,000 in costs over the next three months, your quick liquidity ratio is 0.75. That's R30,000 plus R15,000, divided by R60,000.

Your balance sheet should have all the numbers you need to calculate this ratio.

What's a good quick ratio?

A quick ratio of 1.0 or higher is generally considered healthy, as this level suggests the company can meet short-term debts without having to sell off inventory.

If your ratio is 1.0: You can cover your expenses over the next three months without selling inventory or borrowing.

If your ratio is 1.5: You have R1.50 for every R1.00 in upcoming expenses, giving you a comfortable cushion.

If your ratio is below 1.0: You may struggle to pay upcoming bills. A ratio of 0.3 means you have only 30 cents available for every R1.00 of expenses due in the next three months.

When to use the quick ratio

Use the quick ratio to:

• compare your business's financial health to competitors in your industry
• track your liquidity over different periods to spot trends
• assess whether you can afford new expenses or investments
• evaluate potential investment opportunities in other companies

This ratio works well as a quick guide for short-term decisions. However, don't use it to assess long-term health. A high quick ratio after a successful launch doesn't guarantee your cash flow will last if your product lacks staying power.

Strengths of the quick ratio:

• calculates easily from balance sheet data
• indicates whether you can cover short-term expenses
• helps compare cash flow between periods
• reveals liquidity for spending and investment decisions

Limitations of the quick ratio:

• excludes operating income from the calculation
• covers only a short-term (three-month) period
• may misrepresent value if securities are volatile
• becomes inaccurate if accounts receivable are overstated

Cash ratio

The cash ratio measures whether your business can cover short-term liabilities using only cash and cash equivalents. It's the most conservative liquidity measure because it excludes inventory, receivables, and other assets that take time to convert.

Formula: (Cash + Cash equivalents) ÷ Current liabilities = Cash ratio

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

Cash ratio calculation

Cash ratio liquidity formula

The cash ratio includes only your most liquid assets:

• cash in bank accounts
• cash equivalents (money market funds, treasury bills, short-term government bonds)
• securities you can convert to cash immediately

This ratio excludes:

• inventory
• accounts receivable (money customers owe you)
• prepaid expenses
• expected future revenue

Because it excludes assets that take time to convert, the cash ratio shows your strictest ability to pay bills right now.

Cash ratio example

Imagine you have R50,000 in cash and R50,000 in stocks. Add them together to get R100,000. 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 R250,000, your ratio is: R100,000/R250,000 = 0.4
• If your short-term liabilities are R25,000, your ratio is: R100,000/R25,000 = 4.0

What's a good cash ratio?

A cash ratio of 0.5 to 1.0 is generally considered adequate for most businesses. This means you have 50 cents to R1.00 in cash for every R1.00 of current liabilities.

If your ratio is above 1.0: Your business can cover all short-term expenses with cash alone, providing strong protection against cash flow disruptions.

If your ratio is below 0.5: You may struggle to cover bills if you can't quickly convert other assets to cash. Consider speeding up invoice collections or reducing expenses.

Keep in mind that the ideal cash ratio varies by industry. Comparing your liquidity measures to industry averages can provide context; for example, typical current ratios are 1.0–1.5 for retail but can be 2.0 or higher for service and tech companies.

When to use the cash ratio

Use the cash ratio when you need the most conservative view of your liquidity. It's particularly useful for:

• assessing your ability to cover immediate expenses during a cash crunch
• evaluating worst-case scenarios where you can't sell inventory or collect receivables quickly
• making decisions about large cash outlays

Context matters: A low cash ratio doesn't always signal trouble. If you've invested heavily in a new product line, your ratio may be low because you've chosen to deploy cash for growth rather than hold it in reserve.

Strengths of the cash ratio:

• calculates quickly with minimal data
• provides insight into cash utilisation rates
• shows realistic ability to cover expenses without relying on inventory or receivables

Limitations of the cash ratio:

• excludes operating income from the calculation
• ignores how supplier credit terms affect cash needs
• doesn't account for accounts receivable collection cycles
• overlooks long-term expenses and challenges

How to use liquidity ratios

Liquidity ratios help you make informed decisions about expenses, investments, and growth. Follow these practices to get the most value from liquidity ratios.

• Calculate monthly: Check your ratios at the same time each month. Ratios fluctuate depending on where you are in your billing cycle, so consistency helps you spot real trends.
• Track trends, not snapshots: A single ratio tells you where you stand today. Tracking ratios over time reveals whether your liquidity is improving, declining, or stable.
• Know the limitations: Each ratio has blind spots. The current ratio may hide seasonal patterns. The quick ratio excludes operating income. The cash ratio ignores receivables you'll collect soon.
• Combine with other metrics: Liquidity ratios show short-term health. Analyse them alongside solvency ratios (long-term debt capacity) and efficiency ratios (how well you use assets) for a complete picture.
• Work with an advisor: The stakes are high when it comes to cash flow. An accountant or financial advisor can help you interpret your ratios and make confident decisions.

How to improve liquidity

If your liquidity ratios are lower than you'd like, you can take practical steps to free up cash and strengthen your financial position.

• Speed up invoicing: Use Xero accounting software to send invoices faster and receive payments more efficiently, improving your cash flow.
• Collect receivables faster: Offer early payment discounts and send automated reminders so payments don't slip through the cracks. Improve your accounts receivable process.
• Negotiate better payment terms: Work with suppliers to extend payment deadlines and find more cost-effective vendors, but pay on time to avoid late fees.
• Cut non-essential spending: Review discretionary expenses and eliminate costs that don't contribute to revenue or operations.
• Reduce operating costs: Lease equipment instead of buying to preserve cash reserves, and sell unproductive assets.
• Optimise inventory levels: Manage your inventory by keeping stock at industry standards and use just-in-time ordering so cash isn't tied up in excess inventory. This can be a challenge, as research shows 43% of small businesses do not track their inventory or use a manual process.
• Grow revenue strategically: Increase sales by expanding your customer base or introducing new products without proportionally increasing operating costs.
• Refinance expensive debt: Consolidate high-interest short-term loans into lower-rate options, or secure additional financing during growth periods.

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

Track your liquidity with Xero

Understanding your liquidity ratios is the first step, but tracking them over time helps you make smart financial decisions. Xero accounting software lets you see your cash flow in real time so you can stay in control.

With Xero, you can generate up-to-date balance sheets, view your quick ratio on your dashboard, and run reports to see how your liquidity changes over time. Ready to run your business with more confidence? Get one month free.

FAQs on liquidity ratios

These are answers to common questions about liquidity ratios.

What are the 5 liquidity ratios?

The three most common liquidity ratios are the current ratio, quick ratio, and cash ratio. Some businesses also use the operating cash flow ratio and days sales outstanding (DSO) for a more detailed view.

What does a liquidity ratio of 2.5 mean?

A current ratio of 2.5 means your business has R2.50 in current assets for every R1.00 of current liabilities. This generally indicates a very healthy liquidity position, showing you can comfortably cover your short-term debts.

Can a liquidity ratio be too high?

Yes. A very high ratio (for example, over 3.0) might suggest that you have too much cash or inventory sitting idle instead of being invested back into the business to fuel growth.