Liquidity ratios measure the ability of your business to meet near-term financial obligations, such as loan payments, rent, and payments to suppliers. Overall, various liquidity ratios show your company’s short-term financial health. Learn more about three important liquidity ratios and what they mean for your business.
What Are Liquidity Ratios?
Liquidity ratios measure your company’s ability to pay debts as they come due. These ratios show the cash level of your company and its ability to turn your current assets into cash to meet obligations. Consider three main liquidity ratios: the current ratio, quick ratio, and cash ratio, to gauge your company’s short-term finances.
The current ratio measures your business’s ability to pay its short-term obligations with short-term assets. This measure represents the broadest of the three liquidity ratios as it includes all current assets in the calculation.
- Current ratio (X:1) = current assets / current liabilities
For example, your company has $5 million in current assets and $2 million in current liabilities. This is the current ratio:
- $5 million / $2 million = 2.5:1
This number shows your company has $2.50 of highly liquid assets on hand for every $1 worth of current liabilities.
Your current ratio is an important measure of liquidity because, by definition, current liabilities are due to your creditors within one year. A higher current ratio is better, and it indicates your company is stronger. If the current ratio is less than 1, your company can’t meet its obligations easily. Healthy businesses generally have a current ratio between 1.5 and 3.
The quick ratio, also known as the acid test ratio, is a more focused version of the current ratio. This is because the quick ratio takes out the value of your inventory and prepaid expenses from your current assets, and it relies solely on quick assets, or your cash-on-hand, accounts receivable, and marketable securities. The idea is that your company can turn quick assets into cash more easily in order to pay any debts.
- Quick ratio (X:1) = (cash + cash equivalents + short-term investments + current receivables) / current liabilities
Out of your $5 million in assets from the previous example, you have $3 million in inventory and $200,000 are prepaid expenses. Everything else comes from your cash, short-term investments and accounts receivable.
This is the quick ratio:
($5 million – $3.2 million) / $1 million = 1.8:1
This paints a different picture. The quick ratio shows your company has 1.8 times the current liability coverage. Like the current ratio, a higher quick ratio is better because it indicates you have more money on hand to meet your debt obligations.
Your cash ratio is the most narrow liquidity ratio, only taking into account cash and cash equivalents. This ratio ignores short-term investments and current receivables, because they take longer to convert to cash. The cash ratio is the purest liquidity measure.
Cash ratio (X:1) = (cash + cash equivalents) / current liabilities
Using the previous example, you have $1.05 million in cash and cash equivalents on hand. Cash equivalents include savings accounts, money market accounts, and treasury investments.
This is the cash ratio:
$1.05 million / $1 million = 1.5:1
At this point, your company has $1.05 to cover each of $1 in current liabilities over the next 12 months. This means if your company had to pay all its debts now, it would have $50,000 in cash and cash equivalents left. Investors prefer a ratio of no lower than 0.5 when considering an investment.
Why Are Liquidity Ratios Important?
Investors look at these liquidity ratios to measure how well your company responds to additional debt load. That’s because when more investments come into play, your company owes more debt. Ideally, you would use the extra investment to bring in more cash to pay for short-term debts. However, the more cash you have on hand to pay for short-term liabilities, the better position you’re in to take on a higher debt load from investors.
QuickBooks Online allows you to run custom business reports to check your company’s financial health ahead of getting more investment capital. More than 4.3 million customers use QuickBooks. Join them today to help your business thrive for free.