Liquidity ratios and regulations
Liquidity ratios are key tools for businesses of all sizes, but they’re especially important in the financial industry. In fact, financial institutions are required by law to maintain certain liquidity levels. These rules help protect the economy and reduce the risk of financial crises.
In the U.S., regulators like the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) use liquidity rules to keep banks safe and stable. These rules follow the Basel III framework, which was created after the 2008 financial crisis to make global banking more secure.
One of the key requirements under Basel III is the Liquidity Coverage Ratio (LCR).
Liquidity Coverage Ratio (LCR) and regulation
LCR is a regulatory standard that applies to large financial institutions. Its goal is to make sure they have enough high-quality liquid assets to survive a 30-day period of financial stress without needing emergency funding.
The formula looks like this:
LCR = High-quality liquid assets ÷ net cash outflows over 30 days
To comply, the ratio must be greater than or equal to 100%. Here’s how it breaks down:
- High-quality liquid assets include cash, U.S. Treasury securities, and other assets that can be quickly converted to cash with little or no loss of value.
- Net cash outflows are the expected amounts of money a bank might need to pay out during a financial crunch minus any expected cash coming in.
Even though most small businesses don’t have to follow these rules, understanding the principles behind them can be helpful, especially if you’re working with banks, applying for small business loans, or evaluating financial partners.
How to calculate liquidity ratios
There are three main ways to calculate liquidity—current ratio, quick ratio, and cash ratio. Each one gives you a slightly different view of your financial health.
Why three ratios? Because not all assets are created equal. Some, like cash, are ready to go right away. Others, like inventory, may take more time to turn into usable cash. These different ratios help you see how your business would pay bills and expenses in a variety of real-life situations, from everyday operations to a slow month in revenue.
In the next section, we’ll break down each ratio in detail.
Types of liquidity ratios (with examples)
There are three main types of liquidity ratios, including:
Current ratio
Formula: Current assets ÷ current liabilities
The current ratio is the most common liquidity measure. It compares everything you own that can be turned into cash within a year (current assets) against what you owe in the same timeframe (current liabilities). Examples of current assets include cash, cash equivalents, inventory, and accounts receivable. Current liabilities can include obligations like accounts payable, credit card balances, and income tax liabilities.
This ratio gives a broad look at your ability to pay short-term bills. A result above 1.0 usually means you have enough current assets to cover your current liabilities
When to use it:
- To get a general idea for your liquidity
- When reviewing your balance sheet
- If you’re preparing for a loan or investor meeting
Example:
Let’s say your business has $100,000 in current assets and $60,000 in current liabilities. Your current ratio is 1.67, which means you likely have enough to cover upcoming expenses.
Quick ratio (acid test)
Formula: (Current assets - inventory) ÷ current liabilities
The quick ratio takes a more cautious view. It leaves out inventory and prepaid expenses—i.e., items that may take time to convert to cash—and focuses only on your most liquid assets, like cash, receivables, and marketable securities.
When to use it:
- If your inventory doesn’t sell quickly
- To get a clearer picture during slow seasons
- When you need a conservative view of your finances
Example: You have $80,000 in current assets, $20,000 of which is inventory, and $50,000 in liabilities. Your quick ratio is (80,000 - 20,000) ÷ 50,000 = 1.2, which means you're still in good shape.
Cash ratio
Formula: Cash and cash equivalents ÷ current liabilities
The cash ratio is the strictest test of liquidity. It only considers cash and cash equivalents (short-term investments you can quickly turn into cash without losing value). This ratio ignores accounts receivable and inventory altogether.
Because of how conservative it is, most businesses don’t aim for a cash ratio over 1.0. But it can be a helpful tool for spotting short-term risk or when operating in uncertain markets.
When to use it:
- To measure your ability to pay bills immediately
- To track how much true cash you’ve got on hand
- When you want to be extra cautious
Example: If you have $30,000 in cash and equivalents and $50,000 in liabilities, your cash ratio is 0.6. While that might seem low, it’s not unusual depending on your industry.
Understanding and interpreting ratios
Once you’ve calculated your liquidity ratios, the next step is understanding what those numbers mean. What’s considered “good” can depend on your industry, business model, and even the season.
Here’s a quick breakdown to help you make sense of it all:
