Understanding your company's liquidity—the ease and speed of converting assets into cash—is crucial for making informed financial decisions. Companies with strong liquidity positions are better equipped to navigate economic uncertainties and capitalize on growth opportunities.
Liquidity is commonly measured using liquidity ratios—a key topic explored in the online course Strategic Financial Analysis, taught by Harvard Business School Professor Suraj Srinivasan.
Liquidity ratios provide insights into your company’s short-term cash flow and ability to meet immediate obligations.
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Liquidity ratios assess your business’s ability to meet short-term obligations, which are a type of liability.
Liabilities are anything—usually money—a person or company owes to someone else, such as taxes, wages, bank loans, and accounts payable.
In other words, liquidity ratios measure how quickly your company can convert its assets to cash to cover its debts.
Assets are resources a company owns that have monetary value or can be converted into cash, such as inventory, property, investments, and cash reserves.
Liquidity ratios help assess your company’s financial health over time or compare it to industry competitors.
Liquidity ratios compare assets to liabilities—both listed on a balance sheet—which offers a snapshot of a company’s financial position at a given time. Since balance sheets reflect a single point in time, using data from the same period is ideal for accurate liquidity comparisons. The more recent, the better.
3 Types of Liquidity Ratios and How to Calculate Them
There are three types of liquidity ratios, which are taught in Strategic Financial Analysis:
- Current ratio
- Quick ratio
- Cash ratio
Below is a deeper dive into each.
Current Ratio
A current ratio measures a company’s ability to cover short-term liabilities with its current assets. The formula for calculating the current ratio is:
Current Ratio = Current Assets / Current Liabilities
Note that this liquidity ratio and others assess a company’s short-term or current financial health. Beyond this period, their reliability decreases due to changing economic conditions and business dynamics.
Current ratios are the most inclusive of the three formulas, as they account for assets that may be harder to convert into cash. As a result, they provide a “best-case” view of your company’s liquidity.
Quick Ratio
A quick ratio measures a company’s ability to cover short-term liabilities with its quick assets—those that can be quickly converted into cash. These typically include money at hand, short-term investments, and accounts receivable. The formula for calculating a quick ratio is:
Quick Ratio = (Cash + Short-Term Investments + Accounts Receivable) / Current Liabilities
Quick ratios exclude assets that can’t be readily converted, such as your business’s inventory. While inventory can be a valuable cash source, the conversion process relies on sales and is less immediately accessible. By omitting these asset types, quick ratios provide a more conservative assessment than current ratios.
Cash Ratio
A cash ratio measures a business’s ability to cover short-term liabilities with cash. The formula for calculating it is:
Cash Ratio = (Cash + Short-Term Investments) / Current Liabilities
The cash ratio excludes accounts receivable, as they aren’t immediately liquid. It considers only cash and short-term investments, making it the most conservative liquidity measure. This ratio helps analysts measure liquidity in "worst-case" scenarios when a company must quickly pay off short-term debt.
Related: How to Use Profitability & Margin Ratios
How to Choose the Right Liquidity Ratio
All liquidity ratios use liabilities as a denominator, but the numerator varies in scope—from all current assets to just cash. While each measures your company’s liquidity, they do so with increasing precision: current ratios are the least strict, while cash ratios are the most conservative. The formula you choose depends on your liquidity analysis’s goals and company’s financial circumstances.
For instance, if you assess your company’s liquidity year over year, you may want to use the current ratio to incorporate the full scope of your assets. However, if your company wants to assess its ability to meet short-term obligations in the worst-case scenario, you’d conduct a cash ratio.
What’s a Good Liquidity Ratio?
Any liquidity ratio above one is usually considered healthy, as it indicates that your company has enough short-term assets to cover your immediate obligations while maintaining a financial cushion. In most cases, the higher the liquidity ratio, the better.
Conversely, a liquidity ratio of less than one could indicate your company has more short-term obligations than liquid assets, which may hint at financial strain.
In Strategic Financial Analysis, Srinivasan stresses the importance of knowing your company’s strengths and weaknesses, saying, “Overall, the insights gained from analyzing a company’s historic performance provide the foundation for forecasting the company’s future prospects.”
Measure Short-Term Strength with Liquidity Ratios
A company’s ability to meet short-term obligations is crucial for maintaining long-term financial health. Liquidity ratios help assess how well your assets cover your short-term liabilities, providing a clearer picture of your financial flexibility.
You can learn more about liquidity ratios and other key aspects of ratio analysis, including margin ratios, return on equity, and return on assets, in the online finance course Strategic Financial Analysis. Through interactive learning exercises with a global network and real-world business examples, you’ll cement your understanding and gain actionable insights to drive strategic decision-making.
Do you want to learn essential financial concepts and drive business performance? Explore Strategic Financial Analysis—one of our online finance and accounting courses. To get a jumpstart, download our free Financial Terms Cheat Sheet.
