What are liquidity ratios? Types and how to calculate

As a business owner, how do you measure and communicate the health of your company? 

‍

A lot of businesses would answer this question by touting their sales numbers, employee headcounts, total customers, or revenue figures. But without additional context, these numbers don’t actually tell anyone a whole lot about how healthy and stable your business is from a financial perspective. 

‍

The good news? There are a number of different financial metrics that are specifically designed to help you understand how your business is performing. An important subset of these metrics are known as liquidity ratios. 

Below, we define what a liquidity ratio is and compare it against other financial ratios like solvency and profitability ratios. We also take a closer look at the different types of liquidity ratios that exist, the pros and cons of using them, and why they are broadly considered to be an important financial KPI. 

What is a liquidity ratio?

A liquidity ratio is a financial metric that compares a company’s current liquid assets against its short-term liabilities, with a goal of understanding whether or not the company would be able to pay off its debts if it becomes necessary to do so. 

‍

To find your company’s liquidity ratio, you will need to divide your current assets by your current liabilities. 

‍

Current assets can include things like cash, investments, inventories, accounts receivable, prepaid expenses, and other liquid assets. Current liabilities will typically include things like accounts payable, accrued wages, accrued compensation, and income taxes payable.

‍

Exactly what you include as an asset will depend on the type of liquidity ratio that you are calculating, which we explore in greater detail below.

‍

A number above 1 means that your company has enough assets to cover its liabilities—and the higher, the better. A number below one means that your company would not be able to cover its current liabilities, and is generally unfavorable. 

Solvency ratios vs. liquidity ratios

Solvency ratios are often discussed alongside liquidity ratios, as the two metrics take a close look at a company’s liabilities. The key difference is that while liquidity ratios are focused on short-term liabilities, solvency ratios are focused on longer-term obligations. If you were to ever seek a business loan from a lender, the lender would use various solvency ratios to determine your ability to repay the debt.

‍

Some important solvency ratios to be aware of include your:

• Debt-to-assets ratio
• Debt-to-equity ratio
• Interest coverage ratio
• Equity ratio

Profitability ratios vs. liquidity ratios

Another class of financial metric that sometimes also appears side-by-side with liquidity ratios are profitability ratios which, as you might expect, measure a business’s ability to generate a profit relative to other data points such as revenue or shareholder’s equity. 

‍

Some of the most common profitability ratios include:

• Return on assets (ROA)
• Return on equity (ROE)
• Return on invested capital (ROIC)
• Gross margin
• Operating margin
• Cash flow margin
• Net profit margin

‍

It’s important to note that while both liquidity and profitability are important, they are in fact very different. With this in mind, while both metrics can be used to evaluate the health of your company, they shouldn’t necessarily be compared against one another.

Types of liquidity ratios

A number of different liquidity ratios can be considered. As you will see below, the primary difference between these ratios is what counts as a “current asset.” The stricter this definition, the more stringent the ratio is typically considered to be. 

Current ratio

The current ratio divides a company’s current assets (including its cash, inventories, and accounts receivable) by its current liabilities (due within 12 months). It is used to measure a company’s ability to repay its short-term debts, and is probably the simplest liquidity ratio to calculate. The current ratio is also called the working capital ratio.

‍

Formula: 

Current Ratio = Current Assets / Current Liabilities

Quick ratio

The quick ratio is essentially the same as the current ratio, but has a stricter definition for what counts as a “current asset.” With the quick ratio, only cash or assets that can be quickly converted into cash like accounts receivables and marketable securities are considered—hence the name—while other assets like inventory are not factored in. It’s also called the acid test ratio. 

‍

Formula:

Quick Ratio = (Cash + Accounts Receivables + Marketable Securities) / Current Liabilities

‍

or 

‍

Quick Ratio = (Current Liabilities - Inventory) / Current Liabilities

Cash ratio

Likewise, the cash ratio has an even stricter definition of “current assets,” considering only a company’s cash and equivalents. A high cash ratio implies that a company has enough liquid assets to repay its short-term obligations without needing to sell any other asset or undergo an equity raise. It’s also known as the absolute liquidity ratio.

‍

Formula: 

Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities

Advantages and disadvantages of liquidity ratios

Liquidity ratio benefits

The most obvious advantage of using liquidity ratios is that they provide you with a quick way of understanding your company’s financial health and liquidity. They are quick and simple to calculate, and don’t require any of the complicated financial analysis that other metrics might entail. 

‍

Another benefit of liquidity ratios is the fact that they can be helpful in comparing your company’s performance against competitors and other businesses operating in your industry, so long as their balance sheet is public. These comparisons can help guide your own decisions as to how your business manages its liquidity and debt burden.

‍

Tracking your business’s liquidity ratio over time can help you understand how your business performance is trending—whether in the positive or negative direction. An improving liquidity ratio may indicate that your company is doing well as it executes on its business plan; a deteriorating liquidity ratio may indicate that you are inefficiently managing capital.

Liquidity ratio drawbacks 

While they are helpful, it’s important to note the drawbacks inherent in liquidity ratio analysis. 

‍

One such drawback is the fact that liquidity ratios do not take into account long-term obligations or debts, focusing instead on short-term liquidity. This means that liquidity ratios cannot provide a comprehensive view of your company’s financial health unless they are considered alongside other metrics. 

‍

Likewise, in order to truly benefit from knowing your company’s liquidity ratio, you need to track the metric over time. A one-time calculation provides some insights, but only about the given reporting period; you cannot identify trends in performance unless you are consistently calculating your liquidity ratios over time.

‍

Finally, it’s worth noting that the pursuit of a high liquidity ratio may not always be a good thing. Sure, holding a lot of cash or liquid assets may strengthen your company’s balance sheet and provide a high level of liquidity, but it also raises the question of whether you could be benefiting more by deploying the cash elsewhere in order to generate some kind of return.

‍

Discover Ramp's corporate card for modern finance

Learn more

Importance of liquidity ratios

Liquidity ratios provide an insight into a company’s financial health and ability to repay its short-term obligations. With this in mind, a variety of different people—lenders, investors, business partners—use these metrics to inform important decisions. Just a few examples of how liquidity ratios can be used and why they’re so important include:

• Assessing creditworthiness: Liquidity ratios give lenders and potential lenders an easy way of assessing a business’s ability to repay its debts. A high liquidity ratio may result in a greater likelihood of receiving the loan and more favorable terms than a lower liquidity ratio. 
• Assessing investment opportunities: Investors and analysts will often consider a company’s liquidity ratio before deciding whether or not to invest. A company with low liquidity may be unable to meet its short-term obligations and operate effectively, increasing the risk of bankruptcy and loss of investment capital. 
• Assessing regulatory compliance: In certain industries, such as the banking industry, companies must adhere to liquidity requirements. Those that fail to meet these thresholds may be at risk of regulatory action and fines. 
• Determining funding needs: A company’s management may use liquidity ratios to understand its liquidity position, which may inform strategies around inventory management, cash flow optimization, and funding. 

‍

As a business owner, you can and should calculate your liquidity ratios to have a better sense of how these individuals view your business. 

Facilitate more accurate financial analysis with Ramp

At the end of the day, any financial analysis your company performs must be backed by accurate data, including about how your company spends money and manages its cash flow. And that requires you to have the right processes and tools in place to ensure accurate analysis. 

‍

With Ramp’s all-in-one expense management platform, you have the tools you need to facilitate and manage corporate spend from procurement to employee reimbursements to vendor management and more. AI-powered accounts payable makes it possible to automate much (or all) of your bill pay processes, facilitating you to close your books quicker and with greater transparency each month.