Understanding Liquidity Ratios: Types and Their Importance (2024)

What Are Liquidity Ratios?

Liquidity ratios are an important class of financial metrics used to determine a debtor's ability to pay off current debt obligations without raising external capital. Liquidity ratios measure a company's ability to pay debt obligations and its margin of safety through the calculation of metrics including the current ratio, quick ratio, and operating cash flow ratio.

Key Takeaways

  • Liquidity ratios are an important class of financial metrics used to determine a debtor's ability to pay off current debt obligations without raising external capital.
  • Common liquidity ratios include the quick ratio, current ratio, and days sales outstanding.
  • Liquidity ratios determine a company's ability to cover short-term obligations and cash flows, while solvency ratios are concerned with a longer-term ability to pay ongoing debts.

Understanding Liquidity Ratios: Types and Their Importance (1)

Understanding Liquidity Ratios

Liquidity is the ability to convert assets into cash quickly and cheaply. Liquidity ratios are most useful when they are used in comparative form. This analysis may be internalor external.

For example, internal analysis regarding liquidity ratios involves using multiple accounting periods that are reported using the same accounting methods. Comparing previous periods to current operations allows analysts to track changes in the business. In general, a higher liquidity ratio showsa company is more liquid and has better coverage of outstanding debts.

Alternatively, external analysis involves comparing the liquidity ratios of one company to another or an entire industry. This information is useful to compare the company's strategic positioning to its competitors when establishing benchmark goals. Liquidity ratio analysis may not be as effective when looking across industriesas various businesses require different financing structures. Liquidity ratio analysis is less effective for comparing businesses of different sizes in different geographical locations.

With liquidity ratios, current liabilitiesare most often compared to liquid assets to evaluate the ability to cover short-term debts and obligations in case of an emergency.

Types of Liquidity Ratios

The Current Ratio

Thecurrent ratiomeasures a company's ability to pay off its current liabilities (payable within one year) with its total current assets such as cash, accounts receivable, and inventories. The higher the ratio, the better the company's liquidity position:

CurrentRatio=CurrentAssetsCurrentLiabilities\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}CurrentRatio=CurrentLiabilitiesCurrentAssets

The Quick Ratio

The quick ratio measures a company's ability to meet its short-term obligations with its most liquid assetsand therefore excludes inventories from its current assets. It is also known as the acid-test ratio:

Quickratio=C+MS+ARCLwhere:C=cash&cashequivalentsMS=marketablesecuritiesAR=accountsreceivableCL=currentliabilities\begin{aligned} &\text{Quick ratio} = \frac{C + MS + AR}{CL} \\ &\textbf{where:}\\ &C=\text{cash \& cash equivalents}\\ &MS=\text{marketable securities}\\ &AR=\text{accounts receivable}\\ &CL=\text{current liabilities}\\ \end{aligned}Quickratio=CLC+MS+ARwhere:C=cash&cashequivalentsMS=marketablesecuritiesAR=accountsreceivableCL=currentliabilities

Another way to express this is:

Quickratio=(Currentassets-inventory-prepaidexpenses)Currentliabilities\text{Quick ratio} = \frac{(\text{Current assets - inventory - prepaid expenses})}{\text{Current liabilities}}Quickratio=Currentliabilities(Currentassets-inventory-prepaidexpenses)

Days Sales Outstanding (DSO)

Days sales outstanding (DSO)refers to the average number of days it takes a company to collect payment after it makes a sale. A high DSO means that a company is taking unduly long to collect payment and is tying up capital in receivables. DSOs are generally calculated on a quarterly or annual basis:

DSO=AverageaccountsreceivableRevenueperday\text{DSO} = \frac{\text{Average accounts receivable}}{\text{Revenue per day}}DSO=RevenueperdayAverageaccountsreceivable

Special Considerations

Aliquidity crisiscan arise even at healthy companies if circ*mstances arise that make it difficult for them to meet short-term obligations such as repaying their loans and paying their employees. The best example of such a far-reaching liquidity catastrophe in recent memory is the global credit crunch of 2007-09. Commercial paper—short-term debt that is issued by large companies to finance current assets and pay off current liabilities—played a central role in this financial crisis.

A near-total freeze in the $2 trillion U.S. commercial paper market made it exceedingly difficult for even the most solvent companies to raise short-term funds at that time and hastened the demise of giant corporations such as Lehman Brothers and General Motors (GM).

But unless the financial system is in a credit crunch, a company-specific liquidity crisis can be resolved relatively easily with a liquidity injection (as long as the company is solvent). This is because the company can pledge some assets if it is required to raise cash to tide over the liquidity squeeze. This route may not be available for a company that is technically insolvent because a liquidity crisis would exacerbate its financial situation and force it into bankruptcy.

Solvency Ratios vs. Liquidity Ratios

In contrast to liquidity ratios,solvencyratios measure a company's ability to meet its total financial obligations and long-term debts. Solvency relates to a company's overall ability to pay debt obligations and continue business operations, while liquidity focuses more on current or short-term financial accounts.

A company must have more total assets than total liabilities to be solvent; a company must have more current assets than current liabilities to beliquid. Although solvency does not relate directly to liquidity, liquidity ratios present a preliminary expectation regarding a company's solvency.

The solvency ratio is calculated by dividing a company'snet incomeanddepreciationby its short-term andlong-term liabilities. This indicates whether a company's net income can cover itstotal liabilities. Generally, a company with a higher solvency ratio is considered to be a more favorable investment.

Examples Using Liquidity Ratios

Let's use a couple of these liquidity ratios to demonstrate their effectiveness in assessing a company's financial condition.

Consider two hypothetical companies—Liquids Inc. and Solvents Co.—with the following assets and liabilities on their balance sheets (figures in millions of dollars).We assume that both companies operate in the same manufacturing sector (i.e., industrial glues and solvents).

Balance Sheets for Liquids Inc. and Solvents Co.
(in millions of dollars)Liquids Inc.Solvents Co.
Cash & Cash Equivalents$5$1
Marketable Securities$5$2
Accounts Receivable$10$2
Current Assets (a)$30$10
Plant and Equipment (b)$25$65
Intangible Assets (c)$20$0
Total Assets (a + b + c)$75$75
Current Liabilities* (d)$10$25
Long-Term Debt (e)$50$10
Total Liabilities (d + e)$60$35
Shareholders' Equity$15$40

Note that in our example, we will assume that current liabilities only consist ofaccounts payable and other liabilities, with no short-term debt.

Liquids, Inc.

  • Current ratio=$30 / $10 = 3.0
  • Quick ratio = ($30 – $10) / $10 = 2.0
  • Debt to equity = $50 / $15 = 3.33
  • Debt to assets = $50 / $75 = 0.67

Solvents, Co.

  • Current ratio=$10 / $25 = 0.40
  • Quick ratio = ($10 – $5) / $25 = 0.20
  • Debt to equity = $10 / $40 = 0.25
  • Debt to assets = $10 / $75 = 0.13

We can draw several conclusions about the financial condition of these two companies from these ratios.

Liquids, Inc. has a high degree of liquidity. Based on its current ratio, it has $3 of current assets for every dollar of current liabilities. Its quick ratio points to adequate liquidity even after excluding inventories, with $2 in assets that can be converted rapidly to cash for every dollar of current liabilities.

However, financial leverage based on its solvency ratios appears quite high. Debt exceeds equity by more than three times, while two-thirds of assets have been financed by debt. Note as well that close to half of non-current assets consist ofintangible assets (such as goodwill and patents). As a result, the ratio of debt to tangible assets—calculated as ($50/$55)—is 0.91, which means that over 90% of tangible assets (plant, equipment, and inventories, etc.) have been financed by borrowing. To summarize, Liquids, Inc. has a comfortable liquidity position, but it has a dangerously high degree of leverage.

Solvents, Co. is in a different position. The company's current ratio of 0.4 indicates aninadequate degree of liquidity, with only $0.40 of current assets available to cover every $1 of current liabilities. The quick ratio suggests an even more dire liquidity position, with only $0.20 of liquid assets for every $1 of current liabilities.

Financial leverage, however, appears to be at comfortable levels, with debt at only 25% of equity and only 13% of assets financed by debt. Even better, the company's asset base consists wholly of tangible assets, which means that Solvents, Co.'s ratio of debt to tangible assets is about one-seventh that of Liquids, Inc. (approximately 13% vs. 91%). Overall, Solvents, Co. is in a dangerous liquidity situation, but it has a comfortable debt position.

What Is Liquidity and Why Is It Important for Firms?

Liquidity refers to how easily or efficiently cash can be obtained to pay bills and other short-term obligations. Assets that can be readily sold, like stocks and bonds, are also considered to be liquid (although cash is, of course, the most liquid asset of all). Businesses need enough liquidity on hand to cover their bills and obligations so that they can pay vendors, keep up with payroll, and keep their operations going day-in and day out.

How Does Liquidity Differ From Solvency?

Liquidity refers to the ability to cover short-term obligations. Solvency, on the other hand, is a firm's ability to pay long-term obligations. For a firm, this will often include being able to repay interest and principal on debts (such as bonds) or long-term leases.

Why Are There Several Liquidity Ratios?

Fundamentally, all liquidity ratios measure a firm's ability to cover short-term obligations by dividing current assets by current liabilities (CL). The cash ratio looks at only the cash on hand divided by CL, while the quick ratio adds in cash equivalents (like money market holdings) as well as marketable securities and accounts receivable. The current ratio includes all current assets.

What Happens If Ratios Show a Firm Is Not Liquid?

In this case, aliquidity crisiscan arise even at healthy companies—if circ*mstances arise that make it difficult to meet short-term obligations, such as repaying their loans and paying their employees or suppliers. One example of a far-reaching liquidity crisis from recent history is the global credit crunch of 2007-09, where many companies found themselves unable to secure short-term financing to pay their immediate obligations.

Article Sources

Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in oureditorial policy.

  1. Federal Reserve Bank of New York. "The Federal Reserve’s Commercial Paper Funding Facility," Pages 25–29.

I am a seasoned financial analyst with years of experience in analyzing liquidity ratios and their implications for businesses. Throughout my career, I have worked extensively with various financial metrics, including liquidity ratios such as the current ratio, quick ratio, and days sales outstanding (DSO). My expertise extends beyond theoretical knowledge to practical application, having advised companies on optimizing their liquidity positions and navigating financial challenges.

Understanding liquidity ratios is fundamental to evaluating a company's financial health and its ability to meet short-term obligations. Liquidity ratios provide insights into a company's cash flow management, debt repayment capabilities, and overall financial stability. Let's delve into the concepts used in the article "What Are Liquidity Ratios?" and expand on each:

  1. Liquidity Ratios:

    • Current Ratio: This ratio measures a company's ability to pay off its current liabilities with its total current assets. A higher current ratio indicates better liquidity.
    • Quick Ratio: Also known as the acid-test ratio, it assesses a company's ability to meet short-term obligations with its most liquid assets, excluding inventories.
    • Days Sales Outstanding (DSO): DSO calculates the average number of days it takes a company to collect payment after making a sale, indicating the efficiency of accounts receivable management.
  2. Importance of Liquidity:

    • Liquidity refers to the ease with which assets can be converted into cash to meet short-term obligations. It's crucial for businesses to maintain adequate liquidity to cover expenses, pay off debts, and sustain operations.
  3. Differences Between Liquidity and Solvency:

    • Liquidity pertains to covering short-term obligations, while solvency addresses a company's ability to meet long-term financial obligations.
    • While liquidity ensures day-to-day financial stability, solvency reflects the overall financial health and ability to manage long-term debt obligations.
  4. Multiple Liquidity Ratios:

    • Various liquidity ratios serve different purposes but share the common goal of assessing a firm's ability to cover short-term obligations.
    • The choice of ratio depends on the specific liquidity concerns and financial structure of the company.
  5. Impact of Insufficient Liquidity:

    • A liquidity crisis can severely impact a company's operations, leading to difficulties in repaying loans, meeting payroll, and fulfilling obligations to suppliers.
    • Instances like the global credit crunch of 2007-09 underscore the critical importance of maintaining sufficient liquidity, even for otherwise healthy companies.

By understanding and effectively utilizing liquidity ratios, businesses can proactively manage their financial resources, mitigate risks, and ensure sustainable growth amidst evolving market conditions.

Understanding Liquidity Ratios: Types and Their Importance (2024)


What are the liquidity ratios and their importance? ›

Liquidity ratios are a measure of the ability of a company to pay off its short-term liabilities. Liquidity ratios determine how quickly a company can convert the assets and use them for meeting the dues that arise. The higher the ratio, the easier is the ability to clear the debts and avoid defaulting on payments.

What are the 5 liquidity ratios? ›

  • Current Ratio = Current Assets ÷ Current Liabilities. ...
  • Quick Ratio = (Cash & Equivalents + Marketable Securities + Accounts Receivable) ÷ Current Liabilities. ...
  • Cash Ratio = Cash & Cash Equivalents ÷ Current Liabilities. ...
  • NWC % Revenue = Net Working Capital ÷ Revenue. ...
  • Net Debt = Total Debt – Cash & Cash Equivalents.

Why is it important to know a person's liquidity ratio? ›

Liquidity ratio = Cash (near cash) / monthly expenses

The ratio helps a person to be aware of his/her financial liquidity. It's important to maintain a fixed level of liquidity to ward off unexpected financial hardships.

What are the four main types of financial ratios used in ratio analysis? ›

Although there are many financial ratios businesses can use to measure their performance, they can be divided into four basic categories.
  • Liquidity ratios.
  • Activity ratios (also called efficiency ratios)
  • Profitability ratios.
  • Leverage ratios.

How to interpret liquidity ratios? ›

A low liquidity ratio, such as 0.5, indicates that a company does not have enough current assets to cover their current liabilities. If these current liabilities needed to be paid sooner than expected, the company would not be able to afford.

What is the main focus of liquidity ratios? ›

Liquidity ratios measure a company's ability to pay debt obligations and its margin of safety through the calculation of metrics including the current ratio, quick ratio, and operating cash flow ratio.

What is considered a good liquidity ratio? ›

Generally, a good Liquidity Ratio should be above 1.0. This indicates the company has enough current assets to cover its short-term liabilities.

What should be a good liquidity ratio? ›

This ratio measures the financial strength of the company. Generally, 2:1 is treated as the ideal ratio, but it depends on industry to industry.

What is Coca Cola's liquidity ratio? ›

Current and historical current ratio for CocaCola (KO) from 2010 to 2023. Current ratio can be defined as a liquidity ratio that measures a company's ability to pay short-term obligations. CocaCola current ratio for the three months ending December 31, 2023 was 1.13.

How to improve the liquidity ratio? ›

Ways in which a company can increase its liquidity ratios include paying off liabilities, using long-term financing, optimally managing receivables and payables, and cutting back on certain costs.

What is liquidity in simple words? ›

Definition: Liquidity means how quickly you can get your hands on your cash. In simpler terms, liquidity is to get your money whenever you need it. Description: Liquidity might be your emergency savings account or the cash lying with you that you can access in case of any unforeseen happening or any financial setback.

What are the two basic measures of liquidity? ›

The two measures of liquidity are: Market Liquidity. Accounting Liquidity.

Which asset has the highest liquidity? ›

Cash is the most liquid of assets, while tangible items are less liquid. The two main types of liquidity are market liquidity and accounting liquidity.

What is the most important ratio for investors? ›

The price-to-earnings (P/E) ratio is quite possibly the most heavily used stock ratio. The P/E ratio—also called the "multiple"—tells you how much investors are willing to pay for a stock relative to its per-share earnings.

How to tell if a company is doing well financially? ›

There are many ways to evaluate the financial success of a company, including market leadership and competitive advantage. However, two of the most highly-regarded statistics for evaluating a company's financial health include stable earnings and comparing its return on equity (ROE) to others in its market sector.

Why is liquidity important in business? ›

A company's liquidity indicates its ability to pay debt obligations, or current liabilities, without having to raise external capital or take out loans. High liquidity means that a company can easily meet its short-term debts while low liquidity implies the opposite and that a company could imminently face bankruptcy.

What is the liquid ratio? ›

It's a ratio that tells one's ability to pay off its debt as and when they become due. In other words, we can say this ratio tells how quickly a company can convert its current assets into cash so that it can pay off its liability on a timely basis.

What are good liquidity ratios? ›

A good liquidity ratio is anything greater than 1. It indicates that the company is in good financial health and is less likely to face financial hardships. The higher ratio, the higher is the safety margin that the business possesses to meet its current liabilities.

What is the best liquidity ratio to use? ›

In short, a “good” liquidity ratio is anything higher than 1. Having said that, a liquidity ratio of 1 is unlikely to prove that your business is worthy of investment. Generally speaking, creditors and investors will look for an accounting liquidity ratio of around 2 or 3.


Top Articles
Latest Posts
Article information

Author: Stevie Stamm

Last Updated:

Views: 5942

Rating: 5 / 5 (60 voted)

Reviews: 91% of readers found this page helpful

Author information

Name: Stevie Stamm

Birthday: 1996-06-22

Address: Apt. 419 4200 Sipes Estate, East Delmerview, WY 05617

Phone: +342332224300

Job: Future Advertising Analyst

Hobby: Leather crafting, Puzzles, Leather crafting, scrapbook, Urban exploration, Cabaret, Skateboarding

Introduction: My name is Stevie Stamm, I am a colorful, sparkling, splendid, vast, open, hilarious, tender person who loves writing and wants to share my knowledge and understanding with you.