Liquidity refers to how easily an asset, such as money in your bank accounts, real estate, equipment, and inventory, can be turned into cash. Determining your liquidity ratios can help you understand whether you have enough money immediately available to meet all your obligations as they fall due.
"We calculate liquidity ratios monthly or quarterly," says Jibran Qureshi, Director of UK-based accountancy ClearHouse Accountants. "Regular calculations allow us to stay on top of our cash flow situation and ensure we are prepared to meet our financial obligations without any surprises."
What are the 3 liquidity ratios?
There are three main liquidity ratios, all of which compare your current assets to your current liabilities. Current assets are those you can convert to cash within 12 months, such as real estate and money owed from your clients. Current liabilities are amounts you owe within one year, such as money to suppliers, interest on business loans or credit card balances.
"It is especially important to calculate your liquidity ratios before applying for loans, during times of uncertainty, or when planning for growth," shares Anthony Impey, CEO of Be the Business, a non-profit organisation supporting business owners. A ratio above 1 is what most companies aim for, though this varies widely by ratio and industry. Let's look more closely at the three main liquidity ratios.
Current ratio
The current ratio compares all current assets to current liabilities. In this way, it helps you understand if you can meet your short-term obligations using readily available assets. You can calculate your current ratio by dividing your current assets by your current liabilities as follows:
Current Ratio = Current Assets / Current Liabilities
"We use the current ratio to assess our overall liquidity position, ensuring that our receivables and cash are sufficient to cover liabilities," Qureshi shares. "If our current ratio is strong, it indicates that we have a comfortable buffer to handle upcoming expenses, which may support decisions to reinvest in the business, such as expanding services or hiring more staff."
Quick ratio
The quick ratio, sometimes referred to as the 'acid-test ratio', measures a company's ability to pay its current liabilities without having to sell inventory. In other words, it removes inventory from current assets. This makes it a more conservative ratio since it removes current assets that may not be so easy to turn into cash quickly. You can calculate the quick ratio using the formula below:
Quick Ratio = (Current Assets - Inventory) / Current Liabilities
"The quick ratio gives us a clear picture of our ability to meet obligations using only our most liquid assets - receivables and cash," explains Qureshi.
Cash ratio
The cash ratio only measures cash and cash equivalents against current liabilities. Cash equivalents are assets that can be quickly converted into money, typically within three months or less. For example, short-term Government bonds and money market accounts. To calculate the cash ratio:
Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities
"The cash ratio is crucial when we want to focus exclusively on our cash and cash equivalents, especially during periods when managing cash flow is vital, such as in times of economic uncertainty or when facing large, imminent payments," Qureshi says.
How to use liquidity ratios to analyse business performance
Evaluate trends
Evaluating trends in your liquidity ratios over time can help you identify and address any cash flow issues early. For example, you could shorten your client invoice period or trim budgets in lower priority areas. "If our cash ratio is declining, it could signal that we need to improve our receivables' collection process or adjust our spending to maintain sufficient liquidity," Qureshi notes.
Analyse cash flow
"Monitoring liquidity ratios help us maintain a strong financial foundation, ensuring we can meet our short-term obligations and sustain our operations smoothly," shares Qureshi.
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Check flexibility
Liquidity ratios support business owners in understanding how much cash is available not only to meet obligations but also to reinvest in other areas of the business, such as for growth or a buffer to weather challenging periods. "Liquidity ratios provide insights into our firm's financial flexibility and support decisions related to cash management, budgeting and financial planning," explains Qureshi.
Assess operational efficiency
High liquidity ratios can indicate that a company is holding too much cash, rather than investing it for growth or expansion. In other words, cash resources are being under-utilised. Calculating your liquidity ratios can therefore give you valuable data you can use to better balance your incomings and outgoings to support continued growth or pay off debts.
"For example, if a product launch has been a resounding success, generating significant revenue and cash flow, the quick ratio can help determine whether the business is in a position to invest in growth opportunities or pay down debt to capitalise on that momentum," explains Impey.
Compare benchmarks
By regularly monitoring your liquidity ratios over time, you will gradually start to build a historical picture of performance through which you can benchmark. Moreover, you can compare with industry standards.
If, for example, your ratios dip against your benchmarks, you can use this information to dig deeper into the reasons behind this. Perhaps you're holding onto too much inventory, for example. You can also compare your ratios against industry averages.
"Think of liquidity ratios as your business's financial health check-up," muses Impey. "They tell you if your company has enough assets to stay stable, how well you're juggling cash and working capital, and whether there's a storm brewing in your cash flow," he adds. "They can even gauge how quickly you can turn assets into cash when the pressure's on."
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