Liquidity ratios measure a company's ability to meet its short-term obligations. Understand the definitions, formulas, examples, and compare them to solvency ratios.

A liquidity ratio is a type of accounting metric that highlights a company’s ability to meet its short-term obligations. Liquidity ratios are a class of metrics that include current ratio, quick ratio, and cash ratio.

By contrast, a solvency ratio is a type of accounting metric that highlights a company’s ability to meet its long-term obligations. We will discuss debt to equity, debt to asset ratio, and interest coverage ratio in the section about solvency ratios below.

Financial ratios like these are important to understanding the financial health of a business. For instance, growing revenue while worsening your current ratio could be indicative of long term problems.

On the other hand, potential creditors will want to see that your liquidity ratios are solid before feeling comfortable making debt or equity investments into a company.

In this post, we will provide the definition of liquidity ratios, the formulas of common ratios, how to interpret the ratios, and walk through several examples.

Liquidity refers to the ease at which an asset can be converted to cash at or near its market value. For example, Apple stock is very liquid because there are many buyers, many sellers, and a well understood price.

The opposite of liquid is illiquid, which means difficult to sell or that there is no market for reselling. Companies will need to maintain a balance of liquid assets and illiquid assets.

For instance, a manufacturing company with millions of dollars of fixed assets might have a problem paying its bills if their resources are tied up in factories and large equipment.

A high liquidity ratio can be problematic. A high ratio means that the company has many short-term obligations, like loans and payments to vendors, relative to its cash position. This is a worrying sign for management and investors.

A low liquidity ratio can be an opportunity. A low ratio means that the company has few short-term obligations, like debt and payments to suppliers, relative to its cash position. This is a good sign for management and investors.

Here is a list of liquidity ratios:

- Current Ratio
- Quick Ratio
- Cash Ratio

To lower a liquidity ratio, a company would need to lower its current liabilities. A good liquidity ratio depends on the company stage and industry. That said, anything below 1.2x for current ratio would be a cause for concerns.

Current ratio is a standard view of looking at a company’s liquidity. It looks if all of the company’s current assets can cover its current liabilities. The current ratio formula is:

Current Ratio = Current Assets / Current Liabilities

Current assets are defined as all short-term assets that will convert to cash within the operating cycle of the business. Examples include cash, cash equivalents, accounts receivable, and inventory.

As a reminder, cash equivalents are short-term investments that include marketable securities, certificates of deposit, Treasury bills, government bonds, and commercial paper.

Current liabilities refer to all short-term liabilities that must be repaid within the operating cycle of the business. Examples include accounts payable, salaries payable, interest payable, and taxes payable.

The current ratio is also called the working capital ratio.

Quick ratio is a more strict view. The metric looks at if current assets less inventory (called quick assets) can cover the company’s current liabilities. The quick ratio formula is:

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

Quick Ratio = Quick Assets / Current Liabilities

The quick ratio is also called the acid-test ratio or acid test. This is simply another name for the same calculation.

Cash ratio is the most strict view. The metric only looks at if the cash on hand can cover the company’s current liabilities. The cash ratio formula is:

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

You will note that the denominator in all of these equations is current liabilities.

Now that we have talked through the three most common liquidity ratios, let’s go through the steps. Company A had the following assets and liabilities in the fiscal year 2021.

Company A, Fiscal Year 2021

- Cash: $250,000
- Cash Equivalents: $100,000
- Accounts Receivable: $150,000
- Inventory: $250,000
- Accounts Payable: $375,000
- Short-Term Debt: $120,000

First, let’s find current liabilities (CL). In this case, it’s accounts payable plus short-term debt.

CL = Accounts Payable + Short-Term Debt

CL = $375,000 + $120,000

CL = $495,000

Now let’s calculate the current ratio for Company A in 2021.

Current Ratio = Current Assets / Current Liabilities

Current Ratio = (Cash + Cash Equivalents + Accounts Receivable + Inventory) / $495,000

Current Ratio = ($250,000 + $100,000 + $150,000 + $250,000) / $495,000

Current Ratio = $750,000 / $495,000

Current Ratio = 1.52x

Company A has a current ratio of 1.52x.

To calculate the quick ratio, we will remove inventory from the numerator.

Quick Ratio = Quick Assets / Current Liabilities

Quick Ratio = (Cash + Cash Equivalents + Accounts Receivable) / $495,000

Quick Ratio = (250,000 + $100,000 + $150,000) / $495,000

Quick Ratio = $500,000 / $495,000

Company A has a quick ratio of 1.01x.

To calculate the cash ratio, we will add cash and cash equivalents for the numerator.

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

Cash Ratio = ($250,000 + $100,000) / $495,000

Cash Ratio = $350,000 / $495,000

Company A has a cash ratio of 0.71x.

As you can see, there is a large delta between the company’s current ratio and cash ratio. These metrics are related but do shed light on where assets reside on the balance sheet.

In finance and accounting, solvency ratios show how indebted a company is and provides context on how that company compares to competitors in the industry.

A company’s solvency ratio compares cash flow generated by the business to their outstanding debt to understand if the company has too much debt. In order to find the company’s actual cash flow, you must add non-cash expenses like depreciation and amortization back to net income.

A high solvency ratio (high debt relative to cash flow) can cause problems for companies.A high ratio means the company has more financial risk and could put off potential investors.

A low solvency ratio (low debt relative to cash flow) can be an opportunity for companies.A low ratio means the company has less financial risk and is attractive to both debt and equity investors.

Note that liquidity ratios look at short-term liabilities, whereas solvency ratios focus on a company’s total liabilities.

Here is a list of solvency ratios:

- Debt to Equity Ratio
- Debt to Asset Ratio
- Interest Coverage Ratio

Debt to Equity Ratio = (Short-Term Debt + Long-Term Debt) / Shareholders’ Equity

Debt to Equity Ratio = Total Debt / Total Equity

A company with $1,000,000 of total debt and $1,000,000 in total shareholders’ equity would have a debt/equity ratio of 1.0. As a general rule, a debt/equity ratio of 1.00 to 1.50 is considered good. A ratio above 2.0 would be a cause for concern in more industries.

Debt to Asset Ratio = (Short-Term Debt + Long-Term Debt) / (Current Assets + Noncurrent Assets)

Debt to Asset Ratio = Total Debt / Total Assets

A company with $800,000 in total debt and $1,200,000 in total assets would have a debt/asset ratio of 0.67. That means of the $1,200,000 of assets, 67% are financed with debt and the remaining 33% are financed with shareholders’ equity.

As you can imagine, this is a high level of debt. Generally speaking, companies should strive for a debt/asset below 0.40 and one above 0.60 would be a cause for concern.

Interest Coverage Ratio = Earnings Before Interest and Taxes / Interest Expense

Remember that earnings before interest and taxes (EBIT) is also called operating profit. The EBIT formula is total revenue minus cost of goods sold (COGS) minus operating expenses (OPEX).

This ratio shows how many times greater your operating profit is than your interest payments for the current period. Note that both of these values are found on the income statement, as opposed to the other solvency ratios that get their data from the balance sheet.

In general, an interest coverage ratio 2.0 is the minimum and investors would prefer to see a ratio that is 3.0 or greater.

Liquidity ratios show a company’s ability to cover their short-term borrowings and payments to vendors, suppliers, and employees. It’s vital for management to manage their recurring expenses, short-term debt obligations, and long-term debt obligations.

For instance, a liquidity crisis can happen if a company has promising growth but falls into several back-to-back months of large expenses and debt repayments.

Managers need to understand when debt is due, annual contracts must be renewed, when salaries are paid, and other large cash outflows. Companies that do not take these large payments seriously can find themselves in a poor financial situation.

Ultimately, companies need to practice careful expense management and have access to capital to weather periods of poor cash flow. Businesses that do not have access to immediate cash when they need it can face bankruptcy.

A high current ratio (above 1.5x) is generally a good thing. However, if the ratio is too high then the company might have too much cash on the balance sheet and might not be as productive as it could be.

On the other hand, a low current ratio (below 1.0x) is deemed as risky. Companies that have low assets relative to their liabilities will not be able to raise money at favorable terms from investors and could become insolvent.