Types of liquidity ratio
There are three main liquidity ratios, each measuring the relationship between liquid assets and current liabilities with progressively stricter definitions of what counts as liquid.
- Current ratio: Current Assets / Current Liabilities (includes stock)
- Quick ratio (acid test): (Current Assets - Stock) / Current Liabilities (excludes stock)
- Cash ratio: Cash and Equivalents / Current Liabilities (most conservative)
What the ratios tell you
A current ratio above 1.0 means current assets exceed current liabilities, suggesting the business can cover its short-term obligations. A ratio between 1.5 and 2.0 is generally considered healthy for most industries.
The quick ratio removes stock from current assets because stock may take time to sell and may not realise its full book value in a forced liquidation. A quick ratio of at least 1.0 is generally considered acceptable.
Limitations of liquidity ratios
Liquidity ratios are a snapshot in time. They do not reflect cash flow dynamics, seasonal variations, or the quality of specific assets. A business may have a healthy current ratio but still face a cash flow crisis if its debtors are not paying.
Frequently Asked Questions
What is a good liquidity ratio for a UK SME?
A current ratio of 1.5 to 2.0 is generally considered healthy. A quick ratio of 1.0 or above is acceptable for most sectors. These benchmarks vary by industry.
How do lenders use liquidity ratios?
Lenders use liquidity ratios alongside other metrics to assess a borrower's ability to service debt. A very low liquidity ratio may indicate the business is already over-leveraged relative to its liquid assets.