How to calculate liquidity

Reading time: 5 min

    Add a header to begin generating the table of contents
    Rachel Wait

    Page written by Rachel Wait. Last reviewed on June 5, 2024. Next review due March 1, 2025.

      Add a header to begin generating the table of contents
      Read this article to me

      Liquidity is an important term to understand if you run a business. Liquidity is a company’s ability to convert assets into cash to pay off its short-term obligations or liabilities – those that will become due in less than a year. 

      This guide explains all you need to know about measuring a company’s liquidity, including the different types of liquidity ratio.

      What are liquidity ratios?

      A liquidity ratio is a calculation used to measure a company’s ability to pay off any short-term debt obligations using its current (or liquid) assets. It’s used to indicate whether the business can pay off its debt and business loans with the cash it has readily available, or whether it will need to raise additional capital to do so. It can also show how quickly the assets held can be turned into cash for the debt.

      Why are liquidity ratios important?

      Liquidity ratios are important because they can give you an indication of a business’s financial health. As mentioned above, your liquidity ratio tells you whether you will be able to repay your debts. This usually means that you have sufficient cash, bank deposits or assets that can be quickly converted to cash to pay your bills.  

      If you don’t have sufficient liquidity, it’s likely your business will run into financial difficulties.  

      Liquidity ratios are also important to both lenders and investors. Lenders will want to be sure your business has enough current assets to repay its debts, while investors will also look at liquidity ratios as part of an overall financial analysis. Generally, they will be looking for ratios of 2:1 or 3:1 as this indicates the company has plenty of room to pay its short-term bills and will still have working capital to continue operating.

      Common types of liquidity ratios

      There are a number of different types of liquidity ratios such as current ratio, quick ratio and cash ratio. These are explained below.

      Current ratio

      The current ratio is also known as the working capital ratio and indicates your ability to pay debts that are due within 12 months from your current assets. It’s the easiest calculation to understand.

      Current ratio formula

      The formula for calculating the current ratio is as follows:

      Current ratio = current assets / current liabilities

      For example, if you had current assets of R160,000 and current liabilities of R80,000, your current ratio would be 2:1. This means you’d be able to cover your liabilities. On the other hand, if the ratio was 1:1 or lower, you could struggle to pay off your debts and you’d need to find ways to increase liquidity. 

      Quick ratio

      The quick ratio or ‘acid test ratio’ measures your ability to pay off your current liabilities with assets that can be converted into cash swiftly and without losing too much of their book value. While the current ratio uses all current assets, the quick ratio limits it to accounts receivable (money that clients owe you), marketable securities (assets that are easily traded on a public stock exchange) and cash in the bank.

      Quick ratio formula

      The formula for calculating the quick ratio is as follows:

      Quick ratio = (cash + accounts receivable + marketable securities) / current liabilities

      For example, if your cash, plus accounts receivable, plus marketable securities worked out to be R50 million and your current liabilities were R40 million, your quick ratio would be 1.25. 

      A good quick ratio would be 1.5:1.

      Cash ratio

      This is the ratio of your cash and cash equivalents to total liabilities. It gives you an indication of the health of your business and is also used by lenders to measure your ability to pay back your debt. 

      Cash ratio formula

      The formula used to calculate the cash ratio is as follows: 

      Cash ratio = cash + cash equivalents / current liabilities

      For example, if your cash plus cash equivalents was R800,000 and your current liabilities were R700,000, your ratio would be 1.14. 

      If the cash ratio is above 1, you have the ability to meet your current debts. Anything below this means you won’t be able to meet your current liabilities. 

      The relationship between liquidity and net working capital

      Net working capital is another way to measure liquidity. To do this, you need to use the formula below:

      Net working capital = current assets – current liabilities

      Ideally, you want your net working capital to be growing consistently alongside your business. Sales and assets should be going up as this will increase net working capital. On the other hand, if your working capital is declining, this indicates a lack of liquidity. 

      The goal of working capital management is to ensure the company has sufficient funds that are easily accessible for day-to-day operations, while avoiding excess reserves that can be expensive and affect the business’ profitability and returns.

      Like what you see? Share with a friend.

      Written by

      Rachel Wait

      Rachel has been writing about finance and consumer affairs for over a decade, helping people to get to grips with their finances and cut through the jargon. She's written for a range of websites and national newspapers including MoneySuperMarket, Money to the Masses, Forbes UK, and Mail on Sunday. Rachel has covered almost every financial topic, from car insurance and credit cards, to business bank accounts and mortgages.

      Swoop promise

      At Swoop we want to make it easy for SMEs to understand the sometimes overwhelming world of business finance and insurance. Our goal is simple – to distill complex topics, unravel jargon, offer transparent and impartial information, and empower businesses to make smart financial decisions with confidence.

      Find out more about Swoop’s editorial principles by reading our editorial policy.

      Ready to grow your business?

      Clever finance tips and the latest news

      Delivered to your inbox, every week
      Join the 70,000+ businesses just like yours getting the Swoop newsletter.
      Free. No spam. Opt out whenever you like.

      Clever finance tips and the latest news

      delivered to your inbox, every week

      Join the 70,000+ businesses just like yours getting the Swoop newsletter.

      Free. No spam. Opt out whenever you like.

      Looks like you're in . Go to our site to find relevant products for your country. Go to Swoop No, stay on this page