Liquidity Ratios#

Liquidity ratios measure a company's ability to pay its short-term obligations. They answer a critical question: Can this company meet its bills as they come due?

Liquidity refers to how easily assets can be converted to cash. Liquidity ratios compare liquid assets to near-term liabilities, revealing short-term financial health.

Current Ratio#

The current ratio is the most widely used liquidity measure, comparing all current assets to all current liabilities.

Current Ratio = Current Assets / Current Liabilities

A ratio above 1.0 means the company has more short-term assets than short-term debts.

Interpreting Current Ratio#

Range	Interpretation
> 2.0	Strong liquidity, possibly excess cash
1.5 - 2.0	Healthy liquidity buffer
1.0 - 1.5	Adequate, but watch closely
< 1.0	Potential liquidity stress

Example Calculation#

Item	Amount
Cash	$50M
Accounts Receivable	$80M
Inventory	$70M
Current Assets	$200M
Accounts Payable	$60M
Short-term Debt	$40M
Other Current Liabilities	$20M
Current Liabilities	$120M
Current Ratio	1.67

This company has $1.67 in current assets for every $1 of current liabilities—healthy liquidity.

Industry Context Matters#

Industry	Typical Current Ratio	Why
Technology	2.0 - 4.0	High cash, low inventory
Retail	1.0 - 2.0	Inventory-heavy
Grocery	0.8 - 1.2	Fast inventory turnover
Utilities	0.6 - 1.0	Stable, regulated cash flows
Manufacturing	1.2 - 2.0	Working capital needs

Low Ratio Warning

A current ratio below 1.0 doesn't always signal doom. Some businesses with predictable cash flows (utilities, subscription services) operate safely with low ratios. But for most companies, < 1.0 warrants investigation.

Quick Ratio (Acid Test)#

The quick ratio is more conservative than the current ratio—it excludes inventory, which may be difficult to liquidate quickly.

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

Or: (Cash + Marketable Securities + Receivables) / Current Liabilities

The quick ratio measures ability to pay bills without selling inventory.

Why Exclude Inventory?#

Inventory has liquidation risks:

May sell at a discount if liquidated quickly
May become obsolete (technology, fashion)
Takes time to convert to cash
Value may be overstated on balance sheet

Interpreting Quick Ratio#

Range	Interpretation
> 1.5	Very strong—can pay all short-term debts with liquid assets
1.0 - 1.5	Healthy liquidity
0.5 - 1.0	Adequate for most industries
< 0.5	May need to sell inventory or borrow to pay bills

Quick vs. Current: The Gap#

Company	Current Ratio	Quick Ratio	Gap
Tech Co	2.5	2.3	Small (low inventory)
Retailer	2.0	0.8	Large (inventory-heavy)
Grocery	1.1	0.3	Very large (fast inventory)

A large gap indicates heavy inventory dependence. If the retailer couldn't sell its inventory, it would struggle to meet obligations.

Cash Ratio#

The cash ratio is the most conservative liquidity measure—only cash and cash equivalents count.

Cash Ratio = Cash and Cash Equivalents / Current Liabilities

This is the strictest test: Can the company pay all short-term debts with cash on hand right now?

Interpreting Cash Ratio#

Range	Interpretation
> 1.0	Can pay all current liabilities with cash alone
0.5 - 1.0	Reasonable cash position
0.2 - 0.5	Typical for operating businesses
< 0.2	Low cash buffer

When Cash Ratio Matters Most#

Economic downturns: Receivables may become uncollectible
Credit crunches: Borrowing may become difficult
Industry disruption: Inventory may lose value
Rapid growth: Cash needs increase faster than generation

Cash Is King

During crises (like 2008 or 2020), companies with high cash ratios survived while highly leveraged competitors failed. Cash provides the ultimate safety buffer.

Operating Cash Flow Ratio#

This ratio connects cash flow to current liabilities, showing whether operations generate enough cash.

Operating CF Ratio = Operating Cash Flow / Current Liabilities

A ratio > 1.0 means operating cash flow alone can cover all current liabilities.

Interpretation#

Range	Interpretation
> 1.0	Strong—operations fund all short-term needs
0.5 - 1.0	Adequate cash generation
< 0.5	May need external financing

Practical Application#

Comprehensive Liquidity Assessment#

Metric	Company X	Industry Avg	Assessment
Current Ratio	1.8	1.5	Above average
Quick Ratio	1.2	0.9	Strong
Cash Ratio	0.4	0.3	Adequate
OCF Ratio	0.9	0.7	Healthy

Conclusion: Company X has strong liquidity across all metrics, with above-average ability to meet short-term obligations.

Trend Analysis#

Year	Current Ratio	Quick Ratio
2020	2.2	1.5
2021	1.9	1.2
2022	1.6	0.9
2023	1.3	0.6

Concern: Declining liquidity trend suggests either aggressive expansion, deteriorating operations, or building financial stress.

Red Flags#

Warning Sign	Possible Issue
Current ratio < 1.0	Immediate liquidity stress
Quick ratio declining while current stable	Inventory buildup
Cash ratio near zero	No safety buffer
OCF ratio negative	Operations consuming cash

Key Takeaways

Current Ratio = Current Assets / Current Liabilities—general liquidity measure
Quick Ratio excludes inventory—more conservative, tests immediate payment ability
Cash Ratio uses only cash—strictest test, reveals safety buffer
Operating CF Ratio shows whether operations generate sufficient cash
Industry context matters: grocery stores operate safely at lower ratios than tech companies
Track trends over time—declining liquidity signals potential problems
Cash is the ultimate safety buffer during crises