Liquidity Ratio Definition
A liquidity ratio is used to measure the ability of a business to generate cash to meet its short term liabilities and debts.
Liquidity ratios are normally based on balance sheet items and indicate the number of times the liquid assets of a business cover the short term liabilities.
Popular Liquidity Ratios List
A selection of popular liquidity ratios from the Double Entry Bookkeeping Ratios Guide.
Liquidity Ratio Analysis
A liquidity ratio should not be viewed in isolation but looked at over a period of time using trend analysis and in comparison to other businesses in your industry.
In addition, in order to give a full picture of what is happening, they should be viewed relative to other ratios calculated for the business such as profitability ratios, efficiency ratios, leverage ratios, activity ratios, and investor ratios.
The higher the ratio the more liquidity the business has and the less risky it is seen to be. However, a balance needs to be met as a ratio which is too high implies a lot of money tied up in current assets. It is generally accepted that money tied up in this way earns very little or nothing for the business and is not acceptable.
Liquidity Ratio Formula
There are numerous examples of liquidity ratios, however, it is important to select the key ratios which relate to your business. The industry sector, size, and complexity of the business will determine the most appropriate ratios to use and many may not be relevant or worth calculating, particularly for a small business.
Liquidity Ratios vs Solvency Ratios
Liquidity ratios are often confused with solvency ratios. Liquidity ratios measure the ability of a business to meet its short-term current liabilities whereas in contrast solvency ratios assess its ability to pay off long-term obligations to creditors, bondholders, and banks. Solvency ratios are often referred to as leverage ratios.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.