# Understanding Liquidity Ratios: Types and Their Importance

> **Definition**
>
> Liquidity ratios are a class of financial metrics used to determine a debtor's ability to pay off current debt obligations without raising external capital.

## What Are Liquidity Ratios?

Liquidity ratios measure a company's ability to pay its short-term debt obligations. They include the current ratio, the [quick ratio](https://www.investopedia.com/terms/q/quickratio.asp), and the days sales outstanding ratio.

In general, a higher liquidity ratio shows a company is more liquid and has better coverage of outstanding debts.  

### Key Takeaways

*   Liquidity ratios can determine a debtor's ability to pay off current debt.
*   Common liquidity ratios include the quick ratio, current ratio, and days sales outstanding.
*   Liquidity ratios determine a company's ability to cover short-term obligations and cash flows, while solvency ratios are concerned with a longer-term ability to pay ongoing debts.

![Liquidity ratio](https://www.investopedia.com/thmb/up8uwGFuZZqGhyd6TiqYgFNsLFE=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/terms_l_liquidityratios_FINAL-d2c8aea76ba845b4a050eacd22566cae-6ca853850d8a4eb7ac2f43badb474b1f.jpg)

*— Investopedia / Daniel Fishel*

## Understanding Liquidity Ratios

Liquidity is the ability to [convert assets into cash](https://www.investopedia.com/terms/c/cash-asset-ratio.asp) quickly and cheaply. Liquidity ratios are most useful when they are used in comparative form. This analysis may be internal or external.

Internal analysis with liquidity ratios involves using multiple accounting periods that are reported using the same accounting methods. Comparing previous periods to current operations allows analysts to track changes in the business.  

External analysis involves comparing the liquidity ratios of one company to another or to an entire industry. This information is useful in comparing the company's strategic positioning to its competitors when establishing [benchmark](https://www.investopedia.com/terms/b/benchmark.asp) goals.

Liquidity ratio analysis may not be as effective when looking across industries, as various businesses require different financing structures.

Liquidity ratio analysis is also less effective for comparing businesses of different sizes in different geographical locations.

> **Important**
>
> With liquidity ratios, current liabilities are most often compared to liquid assets to evaluate the ability to cover short-term debts and obligations in case of an emergency.

## Types of Liquidity Ratios

### The Current Ratio

The [current ratio](https://www.investopedia.com/terms/c/currentratio.asp) measures a company's ability to pay off its current liabilities (payable within one year) with its total current assets such as cash, accounts receivable, and inventories.

The higher the ratio, the better the company's liquidity position.

$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$

### The Quick Ratio

The [quick ratio](https://www.investopedia.com/terms/q/quickratio.asp) measures a company's ability to meet its short-term obligations with its most liquid assets and therefore excludes inventories from its current assets.

It is also known as the [acid-test](https://www.investopedia.com/terms/a/acidtest.asp) ratio.

$\begin{aligned} &\text{Quick ratio} = \frac{C + MS + AR}{CL} \\ &\textbf{where:}\\ &C=\text{cash \& cash equivalents}\\ &MS=\text{marketable securities}\\ &AR=\text{accounts receivable}\\ &CL=\text{current liabilities}\\ \end{aligned}$

Another way to express this is:

$\text{Quick ratio} = \frac{(\text{Current assets - inventory - prepaid expenses})}{\text{Current liabilities}}$

### Days Sales Outstanding (DSO)

[Days sales outstanding](https://www.investopedia.com/terms/d/dso.asp) (DSO) refers to the average number of days it takes a company to collect payment after it makes a sale.

A high DSO means that a company is taking unduly long to collect payment and is tying up capital in receivables.

DSOs are generally calculated on a quarterly or annual basis.

$\text{DSO} = \frac{\text{Average accounts receivable}}{\text{Revenue per day}}$

## Who Uses Liquidity Ratios?

Liquidity ratios' versatility makes them useful to a number of different users. The following stakeholders can each use liquidity ratios in distinct ways.

*   **Investors:** Investors use liquidity ratios to assess the short-term financial health of companies that they're considering investing in. By evaluating a company's liquidity position, investors can see the company's ability to meet immediate financial obligations. This is important when trying to reduce the risk of default.
*   **Creditors:** [Creditors](https://www.investopedia.com/terms/c/creditor.asp), such as financial institutions, rely on liquidity ratios to evaluate the creditworthiness of potential borrowers. By analyzing a company's liquidity position, creditors can assess the likelihood of timely repayment of loans. Higher liquidity ratios indicate a lower risk of default, providing creditors with greater confidence in extending credit to the company. Creditors may often impose liquidity ratio requirements as debt covenants.
*   **Analysts:** Financial analysts use liquidity ratios as part of their comprehensive analysis of a company's financial performance and risk profile. By examining liquidity metrics, analysts can identify trends, assess potential liquidity risks, and make informed recommendations to investors or clients. Similar to individual investors, analysts attempt to evaluate the short-term health of a company prior to making decisions about that company.
*   **Management:** Company management utilizes liquidity ratios to monitor and manage the organization's liquidity position. By tracking liquidity metrics regularly, management can identify liquidity gaps, optimize cash flow, and make informed decisions about short-term assets to carry.
*   **Regulators and Authorities:** Regulators and governmental agencies may also use liquidity ratios as part of their oversight and regulatory functions. For instance, regulators impose restrictions on the minimum amount of cash a bank must have on hand at any given time.

## Advantages and Disadvantages of Liquidity Ratios

### Advantages

One of the primary advantages of liquidity ratios is their simplicity and ease of calculation. This makes them accessible to investors, creditors, and analysts.

These ratios offer a quick snapshot of a company's liquidity position without delving into complex financial analysis. For instance, the current ratio, which divides current assets by current liabilities, can quickly be determined with a company's balance sheet.

Another advantage of liquidity ratios is their utility in assessing a company's financial health and risk level. A high liquidity ratio suggests that a company possesses sufficient liquid assets to handle its short-term obligations comfortably.

A low liquidity ratio may signal potential liquidity issues. Though a company's financial health can't be boiled down to a single number, liquidity ratios can simplify the process of evaluating how a company is doing.

Liquidity ratios also facilitate comparison across companies and industries. By benchmarking liquidity ratios against industry averages or competitors' metrics, stakeholders can identify strengths, weaknesses, and potential areas for improvement.

For instance, you can compare Microsoft's current ratio against Google's current ratio to gauge how each company may be structured differently. This can be an important part of deciding which company to invest in, especially if short-term health is one of your primary considerations.

Last, liquidity ratios can [communicate operational efficiency](https://www.investopedia.com/terms/d/defensive-interval-ratio.asp). For instance, a declining liquidity ratio may indicate deteriorating financial health or inefficient [working capital management](https://www.investopedia.com/terms/w/workingcapitalmanagement.asp). However, it may also mean a company is trying to hold onto less cash and deploy capital more rapidly to achieve growth.

### Disadvantages

One drawback of liquidity ratios is that these ratios provide a static view of a company's liquidity position at a particular point in time. This means they don't consider the dynamic nature of business operations and cash flows.

For example, the current ratio may indicate sufficient liquidity based on current assets and liabilities, but it doesn't account for the timing of cash inflows and outflows. A company with high receivables and [inventory turnover](https://www.investopedia.com/terms/i/inventoryturnover.asp) may have a healthy current ratio but struggle to convert these assets into cash quickly when needed.

As mentioned above, liquidity ratios may not always capture the full picture of a company's financial health. They focus solely on short-term liquidity.  

A company may maintain high liquidity ratios by holding excess cash or highly liquid assets, which could be more effectively deployed elsewhere to generate returns for shareholders. In addition, a company could have a great liquidity ratio but be unprofitable and lose money each year.

Last, liquidity ratios may vary significantly across industries and business models. There is a risk that wrong decisions could be made when comparing different liquidity ratios.

For instance, a capital-intensive industry like construction may have a much different operational structure than that of a service industry like consulting. Comparing the liquidity ratios of different companies may not always be comparable, fair, or truly informative.

Pros

*   Easy to calculate and understand
    
*   Provides quick snapshot of liquidity position
    
*   Helps gauge financial stability and resilience
    
*   Facilitates comparison across companies and industries
    

Cons

*   Doesn't account for dynamic cash flows
    
*   Focuses solely on short-term liquidity
    
*   May overlook profitability and solvency issues
    
*   Comparisons across industries can be challenging or misleading
    

## Special Considerations

A [liquidity crisis](https://www.investopedia.com/terms/l/liquidity-crisis.asp) can arise even at healthy companies. One example is the global credit crunch of 2007-09. [Commercial paper](https://www.investopedia.com/terms/c/commercialpaper.asp)—short-term debt that is issued by large companies to finance current assets and pay off current liabilities—played a central role in this financial crisis.

A near-total freeze in the $2 trillion U.S. commercial paper market made it exceedingly difficult for even the most solvent companies to raise short-term funds at that time and hastened the demise of giant corporations such as Lehman Brothers and General Motors ([GM](https://www.investopedia.com/markets/quote?tvwidgetsymbol=gm)).

However, unless the financial system is in a [credit crunch](https://www.investopedia.com/terms/c/creditcrunch.asp), a company-specific liquidity crisis can be resolved relatively easily with a liquidity injection (as long as the company is solvent).

This is because the company can pledge some assets if it is required to raise cash to tide over the liquidity squeeze. This route may not be available for a company that is technically insolvent because a liquidity crisis would exacerbate its financial situation and force it into [bankruptcy](https://www.investopedia.com/terms/b/bankruptcy.asp).

## Solvency Ratios vs. Liquidity Ratios

In contrast to liquidity ratios, [solvency ratios](https://www.investopedia.com/terms/s/solvencyratio.asp) measure a company's ability to meet its total financial obligations and long-term debts. [Solvency](https://www.investopedia.com/terms/s/solvency.asp) relates to a company's overall ability to pay debt obligations and continue business operations, while liquidity focuses more on current or short-term financial accounts.

A company must have more total assets than total liabilities to be solvent. A company must have more current assets than current liabilities to be liquid.

Although solvency does not relate directly to liquidity, liquidity ratios present a preliminary expectation regarding a company's solvency.

The solvency ratio is calculated by dividing a company's net income and depreciation by its short-term and long-term liabilities. This indicates whether a company's net income can cover its total liabilities. Generally, a company with a higher solvency ratio is considered to be a more favorable investment.

## Profitability Ratios vs. Liquidity Ratios

Profitability ratios measure a company's ability to generate profit relative to its revenue, assets, or equity. These ratios assess the efficiency and effectiveness of a company's operations, providing insights into its ability to generate returns for shareholders.

In contrast, liquidity ratios focus on a company's ability to meet its short-term financial obligations promptly.

> **Fast Fact**
>
> While profitability ratios focus on generating returns and maximizing profits, liquidity ratios prioritize maintaining sufficient cash to cover short-term obligations.

A company can have sufficient money on hand to operate if it's built up capital. However, it may be draining the amount of reserves it has if operations aren't going well. Alternatively, a company may be cash-strapped but just starting out on a successful growth campaign with a positive outlook.

Both types of ratios are essential for assessing different dimensions of a company's financial performance and risk profile. Investors and analysts often use them in combination to gain an understanding of a company's financial health. Note that a company may be profitable but not liquid, and a company can also be highly liquid but not profitable.

## Example of Using Liquidity Ratios

Let's use a couple of these liquidity ratios to demonstrate their effectiveness in assessing a company's financial condition.

Consider two hypothetical companies—Liquids Inc. and Solvents Co.—with the following assets and liabilities on their balance sheets (figures in millions of dollars). We assume that both companies operate in the same manufacturing sector (i.e., industrial glues and solvents).

\*Note that in our example, we will assume that current liabilities only consist of accounts payable and other liabilities, with no short-term debt.

### Liquids Inc.

*   Current ratio \= $30 / $10 = 3.0
*   Quick ratio = ($30 – $10) / $10 = 2.0
*   [Debt to equity](https://www.investopedia.com/terms/d/debtequityratio.asp) = $50 / $15 = 3.33
*   [Debt to assets](https://www.investopedia.com/terms/t/totaldebttototalassets.asp) = $50 / $75 = 0.67

### Solvents Co.

*   Current ratio \= $10 / $25 = 0.40
*   Quick ratio = ($10 – $5) / $25 = 0.20
*   Debt to equity = $10 / $40 = 0.25
*   Debt to assets = $10 / $75 = 0.13

We can draw several conclusions about the financial condition of these two companies from these ratios.

Liquids Inc. has a high degree of [liquidity](https://www.investopedia.com/terms/l/liquidity.asp). Based on its current ratio, it has $3 of current assets for every dollar of current liabilities. Its quick ratio points to adequate liquidity even after excluding inventories, with $2 in assets that can be converted rapidly to cash for every dollar of current liabilities.

However, [financial leverage](https://www.investopedia.com/terms/d/dfl.asp) based on its solvency ratios appears quite high. Debt exceeds equity by more than three times, while two-thirds of assets have been financed by debt. Note as well that close to half of non-current assets consist of intangible assets (such as goodwill and patents).

As a result, the ratio of debt to tangible assets—calculated as ($50/$55)—is 0.91, which means that over 90% of tangible assets (plant, equipment, inventories, etc.) have been financed by borrowing. To summarize, Liquids, Inc. has a comfortable liquidity position, but it has a dangerously high degree of leverage.

Solvents Co. is in a different position. The company's current ratio of 0.4 possibly indicates an inadequate degree of liquidity, with only $0.40 of current assets available to cover every $1 of current liabilities. The quick ratio suggests an even less liquid position, with only $0.20 of liquid assets for every $1 of current liabilities.

Financial leverage, however, appears to be at comfortable levels, with debt at only 25% of equity and only 13% of assets financed by debt.

Even better, the company's asset base consists wholly of tangible assets, which means that Solvents Co.'s ratio of debt to tangible assets is about one-seventh that of Liquids Inc. (approximately 13% versus 91%). Overall, Solvents, Co. is in a potentially dangerous liquidity situation, but it has a comfortable debt position.

## What Is Liquidity?

Liquidity refers to how easily or efficiently cash can be obtained to pay bills and other short-term obligations. Assets that can be readily sold, like stocks and bonds, are also considered to be liquid (although cash is the most liquid asset of all).

## Why Is Liquidity Important?

Businesses need enough liquidity on hand to cover their bills and obligations so that they can pay vendors, keep up with payroll, and keep their operations going day in and day out.

## How Does Liquidity Differ From Solvency?

Liquidity refers to the ability to cover short-term obligations. Solvency, on the other hand, is a firm's ability to pay long-term obligations. For a firm, this will often include being able to repay interest and principal on debts (such as bonds) or long-term leases.

## Why Are There Several Liquidity Ratios?

Fundamentally, all liquidity ratios measure a firm's ability to cover short-term obligations by dividing current assets by current liabilities (CL). The cash ratio looks at only the cash on hand divided by CL, while the quick ratio adds in cash equivalents (like money market holdings) as well as marketable securities and accounts receivable. The current ratio includes all current assets.

## What Happens If Ratios Show a Firm Is Not Liquid?

In this case, a liquidity crisis can arise even at healthy companies—if circumstances arise that make it difficult to meet short-term obligations, such as repaying loans and paying employees or suppliers.

One example of a far-reaching liquidity crisis is the global credit crunch of 2007-09, where many companies found themselves unable to secure short-term financing to pay their immediate obligations.

## The Bottom Line

Liquidity ratios are simple yet powerful financial metrics that provide insight into a company's ability to meet its short-term obligations promptly. They offer a quick snapshot of a company's liquidity position, aiding stakeholders in assessing a company's financial stability and resilience.

> **Article Sources**
>
> 1.  Office of the Comptroller of the Currency. "[Liquidity Coverage Ratio - Final Rule](https://www.occ.treas.gov/topics/supervision-and-examination/capital-markets/balance-sheet-management/liquidity/liquidity-coverage-ratio-final-rule.html)."
>     
> 2.  Federal Reserve Bank of New York. "[The Federal Reserve’s Commercial Paper Funding Facility](https://www.newyorkfed.org/medialibrary/media/research/epr/11v17n1/1105adri.pdf)," Pages 25–29.