Liquidity ratios measure the capacity of the business to meet short term financial commitments as they become due.

Current ratio

The current ratio (also called the working capital ratio)  is a measure of the solvency or liquidity of your business. It tells you whether your business has enough current assets to meet its short term financial obligations (current liabilities) as they become due.

The formula used to calculate the current ratio is:

The higher the current ratio, the better the capacity to meet short term financial commitments. A current ratio of 2:1 (which means the business has current assets of $2 for every $1 of current liabilities) is regarded as desirable for a healthy business. However, the circumstances of every industry or business are different so consider how your business operates and set an appropriate ratio. As a general rule, try to achieve a current ratio above 1:1 and as close to 2:1 as possible.

• A current ratio that is too high may indicate investment in current assets that could otherwise be used to produce income.
• A current ratio that is too low means there may not be enough current assets to meet short term financial obligations when they are due.

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Quick ratio

The quick ratio is a measure of the liquidity of your business. It measures the level of all assets that can be quickly convertible into cash and used to meet short term liabilities. The quick ratio provides a more conservative measure than the current ratio because it excludes inventory.

The formula used to calculate the quick ratio is:

• The higher the ratio, the higher the level of liquidity for your business.
• The optimal quick ratio is 1:1 or higher, which means that current liabilities can be met from current assets without the need to sell inventory.

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What's next…

• Analyse your accounts using the debt ratios
• Analyse your accounts using the efficiency ratios
• Find out how much working capital your business needs

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