Last updated on September 25th, 2025 at 03:28 pm
Imagine lending money to a friend. Before you do, you’d want to know if they have enough cash or quick assets to pay you back tomorrow.
The same logic applies to companies. Creditors, investors, and analysts want to know whether a company can meet its short-term obligations without struggling. This is where liquidity ratios come in.
Liquidity ratios are among the most widely used financial ratios in corporate finance and investment analysis. They provide a snapshot of how prepared a business is to deal with upcoming bills, interest payments, and short-term debt.
What is a Liquidity Ratio?
A liquidity ratio is a type of financial ratio that is used to determine a company’s ability to pay off its short-term obligations/debt. It helps determine if a company can use its current or liquid assets to cover its current liabilities. There are three commonly used ratios: the current ratio, quick ratio, and the cash ratio. In each of the liquidity ratios, the current liabilities amount is placed in the denominator of the equation, and the amount of the liquid assets are placed in the numerator. A ratio of 1 means that a company can exactly pay off all its current liabilities with its current assets. A ratio of less than 1 would imply that the company is not able to satisfy its current liabilities. A ratio greater than 1, say 3, would imply that a company is able to satisfy the current liabilities 3 times over.
📌 In simple words:
Liquidity ratios answer — “If all short-term obligations are due today, can the company pay them?”
Why Liquidity Ratio Matters?
- Creditors & Banks → Use them to decide whether to extend credit or loans.
- Investors → Analyze liquidity to judge financial health before investing.
- Management → Tracks operational efficiency and ensures solvency.
- Rating Agencies → Liquidity is a key factor in credit ratings.
A company may be profitable on paper but still face a liquidity crisis if it can’t convert assets to cash quickly enough.
Types of Liquidity Ratios
Current Ratio:
Current ratio = Current Assets / Current Liabilities
The current ratio is the simplest liquidity ratio to calculate and interpret.
Interpretation:
- Ratio >1 → Current assets exceed current liabilities (healthy)
- Ratio <1 → Firm may face liquidity stress
Benchmark: Generally considered good between 1.2 – 2.0.
Quick ratio:
Quick Ratio = (Cash + Accounts Receivables + Marketable Securities) / Current Liabilities
The quick ratio is a stricter test of liquidity than the current ratio. However, the quick ratio only considers certain assets. It considers more liquid assets such as cash, accounts receivable, and marketable securities. It leaves out current assets such as inventory and prepaid expenses because the two are less liquid. So, the quick ratio is more of a true test of a company’s ability to cover its short-term obligations.
- Excludes inventory and prepaid expenses because they may not convert to cash quickly.
- A more conservative measure than current ratio.
Benchmark: Healthy if ≥1.
Cash ratio:
Cash Ratio = (Cash + Marketable Securities) / Current Liabilities
The cash ratio takes the test of liquidity even further. This ratio only considers a company’s most liquid assets – cash and marketable securities. They are the assets that are most readily available to a company to pay short-term obligations.
Liquidity Ratio Example
Let’s take a sample company:
- Cash = ₹40,000
- Marketable Securities = ₹10,000
- Accounts Receivable = ₹20,000
- Inventory = ₹30,000
- Current Liabilities = ₹60,000
Step 1: Current Ratio
= \frac{40,000 + 10,000 + 20,000 + 30,000}{60,000} = \frac{100,000}{60,000} = 1.67
Step 2: Quick Ratio
= \frac{40,000 + 10,000 + 20,000}{60,000} = \frac{70,000}{60,000} = 1.17
Step 3: Cash Ratio
= \frac{40,000 + 10,000}{60,000} = \frac{50,000}{60,000} = 0.83
Analysis:
- The company has 167% coverage with all assets.
- Even without inventory, it can cover 117% of obligations.
- With cash alone, it can cover 83% — indicating decent liquidity.
Industry Liquidity Ratio Benchmarks (Indicative Ranges)
| Industry | Current Ratio | Quick Ratio | Cash Ratio | Notes |
|---|---|---|---|---|
| Technology / IT | 1.5 – 3.0 | 1.2 – 2.0 | 0.5 – 1.5 | Often cash-rich; strong operating cash flows and marketable securities. |
| Pharma / Healthcare | 1.5 – 2.5 | 1.0 – 1.5 | 0.4 – 1.0 | Cash buffers for R&D and long approval cycles. |
| Retail (Non-Food) | 1.0 – 1.5 | 0.5 – 1.0 | 0.1 – 0.3 | Inventory-heavy; seasonal working capital swings. |
| Manufacturing | 1.2 – 2.0 | 0.8 – 1.2 | 0.2 – 0.6 | Capital-intensive; liquidity often managed via credit lines. |
| Automobiles & Auto Components | 1.1 – 1.8 | 0.7 – 1.1 | 0.2 – 0.5 | Supplier terms and inventory cycles drive ratios. |
| Airlines | 0.7 – 1.2 | 0.4 – 0.8 | 0.05 – 0.30 | High operating leverage; demand sensitive. |
| Hospitality / Travel | 0.8 – 1.3 | 0.4 – 0.9 | 0.05 – 0.30 | Seasonality impacts cash conversion cycles. |
| Utilities | 0.9 – 1.4 | 0.5 – 0.9 | 0.1 – 0.4 | Stable regulated cash flows; lower cash ratios typical. |
| Telecom | 0.9 – 1.4 | 0.5 – 0.9 | 0.1 – 0.4 | Capex-heavy; liquidity balanced with rolling debt. |
| Real Estate / REITs | 0.8 – 1.3 | 0.4 – 0.8 | 0.05 – 0.30 | Cash managed vs lease inflows; focus on LTV/ICR. |
| Oil & Gas / Energy | 1.0 – 1.8 | 0.6 – 1.1 | 0.15 – 0.50 | Commodity cycles influence liquidity buffers. |
| IT Services | 1.3 – 2.2 | 0.9 – 1.4 | 0.4 – 1.0 | Asset-light; healthy cash conversion from receivables. |
| Banks & Financials | Not comparable | Use regulatory metrics (LCR, NSFR) instead of liquidity ratios. | ||
Note: Ranges are indicative for education/benchmarking. For decisions, compute peer medians using the latest filings (same accounting framework, fiscal year, and region) and adjust for seasonality.
Importance of Liquidity Ratios
- Determine the ability to cover short-term obligations:
Liquidity ratios are important to investors and creditors to determine if a company can cover their short-term obligations, and to what degree. A ratio of 1 is better than a ratio of less than 1, but it isn’t ideal. Creditors and investors like to see higher liquidity ratios, such as 2 or 3. The higher the ratio is, the more likely a company is able to pay its short-term bills. A ratio of less than 1 means the company faces a negative working capital and can be experiencing a liquidity crisis.
- Determine creditworthiness:
Creditors analyze liquidity ratios when deciding whether or not they should extend credit to a company. They want to be sure that the company they lend to has the ability to pay them back. Any hint of financial instability may disqualify a company from obtaining loans.
- Determine investment opportunities:
For investors, they will analyse a company using liquidity ratios to ensure that a company is financially healthy and worthy of its investment. Working capital issues will put restraints on the rest of the business as well. A company needs to be able to pay its short-term bills with some leeway.
Use of Liquidty Ratios in Practice
It is one thing to know the ratios and quite another to actually use it in real life. A good example of using liquidty ratios would be to screen stocks to research further. For example if go to https://www.screener.in/screens/ and try to find company based on the the following quality characteristic given by benjamin graham
- Current ratio is greater than 1.25 (it signifies that the company has the ability to pay off short term expenses
- Check out the companies that turn up when we use this liquidity screen.
Conclusion
Liquidity ratios are essential tools in financial analysis. They provide insight into a company’s ability to survive the next 12 months without external help.
👉 Remember:
- Current Ratio = broad measure
- Quick Ratio = conservative
- Cash Ratio = strictest test
But they should always be interpreted in context — industry benchmarks, cash flow trends, and strategic policies matter just as much as the numbers.
📢 Want to go deeper? Explore MentorMeCareers’ Financial Modeling Course to learn how analysts apply liquidity ratios in real-world company analysis, alongside profitability and solvency measures.
FAQs on Liquidity Ratios
Q1. What are liquidity ratios used for?
They measure a company’s ability to cover short-term obligations.
Q2. Which is the most conservative liquidity ratio?
The Cash Ratio.
Q3. Is a high liquidity ratio always good?
No. Too high may mean idle cash not invested in growth.
Q4. Can liquidity ratios be negative?
Not negative, but they can be below 1, signaling short-term stress.
Q5. What is the difference between liquidity and solvency ratios?
Liquidity = short-term ability. Solvency = long-term debt sustainability.
Q6. Are liquidity ratios important for banks?
Not directly. Banks are governed by regulatory liquidity ratios like LCR and NSFR.
Q7. Which industries usually have low liquidity ratios?
Retail, airlines, hospitality, and manufacturing often run with lower ratios due to high inventory or capital requirements.
