Liquidity Ratio

Liquidity Ratio

Financial stability is the bedrock of any successful business, and one of the crucial metrics that helps measure this stability is the liquidity ratio. Liquidity ratios are essential tools in the world of finance, offering a clear view of a company’s ability to handle short-term financial obligations. They are instrumental in guiding businesses’ financial decisions and helping investors assess the risk associated with their investments. Understanding the different types of liquidity ratios and their significance is vital for financial stability and success in the world of business and investment. 

What is a Liquidity Ratio? 

Liquidity ratio, in financial terms, is a measure of a company’s ability to meet its short-term obligations using its liquid assets. In simpler words, it gauges how readily a business can access cash or assets that can quickly be converted into cash to pay off its immediate debts. The higher the liquidity ratio, the more financially secure a company is considered to be. This metric is pivotal for businesses, as it empowers them to make informed decisions regarding their financial strategies and capital management. It also offers investors a crucial insight into the company’s financial health, assisting them in evaluating the risk associated with their investments. 


Liquidity ratios are a reflection of a company’s financial health and its capacity to withstand unexpected financial shocks. They are a critical factor for both businesses and investors. For companies, maintaining a healthy liquidity ratio is a key part of their financial strategy, ensuring they can meet their commitments promptly. 

For investors, analysing a company’s liquidity ratio helps assess the risk associated with their investment. A low liquidity ratio might indicate a risk of insolvency or an inability to manage short-term financial challenges. On the other hand, a high liquidity ratio could mean that the company is not efficiently utilising its resources and might not be generating maximum returns for its shareholders. 


Formula of Liquidity Ratio 

The formula for calculating liquidity ratio is relatively straightforward and typically involves two common metrics: 

  1. Current Ratio: This is the ratio of current assets to current liabilities and is one of the most widely used liquidity ratios. The formula is as follows:

 Current Ratio = Current Assets / Current Liabilities 

Current assets include cash, accounts receivable, and inventory, while current liabilities comprise short-term debts and obligations. Generally, a current ratio above 1.0 is considered favourable, as it implies that the company has more current assets than current liabilities. 

  1. Quick Ratio (Acid-Test Ratio): This is a more stringent measure of liquidity, excluding inventory from current assets as it is not always quickly convertible into cash. The formula for the quick ratio is:

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

The quick ratio provides a more conservative estimate of a company’s ability to meet short-term obligations. A quick ratio of 1.0 suggests that without considering the inventory, Company ABC still has sufficient assets to cover its short-term obligations. While a quick ratio of 1.0 is generally considered adequate, it indicates that the company may face more challenges if it needs to meet its liabilities without relying on inventory. 

Types of Liquidity Ratio 

There are several types of liquidity ratios, but the most common ones include: 

  1. Current Ratio: This is one of the most commonly used liquidity ratios and measures a company’s capacity to cover its short-term liabilities with all current assets, including cash, accounts receivable, and inventory. A current ratio above 1 indicates a healthier financial position.
  2. Quick Ratio (Acid-Test Ratio): This ratio is a more stringent measure as it excludes inventory from current assets. It focuses on the company’s ability to meet immediate obligations without relying on the sale of inventory.
  3. Cash Ratio: The most conservative of all, the cash ratio considers only cash and cash equivalents in relation to current liabilities. It provides a clear picture of a company’s cash-only liquidity, which can be especially useful during times of financial stress. 

These different liquidity ratios offer varying degrees of insight into a company’s short-term financial strength, allowing for a comprehensive assessment of its financial stability and liquidity management 

Examples of Liquidity Ratio 

Let’s consider an example to understand how liquidity ratios work. Company ABC has US$150,000 in current assets, including US$30,000 in cash, US$50,000 in accounts receivable, and US$70,000 in inventory. Their current liabilities amount to US$80,000. 

Current Ratio: = 150,000 / 80,000 = 1.875 

Quick Ratio = (150,000 – 70,000) / 80,000 = 1.0 

Cash Ratio = 30,000 / 80,000 = 0.375 

In this example, Company ABC’s current ratio suggests they can meet their short-term obligations comfortably, but the quick ratio is lower, indicating that without the inventory, they might face more challenges. The cash ratio is the most conservative and reflects their cash-only position. 

Frequently Asked Questions

The importance of liquidity ratios lies in their ability to provide insights into a company’s short-term financial health. They help businesses manage their liquidity effectively, aiding in decision-making and financial planning. For investors, liquidity ratios serve as a valuable tool for assessing the risk associated with their investments. 

The Liquidity Coverage Ratio, or LCR, is a regulatory requirement imposed on banks to ensure that they have enough high-quality liquid assets to cover their short-term liquidity needs in times of financial stress. It aims to prevent bank runs and liquidity crises. 

The ideal liquidity ratio varies by industry and a company’s specific circumstances. However, a current ratio between 1.5 and 2 and a quick ratio around 1 are often considered healthy. It’s important to compare a company’s ratios with industry benchmarks and historical data for a more meaningful assessment. 

Three common types of liquidity ratios are the current ratio, quick ratio (or acid-test ratio), and cash ratio. The current ratio assesses a company’s ability to meet short-term obligations with all current assets. The quick ratio is more conservative, excluding inventory, while the cash ratio is the strictest measure, focusing solely on cash and cash equivalents. 

The most common liquidity ratios are the current ratio, which considers all current assets, and the quick ratio, which excludes inventory from current assets. These ratios offer valuable insights into a company’s short-term financial strength. 

Related Terms

    Read the Latest Market Journal

    Weekly Updates 15/4/24 – 19/4/24

    Published on Apr 15, 2024 27 

    This weekly update is designed to help you stay informed and relate economic and company...

    From $50 to $100: Unveiling the Impact of Inflation

    Published on Apr 12, 2024 107 

    In recent years, inflation has become a hot topic, evoking strong emotions as the cost...

    Japan’s Economic Resurgence: Unveiling the Tailwinds Behind Nikkei 225’s Record Leap

    Published on Apr 11, 2024 69 

    Source: eSignal, Intercontinental Exchange, Inc. In the heart of Japan’s economic landscape, the Nikkei 225...

    Weekly Updates 8/4/24 – 12/4/24

    Published on Apr 8, 2024 103 

      This weekly update is designed to help you stay informed and relate economic and...

    What Makes Forex Trading Attractive?

    Published on Apr 2, 2024 182 

    In a world where the click of a button can send goods across oceans and...

    Weekly Updates 1/4/24 – 5/4/24

    Published on Apr 1, 2024 96 

    This weekly update is designed to help you stay informed and relate economic and company...

    How to soar higher with Positive Carry!

    Published on Mar 28, 2024 132 

    As US Fed interest rates are predicted to rise 6 times this year, it’s best...

    Why 2024 Offers A Small Window of Opportunity and How to Position Yourself to Capture It

    Published on Mar 28, 2024 182 

    With the Federal Reserve (FED) finally indicating rate cuts in 2024, we witnessed a significant...

    Contact us to Open an Account

    Need Assistance? Share your Details and we’ll get back to you


    This material is provided by Phillip Capital Management (S) Ltd (“PCM”) for general information only and does not constitute a recommendation, an offer to sell, or a solicitation of any offer to invest in any of the exchange-traded fund (“ETF”) or the unit trust (“Products”) mentioned herein. It does not have any regard to your specific investment objectives, financial situation and any of your particular needs. You should read the Prospectus and the accompanying Product Highlights Sheet (“PHS”) for key features, key risks and other important information of the Products and obtain advice from a financial adviser (“FA“) pursuant to a separate engagement before making a commitment to invest in the Products. In the event that you choose not to obtain advice from a FA, you should assess whether the Products are suitable for you before proceeding to invest. A copy of the Prospectus and PHS are available from PCM, any of its Participating Dealers (“PDs“) for the ETF, or any of its authorised distributors for the unit trust managed by PCM.  

    An ETF is not like a typical unit trust as the units of the ETF (the “Units“) are to be listed and traded like any share on the Singapore Exchange Securities Trading Limited (“SGX-ST”). Listing on the SGX-ST does not guarantee a liquid market for the Units which may be traded at prices above or below its NAV or may be suspended or delisted. Investors may buy or sell the Units on SGX-ST when it is listed. Investors cannot create or redeem Units directly with PCM and have no rights to request PCM to redeem or purchase their Units. Creation and redemption of Units are through PDs if investors are clients of the PDs, who have no obligation to agree to create or redeem Units on behalf of any investor and may impose terms and conditions in connection with such creation or redemption orders. Please refer to the Prospectus of the ETF for more details.  

    Investments are subject to investment risks including the possible loss of the principal amount invested. The purchase of a unit in a fund is not the same as placing your money on deposit with a bank or deposit-taking company. There is no guarantee as to the amount of capital invested or return received. The value of the units and the income accruing to the units may fall or rise. Past performance is not necessarily indicative of the future or likely performance of the Products. There can be no assurance that investment objectives will be achieved.  

    Where applicable, fund(s) may invest in financial derivatives and/or participate in securities lending and repurchase transactions for the purpose of hedging and/or efficient portfolio management, subject to the relevant regulatory requirements. PCM reserves the discretion to determine if currency exposure should be hedged actively, passively or not at all, in the best interest of the Products.  

    The regular dividend distributions, out of either income and/or capital, are not guaranteed and subject to PCM’s discretion. Past payout yields and payments do not represent future payout yields and payments. Such dividend distributions will reduce the available capital for reinvestment and may result in an immediate decrease in the net asset value (“NAV”) of the Products. Please refer to <> for more information in relation to the dividend distributions.  

    The information provided herein may be obtained or compiled from public and/or third party sources that PCM has no reason to believe are unreliable. Any opinion or view herein is an expression of belief of the individual author or the indicated source (as applicable) only. PCM makes no representation or warranty that such information is accurate, complete, verified or should be relied upon as such. The information does not constitute, and should not be used as a substitute for tax, legal or investment advice.  

    The information herein are not for any person in any jurisdiction or country where such distribution or availability for use would contravene any applicable law or regulation or would subject PCM to any registration or licensing requirement in such jurisdiction or country. The Products is not offered to U.S. Persons. PhillipCapital Group of Companies, including PCM, their affiliates and/or their officers, directors and/or employees may own or have positions in the Products. Any member of the PhillipCapital Group of Companies may have acted upon or used the information, analyses and opinions herein before they have been published. 

    This advertisement has not been reviewed by the Monetary Authority of Singapore.  


    Phillip Capital Management (S) Ltd (Co. Reg. No. 199905233W)  
    250 North Bridge Road #06-00, Raffles City Tower ,Singapore 179101 
    Tel: (65) 6230 8133 Fax: (65) 65383066