Last updated: 25th Aug 2025
Not being able to pay your business’ bills on time is a bad look. You’ll lose credibility with vendors. Your credit score will suffer. How do you prevent this? You start by knowing your liquidity ratios.
A recent review by the Reserve Bank of Australia has identified “an extended period of cashflow difficulty, leading to an inability to repay debts” as a common denominator behind company insolvencies.
Yes, times are tough for business.
But the RBA notes that:
The good news? You can tackle underlying issues that could lead to a cash flow crisis.
Above: Inadequate cash flow is the #1 killer of Australian businesses.
What Is A Liquidity Ratio?
Can you cover your business’ debts in the short-term, using cash and other liquid assets on hand?
A liquidity ratio helps you answer this question.
If you’ve got more liquid assets than payments due in the coming year, that’s a healthy sign for your cash flow.
- Liquidity refers to how easily you can convert assets into cash to meet your business’ day-to-day expenses. For instance, in addition to the money in your business’ transaction and savings accounts, you might hold a stock portfolio that could be sold quickly to access money.
- Staying solvent long-term can be impacted by ongoing cashflow issues. If you’re regularly struggling to manage daily expenses, your growth will stall, you may be forced to sell fixed assets, and it puts you at risk of insolvency, business closure or bankruptcy.
Expert Tip.
The liquidity ratio calculation is very simple. Divide the value of your current assets by the current liabilities.
Liquidity Ratio Calculation Example:
You must be able to trust the current assets and current liabilities listed on your balance sheet report.
This is why using top-tier accounting software to accurately record your assets, income, payroll, inventory, and accounts payable/receivable is critical.
Important!
Do not rely on spreadsheets! We’re no longer in 1998.
- Current assets can include cash, bank deposits, money owed to you, stock on hand, raw materials, and short-term investments.
- Current liabilities can include bills, employee wages, supplier invoices you need to pay, taxes and loan payments.
Important!
Your business may also have a range of fixed assets (e.g., equipment, vehicles, buildings) that can’t be factored into your liquidity ratio – because they can’t efficiently be traded for cash as needed.
What Is A Good Liquidity Ratio?
Do your liabilities match your assets? That’s a 1:1 relationship.
A liquidity ratio above 1 reflects that your available assets exceed your financial obligations.
This means you’re in a better financial position to handle your known operational expenses.
Did You Know?
A ratio of 2 (or above) is good. It shows you have 2X more current assets than bills or debts to pay. That gives you room to cover any unexpected costs that arise.
If your liquidity ratio is below 1, you could be caught short and miss payments.
You are at risk of seriously damaging your relationships with vendors or employees, or potentially running up further costs from penalties, fines or interest.
(Unless you can find emergency cash or negotiate terms).
(Related: How To Calculate And Improve Your Net Profit Margin).
If it’s a momentary blip, that’s one thing. It’s quite another if your ratio is regularly below 1, because it means you literally can’t afford to stay in business.
Important!
Poor bookkeeping and not being able to analyse your finances is a major contributor to insolvencies. No visibility leads to careless decision-making or overspending that eats into your profits and cash reserves.
Types Of Liquidity Ratios.
There are three main ways to calculate a liquidity ratio.
The calculations differ based on what you include in ‘current assets’:
- Current ratio: calculates the ratio using all of your current assets.
- Quick ratio (aka acid-test ratio): excludes inventory from your current assets to determine the ratio.
- Cash ratio: excludes everything except cash (and cash equivalents like money market fund, stocks, short-term bonds).
Current ratio is the broadest, and easiest calculation.
But knowing your assets-to-liabilities ratio in the context of a narrower set of assets can be useful.
(Because not all assets are equal in terms of their liquidity).
Think worst-case scenario.
Let’s say you get an illness that puts you out of action long-term, or another global pandemic hits and the demand for all the products sitting in your warehouse dries up overnight.
If your current ratio looks healthy, but your quick ratio falls below 1, you might be too reliant on future sales that may not eventuate.
Liquidity Quick Ratio Calculation Example:
Why Does Your Liquidity Ratio Matter?
Ongoing price inflation, reasonably high interest rates (although easing), and a somewhat rocky global economic outlook mean that SMB owners need to be prepared in case of downturns in demand.
If anything goes wrong, your cash reserves can dry up quickly.
Did you know?
Almost 90% of small businesses surveyed by the NSW Small Business Commissioner in June said they were concerned about the cost of business inputs. Just 20% felt confident about their individual business prospects.
A recent survey of over 700 Australian small-to-medium enterprises with revenues of between $1-$20 million found that one in five businesses believe the loss of just one key client or supplier would tip their business into failure.
Over 75% said they’d lose an average of around 22% in revenues if a major client departed.
Also, a higher liquidity ratio is one of the indicators of financial health that will put you in a better position to secure a business loan.
- Creditors will analyse your liquidity ratio as part of a loan application to determine if you’ll be able to manage the repayments.
- Investors will use the metric as a guide to whether your business has long-term viability, including enough working capital to grow.
(Related: The Ultimate Guide To CapEx For SMBs).
How To Improve Your Liquidity.
Here are some tips for improving liquidity in your SMB:
- Free up cash flow where you can. Cut back on wasteful expenditure like subscriptions or software you don’t use often, or perhaps hiring freelancers on a project basis rather than a full-time employee.
- Open a high interest savings account for your business. Get intentional about setting aside a portion of income regularly. It’s smart to build a savings habit so you’ve always got cash reserves for tax bills and emergencies.
- Aim for a leaner, just-in-time approach to purchasing. Be strategic with the products you keep in stock. Too much slow-moving stock can unnecessarily tie up cash.
- Negotiate your contract and payment terms. This will help you collect promptly on what you’re owed by clients/customers to have cash flowing in.
- Carefully manage debts. Think twice about using credit cards instead of cash for payments, and make sure you’re making card repayments on time to avoid interest costs.
Improving your liquidity will reduce your stress, but it’s also critical to being able to jump on business opportunities as they arise.
For example, being able to fund the development or purchase of new product lines, or run marketing campaigns that extend your market share and long-term success.
Jody
