Liquidity ratio - How to calculate your liquidity ratio! Read more here

Learn about liquidity ratio and how it can help your business measure its ability to pay short-term obligations. Gain insights into how you can improve the financial health of your business through effective cash flow management

Understand and optimise your business cash flow: A guide to calculating and improving your liquidity ratio

What is liquidity ratio?

The liquidity ratio is a key financial metric that gives you a quick overview of your company’s ability to meet its short-term obligations. In other words, the liquidity ratio shows whether you have enough cash (or assets that can easily be converted into cash) to cover bills and loans due within the next year.

There are two types of liquidity ratios you should be familiar with:

  • Liquidity Ratio 1: This metric focuses on the most liquid assets, such as cash and securities.
  • Liquidity Ratio 2: This ratio also includes inventory, providing a broader picture of the company's liquidity.

How is liquidity ratio calculated?

The liquidity ratio is calculated using the following formulas:

Liquidity Ratio 1:

Liquidity Ratio 1 = (Current Assets - Inventory) / Current Liabilities

Liquidity Ratio 2:

Liquidity Ratio 2 = Current Assets / Current Liabilities

Why is liquidity ratio important?

Maintaining a good liquidity ratio is crucial for any business, but it’s especially important for webshops that often deal with many small transactions and need to quickly adapt to market changes. A healthy liquidity ratio means you can pay your suppliers on time, avoid costly short-term loans, and generally keep your business running smoothly without financial hiccups.

Example of liquidity ratio calculation

To make this more concrete, let’s look at a practical example.

Example:

Imagine your webshop has the following balance sheet figures:

  • Cash and bank balance: 100,000 DKK
  • Securities: 50,000 DKK
  • Inventory: 200,000 DKK
  • Current liabilities: 250,000 DKK

First, we calculate Liquidity Ratio 1:

Liquidity Ratio 1 = (100,000 DKK + 50,000 DKK) / 250,000 DKK = 0.6

This means your business has 60% of the necessary most liquid assets to cover your current liabilities. Ideally, this figure should be 1 or higher.

Next, we calculate Liquidity Ratio 2:

Liquidity Ratio 2 = (100,000 DKK + 50,000 DKK + 200,000 DKK) / 250,000 DKK = 1.4

Here we see that including inventory, the business has 140% of the necessary assets to cover its current liabilities. This is a healthier sign of liquidity.

How can you improve your liquidity ratio?

If your liquidity ratio is low, there are several things you can do to improve it:

  • Increase your cash reserves: Ensure you have enough cash available by boosting sales efforts or cutting unnecessary costs.
  • Improve inventory management: Reduce excess stock and sell off old or slow-moving items.
  • Tighten credit policies: Collect payments faster and offer incentives for early payment.
  • Negotiate better payment terms: Extend payment deadlines with your suppliers to give you more time to pay your bills.

Learn about liquidity ratio and how it can help your business measure its ability to pay short-term obligations. Gain insights into how you can improve the financial health of your business through effective cash flow management