The liquidity ratios 1, 2 and 3 show you at a glance whether your business can cover its short-term liabilities from available assets. In this article you’ll find all three formulas, a fully worked example, industry benchmarks and an honest assessment of what these metrics can – and can’t – tell you.
What are liquidity ratios?
Liquidity ratios are three standardised metrics from balance sheet analysis. They set various asset positions in relation to short-term liabilities and answer one simple question: Is what you have enough to pay what you owe in the short term?
Each ratio builds on the previous one. Ratio 1 takes only what is immediately available: current account and cash. Ratio 2 adds what should come in soon: open customer receivables. Ratio 3 also includes what still needs to be sold: inventory and stock.
The underlying logic is straightforward: short-term debt should be covered by short-term available funds. Paying a supplier invoice with a five-year loan means paying unnecessary interest. Financing machinery via an overdraft leaves no money for day-to-day bills. When these maturities don’t align, liquidity ratios come under pressure.
The three ratios are known internationally as the Cash Ratio, Quick Ratio and Current Ratio. You’ll encounter these terms regularly in bank discussions or international balance sheets. But how do you calculate the different liquidity ratios?
Calculating liquidity ratios – a worked example
Let’s look at the example of Marco. He runs an online office supplies business, with around €400,000 in annual revenue – a typical small trading company. To calculate his liquidity ratios we need a breakdown of his liquid assets and short-term liabilities.
On the asset side: €15,000 in the business account, €5,000 in cash, €35,000 in open customer invoices due in the coming weeks, and €45,000 in stock.
On the liability side: €60,000 in open supplier invoices, a tax provision of €5,000 and an overdraft of €10,000. Together that’s €75,000 in short-term liabilities – the number we’ll use as the denominator in every calculation. With this data we can calculate all three liquidity ratios.
Liquidity Ratio 1 Formula (Cash Ratio)
Liquidity Ratio 1 = liquid funds × 100 ÷ short-term liabilities
You divide what’s sitting in your current account and cash today by everything you need to service short-term – invoices, provisions and credit lines. The result shows in percentage terms how much of that you could pay right now.
Liquidity Ratio 1 – worked example
Liquid funds: €15,000 (bank) + €5,000 (cash) = €20,000
Short-term liabilities: €75,000
Marco’s liquid funds: €15,000 in the business account plus €5,000 in cash – €20,000 in total. Against that stand €75,000 in short-term liabilities: open supplier invoices, a tax provision and the overdraft.
Marco’s Liquidity Ratio 1 = 20,000 ÷ 75,000 × 100 = 26.7%
Marco could pay around a quarter of his short-term debt immediately – purely from what’s in the account today.
Benchmark and interpretation
The benchmark is around 10–30%, depending on the industry. Marco’s 26.7% is solid. A figure of 20% may look low at first glance but is normal in practice. No business leaves all its capital sitting idle in an account. Too much liquidity means idle capital; too little means risk.
It becomes critical when the figure falls below 10% persistently. Even small unexpected expenses – a repair, a tax back-payment – can then become a problem.
What Ratio 1 doesn’t show: it ignores that customer payments may be arriving in the coming days or weeks. That’s why it’s never sufficient on its own.
Liquidity Ratio 2 Formula (Quick Ratio)
Liquidity Ratio 2 = (liquid funds + short-term receivables) × 100 ÷ short-term liabilities
Here you’re not just working with today’s account balance – you’re also including money customers still owe you. You add liquid funds and open receivables and divide by short-term liabilities. This shows whether you can cover your debts if all outstanding invoices are paid as planned.
Liquidity Ratio 2 – worked example
Liquid funds + short-term receivables: €20,000 (account and cash) + €35,000 (open customer invoices) = €55,000 – Short-term liabilities: €75,000
On top of Marco’s €20,000 in the account come €35,000 in open customer invoices – money that should arrive in the coming weeks. That’s €55,000 in total, against €75,000 in short-term liabilities.
Marco’s Liquidity Ratio 2 = 55,000 ÷ 75,000 × 100 = 73.3%
Even if all customers pay on time, Marco can only cover around three quarters of his short-term debt. The remaining 25% stays uncovered – and that’s exactly where the problem lies.
Benchmark and interpretation
The benchmark is at least 100–120%. Marco’s 73.3% falls well short: a warning signal. His short-term liabilities aren’t fully covered by available funds and expected incoming payments.
In practice: Marco is reliant on inventory selling in time or new revenue coming in. If a supplier invoice arrives unexpectedly early or a large customer misses a payment, things get tight.
The receivables in the Ratio 2 numerator are therefore not guaranteed money. 40 days on average means: between sending an invoice and receiving payment, more than a month passes. Ratio 2 treats receivables almost as good as cash – in reality that’s often not the case.
Liquidity Ratio 3 Formula (Current Ratio)
Liquidity Ratio 3 = (liquid funds + receivables + inventory) × 100 ÷ short-term liabilities
Now, on top of the account and open receivables, you also add what’s sitting in the warehouse: stock, raw materials, semi-finished goods. You’re putting the entire current assets in relation to short-term liabilities. The result shows whether you have enough substance in the medium term to cover your debts.
Liquidity Ratio 3 – worked example
Liquid funds + receivables + inventory: €20,000 + €35,000 + €45,000 = €100,000 – Short-term liabilities: €75,000
On top of Marco’s €55,000 from account and receivables come €45,000 in stock – office supplies, printer cartridges, paper. Together that’s €100,000 in current assets, against €75,000 in short-term liabilities.
Marco’s Liquidity Ratio 3 = 100,000 ÷ 75,000 × 100 = 133.3%
Marco has more current assets than short-term debt overall. That sounds reassuring at first – but a large portion is tied up in stock. And inventory can’t be credited to your account tomorrow.
Benchmark and interpretation
The benchmark is 150–200%. Marco’s 133.3% falls slightly short. Part of his short-term debt is not fully covered by current assets.
The third ratio is especially relevant for traders and manufacturers with high stock levels. A service business with no significant inventory will see almost identical figures to Ratio 2 here.
A word of caution: high stock levels push Ratio 3 up. That looks good at first but can point to slow-moving stock – tied-up capital that isn’t working. €45,000 in stock is only worth €45,000 if someone actually buys the goods. The third ratio is therefore only of limited significance on its own. That’s why it’s important to consider the liquidity ratios in the right context.
Liquidity Ratios 1, 2 and 3 Compared
Marco’s results show a typical pattern: Ratio 1 solid, Ratio 2 problematic, Ratio 3 just below the benchmark. What does that mean – and which ratio matters most?
Ratio 1 is your early warning system. It shows whether you’re solvent today – not in three weeks. If it falls persistently below 10%, you have almost no buffer for the unexpected.
Ratio 2 is the most important. It compares like with like: short-term available funds against short-term liabilities due. Banks and investors look at this first in a credit assessment. Below 100%, action is needed.
Ratio 3 is most relevant for traders and manufacturers. For service businesses without stock it adds little beyond Ratio 2. Important: a high Ratio 3 with a low Ratio 2 is not reassuring – the money is tied up in stock, but next week’s invoice still needs to be paid.
What if one of Marco’s customers doesn’t pay their €10,000 invoice? His Ratio 2 drops from 73.3% to 60%. A warning signal becomes an acute problem – a reason not to check these figures only once a year. Because knowing your liquidity ratios gives you an advantage: you can act before things get tight.
What to do when your liquidity ratio is too low?
Marco’s Ratio 2 of 73.3% shows he needs either faster payments from customers, fewer short-term debts, or an additional liquidity buffer. The most common causes of weak liquidity ratios are overdue receivables and excess stock.
Short-term measures that get money into the account faster: issue invoices immediately after delivery, set customer payment terms to under 20 days, chase payments consistently, and make your own payments as late within the deadline as possible.
Medium-term measures to improve the structure: introduce advance payments on larger orders, review inventory regularly and offload slow-moving stock, negotiate longer payment terms with suppliers.
Financing as a tool: Those who know their ratios and act early have more options. External financing shouldn’t only come into play once there’s already a gap – it’s a strategic decision made beforehand. Providers like Banxware can bridge short-term gaps – digitally, without a traditional bank process, often within a few hours.
Financing closes the gap. Liquidity planning prevents the gap from opening in the first place. For that to work, the ratios need to be interpreted correctly – because they don’t show everything.
Limits of liquidity ratios – what they don’t show
Liquidity ratios are useful as a quick check, but they don’t give a complete picture. Here are the key limitations.
- Point-in-time problem: The figures are based on a balance sheet – a single day. Months often pass between the balance sheet date and publication. What happened yesterday or tomorrow is not reflected.
- No ongoing payments: Salaries, rent and insurance premiums don’t appear in short-term balance sheet liabilities, even though they fall due every month. The ratios only capture balance sheet liabilities.
- Industry differences: A wholesaler with 180% on Ratio 3 is in a completely different position to a software agency with the same figure. Benchmarks are reference points, not absolute values. What’s solid in one industry can be critical in another.
- Receivables ≠ cash: Ratios 2 and 3 treat open receivables as near-liquid. In reality they can become bad debts or payment can be delayed by weeks.
- No forward view: The ratios show a snapshot of the past. Whether you’ll be solvent next month is only shown by a rolling liquidity plan.
That’s why it’s worth knowing the limits of these metrics – and interpreting them correctly.
The dynamic alternative is the cash flow-based liquidity ratio, which sets actual payment flows in relation to short-term liabilities. It feeds into liquidity planning and supplements the static ratios where they reach their limits.
Conclusion: liquidity ratios
Liquidity ratios aren’t an end in themselves. They show you in three figures how stable your business really is – not on paper, but when next week’s invoice arrives.
Ratio 1 tells you whether you’re solvent today. Ratio 2 tells you whether you’ll stay solvent over the coming weeks. Ratio 3 shows whether the overall substance holds up.
Those who calculate these metrics once a quarter spot problems early enough to act – before a warning signal becomes a cash crunch. And those who also run a rolling liquidity plan don’t just know where they stand – they know where they’re heading.
Sources:
Creditreform (2024). Zahlungsindikator Deutschland, H1 2024. Creditreform Wirtschaftsforschung.
BGH (2005). Urteil vom 24. Mai 2005, Az. IX ZR 123/04. Bundesgerichtshof.
Wöhe, G. / Döring, U. (2013). Einführung in die Allgemeine Betriebswirtschaftslehre. 25. Auflage. Verlag Franz Vahlen.
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