• How Liquid Each Asset Is
  • The Three Liquidity Ratios

Liquidity is how easily a business can turn its assets into cash to pay what it owes soon. OpenStax's Principles of Finance defines it as the "ability to convert assets into cash in order to meet primarily short-term cash needs or emergencies". Three ratios measure it: the current ratio, the quick ratio and the cash ratio. The quick ratio leaves out inventory and prepaid expenses, so it shows what the business could pay with cash, short-term investments and receivables.

Billed publishes this page. Definitions are quoted from OpenStax, Principles of Finance 2e, chapter 6, opened on October 30, 2026. For working capital and the wider set of financial ratios, see what is working capital and what is financial ratio analysis.

How Liquid Each Asset Is

Cash is already cash. Accounts receivable turns into cash when customers pay. Inventory has to be sold first. OpenStax's section 6.3 puts it this way: "Inventory is less liquid than accounts receivable because the product must first be sold before it generates cash (either through a cash sale or sale on account)."

The Three Liquidity Ratios

From OpenStax's chapter 6 key terms and section 6.3:

  • Current ratio = current assets ÷ current liabilities. The key term: "current assets divided by current liabilities; used to determine a company’s liquidity (ability to meet short-term obligations)".
  • Quick ratio = (cash + short-term investments + accounts receivable) ÷ current liabilities. The key term: "also known as the acid test ratio; ratio used to determine a firm’s ability to pay short-term debts using its most liquid assets". Section 6.3 explains which assets count: current assets "are more narrowly defined as the most liquid assets, which exclude inventory and prepaid expenses."
  • Cash ratio = cash and cash equivalents ÷ current liabilities. Section 6.3: "It represents the firm’s cash and cash equivalents divided by current liabilities and is a more conservative look at a firm’s liquidity than the current or quick ratios."

Reading the Ratios

Section 6.3 explains the cash ratio this way: "A cash ratio of 1.0 means the firm has enough cash to cover all current liabilities if something happened and it was required to pay all current debts immediately." It also recommends reading the ratios together: "Again, it’s recommended that ratios be used in conjunction with one another." A gap between the current ratio and the quick ratio shows how much of the business's short-term assets are tied up in inventory and prepaid expenses.

Worked Example: A Shop With a Lot of Inventory (sample figures)

These are sample figures for a fictional shop, invented for this example. Its balance sheet at the end of the month shows:

  • Cash: $8,000.00
  • Short-term investments: $0.00
  • Accounts receivable: $6,000.00
  • Inventory: $26,000.00
  • Prepaid expenses: $2,000.00
  • Current assets: $8,000.00 + $0.00 + $6,000.00 + $26,000.00 + $2,000.00 = $42,000.00
  • Current liabilities: $20,000.00

The three ratios:

  • Current ratio: $42,000.00 ÷ $20,000.00 = 2.1
  • Quick ratio: ($8,000.00 + $0.00 + $6,000.00) ÷ $20,000.00 = $14,000.00 ÷ $20,000.00 = 0.7
  • Cash ratio: $8,000.00 ÷ $20,000.00 = 0.4

The current ratio is above 1, but the quick ratio is below 1. Of the shop's $42,000.00 of current assets, $26,000.00 + $2,000.00 = $28,000.00 is inventory and prepaid expenses. To pay all $20,000.00 of its current liabilities at once, the shop would need to sell some of its inventory first.

Receivables and Liquidity

Money customers owe you counts in the quick ratio, so collecting it on time matters. See what is accounts receivable and accounts receivable turnover. Billed's invoice software page says: "Invoice reports show which invoices are paid, partially paid or past due, and you can see who owes you money and send them a payment reminder."

When This Guide Isn't for You

If a lender or investor sets a minimum ratio in a loan agreement, or you're comparing your ratios with your industry's, ask your accountant which figures to use and how they're calculated.

Related Guides

FAQ

What is liquidity in accounting?

OpenStax defines liquidity as the "ability to convert assets into cash in order to meet primarily short-term cash needs or emergencies".

What is the difference between the current ratio and the quick ratio?

The current ratio divides all current assets by current liabilities. The quick ratio uses only cash, short-term investments and accounts receivable, leaving out inventory and prepaid expenses. In this page's sample, the shop's current ratio is 2.1 and its quick ratio is 0.7.

Why does the quick ratio leave out inventory?

OpenStax explains: "Inventory is less liquid than accounts receivable because the product must first be sold before it generates cash".

What is the cash ratio?

It's cash and cash equivalents divided by current liabilities. OpenStax describes it as "a more conservative look at a firm’s liquidity than the current or quick ratios."

Share

Was this article helpful?