Liquidity ratio for SMBs: How to calculate & how to improve yours

Running an SMB means juggling day-to-day cash flow while keeping an eye on the long-term health of your business. Even temporary cash shortages can set you back significantly, especially if you don’t have time to prepare. 

Liquidity ratios are a simple, useful tool to assess your financial health. They’re a straightforward measure of whether your business has the resources readily available to pay its bills on time. 

In this article, we’ll break down what liquidity ratios are, why they matter for SMBs, and how you can use them to make smarter financial decisions, avoid cash crunches, and position your business for sustainable success.

What is a liquidity ratio?

Liquidity ratios measure your company’s ability to cover its short-term obligations using available assets. Think of them as a quick check on how easily your business can pay its bills, wages, and other immediate expenses without relying on outside help (like loans or credit).

We talk about “ratios” (plural) because there are actually several common ratios which give insight into liquidity. These include the current ratio, quick ratio, and operating cash flow ratio. We’ll go into detail on each (and how to calculate them) shortly. 

Liquidity vs solvency

Liquidity and solvency are similar but fundamentally different concepts: 

• Liquidity: Liquidity concerns whether you have enough money (or assets that can be quickly turned into money) to cover short-term expenses. These include things like rent, payroll, utility bills, or inventory purchases. Liquid assets include cash in your business bank account, money owed to you by customers (accounts receivable), or products you can sell quickly.
  
  If a bill comes due tomorrow, can you pay it without delay? If yes, you’re liquid. Good liquidity means your business can operate smoothly, even when times are tight. Poor liquidity often leads to stress and, potentially, late payments or penalties.

• Solvency: Solvency is a long-term measure of whether your business has enough overall value to cover all its debts. This includes both short-term liabilities (like monthly bills) and long-term ones (like loans or leases). Compare your total assets (like equipment, property, cash, and accounts receivable) to your total debts (like loans, credit lines, and unpaid bills). If assets outweigh debts, your business is solvent.
  
  If you sold everything your business owns and paid off everything you owe, would you still have money left? If yes, your business is solvent.

How to calculate liquidity ratios

Because there are several different liquidity ratios to consider, there are different ways to calculate them. These are the three most common:

1. Current ratio = current assets ÷ current liabilities
   
   This tells you how much you have in assets (cash, inventory, accounts receivable) compared to what you owe soon (like accounts payable, short-term loans). This is also known as your working capital ratio.
   
   
2. Quick ratio (AKA the “acid-test”) = (current assets - inventory) ÷ current liabilities
   
   This removes inventory from the equation (which can take time to convert to cash) and focuses on your most liquid assets.
   
   
3. Operating cash flow ratio = operating cash flow ÷ current liabilities

This shows your cash flow after operating expenses. A higher ratio shows that your company generated more cash in a given period than you needed to pay off current liabilities.

The operating cash flow ratio is particularly interesting for investors, because there’s less possibility to paint revenue numbers in an overly positive light. 

Why is the liquidity ratio important for SMBs?

There is certainly such thing as too much data. As a busy SMB owner, most of your time should be spent on building a client base, making sales, and creating the best possible products. 

But measuring and monitoring your liquidity ratios from time to time can be helpful. At the very least, you’ll know that you can meet your obligations and aren’t at risk of serious cash shortfalls. Here are the key benefits of this analysis: 

1. Avoids cash crunches: Monitoring liquidity ensures you can handle unexpected expenses or delays in customer payments without scrambling for emergency funding.
   
   
2. Keeps you in business: A poor liquidity ratio can lead to missed payments, penalties, and damage to supplier relationships, which can disrupt operations or even lead to business failure. It becomes impossible to keep the lights on and pay staff. If you’re out of cash, you’ll soon be out of business.
   
   
3. Guides decision-making: A strong liquidity ratio gives you the confidence to invest in growth opportunities, like buying new equipment or hiring staff. A weak ratio signals it’s time to focus on cutting expenses or collecting payments faster.
   
   
4. Builds trust with lenders and suppliers: A healthy liquidity ratio reassures banks and vendors that your business is financially stable, making it easier to secure loans or favorable terms.

What SMB owners should do

You’re busy enough already. But a little smart analysis will help you understand your current cash position, and inform your planning for the future. 

1. Calculate your liquidity ratios periodically
   
   Set a schedule to review your current and quick ratios monthly. Good accounting software will do this for you, or your bookkeeper can pull the numbers easily.
   
   This is especially easy at the end of the year when your annual financials are prepared. But ideally you’ll have up-to-date accounting records in real time, so the calculations should be near-instant.
   
   
2. Target a healthy ratio
   
   For most businesses, a current ratio above 1.5 is a good benchmark. This means you have $1.50 in assets for every $1 of liabilities.
   
   A quick ratio of at least 1.0 is ideal, ensuring you can cover short-term debts without relying on selling inventory.
   
   
3. Improve your liquidity where necessary

If liquidity is an issue, it makes sense to improve and optimize cash flow. We’ll see a few quick solutions in a moment. 

4. Monitor the warning signs
   
   If your ratios are consistently low, act immediately. Delays could worsen the problem, making recovery harder. Seek advice from a financial advisor or accountant if needed.

By tracking and managing your liquidity ratio, you ensure your business has the flexibility to meet obligations, seize opportunities, and stay resilient during challenging times.

How to improve your liquidity ratios

At heart, liquidity is a measure of the success and ongoing viability of your business. So there are no quick fixes to overcome comprehensive cash flow issues. 

But there are some pragmatic actions you can take to keep cash flowing in smoothly. 

Speed up sales and collections

A very long sales cycle is a key liquidity challenge. Even if negotiations are going well, until the customer actually signs you don’t have new revenue to add to your ledger. 

And the longer the period between completing a sale and the customer actually paying, the longer you go without cash in the bank. Even though outstanding receivables count as an asset (and will help improve your liquidity ratio), it’s still best practice to make your “days sales outstanding” (DSO) as short as possible. 

Optimize your inventory

While inventory is an asset, the quick ratio removes inventory from the calculation. For the simple reason that stock can be long and unpredictable to turn over. For a healthy ratio, then, you need to ensure you’re not tying up too much cash in inventory. 

“Days inventory outstanding” (DIO) is another useful measure here, and you want it to be as low as possible. If you find yourself holding certain product lines for a very long period, revisit your processes to avoid doing so excessively in future.  

Pay off debts

This is obviously easier said than done. But if you can reduce debts during positive periods, you’ll have an easier time managing liquidity ratios when income is harder to come by. 

Or to put it another way, you need fewer assets if you have lower liabilities. 

Use short-term financing

This is probably the most practical step you can take immediately. As long as solvency isn’t a major issue, you should be able to create a working capital line of credit to get you through periods of slower income. 

Good options include factoring, reverse factoring (sometimes called accounts payable financing), bridging loans, and even a bank overdraft if you can access one. As long as your borrowing is targeted and you’re in control, you should be able to use this cash injection strategically. 

Get the funds you need for healthy liquidity

Smart financing is the number one tool in your kit to maintain healthy liquidity and avoid serious cash issues. And there are good, efficient sources of quick funds available to SMBs. 

If you need working capital help, look for a financing provider that is: 

• Flexible, letting you borrow against the payables, receivables, or other collateral that makes most sense to you.
• Fast and efficient, with a rapid application process and quick access to funds. 
• Fair, so you’re not locked into unsustainable contracts with onerous terms. 
• Built for SMBs, and can understand your particular pain points and biggest needs. 

If that sounds good, consider Defacto. We offer working capital financing for SMBs, with an application process that takes just 27 seconds. You use this line of credit however you need, and can refinance easily for each new challenge. 

Ready to take control over your cash flow? Try Defacto today.