It's been a point of contention for many historians. In George Dangerfield's thesis The Strange Death of Liberal England he points to the failings of the Liberal Party 1910-1914 to suggest that the party was in terminal decline before the war, with the Labour Party rising to take its place. This view has been criticised, however, as the party was still in government and Labour was polling quite poorly in by-elections. The North-East Derbyshire y-election, for example, showed that Labour could not stand against Liberal candidates even in strong mining areas, where they were expected to do best. Due to the nature of the War, there were no elections between December 1910 and 1918, so it's hard to conclusively dismiss either theory.
Most, however, would point to the War as the main downfall of the Liberal Party (Lowe - 'WW1 started the rot'). Within the Liberal Party there were fundamental differences, that emerged primarily as pacifism and war supporters. The pacifist wing of the Party was small to begin with, but it grew in time due to the nature of total war, with some Liberals becoming concerned about the erosion of liberties caused by, amongst other things, the Defence of the Realm Act 1916. During this, the Labour Party was also split. Informal and formal ties with the Liberal Party, which had been present since the 1906 Lib-Lab Pact, were cut. In some ways this strengthened Labour; they were finally their own party and many of them (eg Ramsay MacDonald) resigned in protest soon after the outbreak of war. Problematically, some senior Labour ministers did not resign, Arthur Henderson most prominent amongst them, so the Labour Party was also split.
The key turning point was the removal of Asquith as Prime Minister on December 7th 1916. A year earlier Asquith had called a grand coalition together to help with the war, concerned that he would not be strong enough to win another election if he was forced to call one. This was dominated by Conservatives, led by Bonar Law. There were concerns that the war effort was being run inefficiently and that Asquith was not giving them sufficient leadership. On December 5th, with the agreement of Bonar Law, David Lloyd George went to Asquith with a recommendation of a new, smaller War Cabinet of 5: Lloyd George, Bonar Law, Curzon, Henderson and Balfour. Asquith could remain Prime Minister in name but, effectively, not in power. Asquith seemed likely to accept this until a Times article was published on December 6th that ridiculed him, provoking a refusal. Lloyd George, Bonar Law and other key Conservatives all resigned, effectively ensuring that Asquith could not continue. On December 7th the King called for Lloyd George, making him Prime Minister.
With this caused a split between the Asquithian Liberals and the Lloyd George Liberals. The Asquithian Liberals saw this as a coup d'etat by Lloyd George, whilst Lloyd George Liberals saw it as a necessary change for the good of the war effort. Asquith refused to serve under Lloyd George and this arrangement continued until the end of the war in 1918. Both Asquith and Lloyd George were never short of self-assurance, and a return to the pre-war ways seemed impossible.
Meanwhile the Labour Party was more united than ever. In 1917 Arthur Henderson resigned from the War Cabinet, and in 1918 the Labour Party launched its own constitution. The key addition here was Clause IV, which committed the Labour Party to a socialist agenda and the common ownership of the means of production. They were now significantly different than the flagging Liberal Party and offered a viable alternative for the working class.
When the war ended in 1918, Asquith and Lloyd George continued to disagree about the running of the Liberal Party. As such, Lloyd George decided to continue with the current arrangement; Bonar Law and the Conservatives were concerned that they had not won an election in 18 years, and the propaganda gained from 'The Man Who Won The War' was significant. The election was a whitewash; the coalition could call on 505 votes in the Chamber. Asquithian Liberals were reduced to 36 seats, with Asquith himself losing his seat (he would return to the Commons in a 1920 by-election). The third largest party was Sinn Fein, who refused to sit in the Commons. As such, the Labour party became the de-facto Opposition Party, giving them more credibility than they previously had.
The coalition was a significant disaster for Lloyd George and he was removed from power in the 1922 Carlton Club Meeting. Asquith had taken with him the grassroots organisation of the party and Lloyd George could not build a new party by scratch. By the end of his tenure he was distrusted by a large majority of the electorate, particularly due to incidents like the Chanak Crisis 1922, where he nearly dragged Britain into another war with Turkey. In 1923 Asquith and Lloyd George agreed to reunite to fight the election together in opposition to Imperial Preference, but by then it was too late. Asquith was old and Lloyd George was not trusted.
One last, fatal mistake was made in the aftermath of the 1923 General Election. The Conservatives had won a plurality of seats with 258, but as the only party of Imperial Preference they could not gain the support necessary to form a functioning government. The Liberal Party, convinced that it would ruin Labour, allowed Labour to form a minority government with their backing. It only lasted 9 months, but Ramsay MacDonald followed a moderate stance that cemented Labour's credibility in the midst of a Red Scare. It solidified Labour as the second party and left the Liberals without a voter base - the working class vote belonged to Labour and the businessmen vote belonged to the Conservatives.
Sources: Dangerfield, George: The Strange Death of Liberal England
Hattersley, Roy: David Lloyd George: The Great Outsider
Pugh, Martin: Speak for Britain!: A New History of the Labour Party

So far i only have one source on the subject which I am reading right now. In the book English History 1914-1945 by Taylor it is stated: That the Liberal party in 1929-1931 had failed to adopt itself to the new trend of municipal elections becoming an integral part of local administration. Furthermore he claims that many of it's supporters were nonconformists who lost interest in politics after significant advances in education had been made. There was insufficient contribution to local affairs where the Liberal party made no strong points. Labour would act in the interests of the needy and the conservatives in the interests of the ratepayers. The Liberals intended to position themselves as independents but in reality mostly went with the conservatives. This all caused the Liberals to become detached from local politics and turned into a national cause. Here to it ran into great difficulties with party finance being the largest. Though financially supported by Lloyd George the liberal party was chronically short on funds which further impeded their position in government.

I hope this helps.

If you're interested on the subject there are two good books by Michael Freeden and David Dutton. I can't remember the titles though (I'll edit later if you need). Personally I feel Dangerfield's work might be a tad outdated but it's still a good first read. But the first comment provided a good summary of the subject. I've spent quite a lot of time working on the subject lately, and it appears there's basically no real consensus as to why the party declined. Historians usually provide the same arguments (ww1, the internal division, the rise of labour etc...), but since one's historian explanation does not fit another one's political beliefs it goes full circle.

If you're interested I have a bibliography of 10+ references on the subject, I'll edit it in if people are interested (I'm on my tablet)

Edit:

• Dutton, David. Liberals in Schism. London: Tauris Academic Studies, 2008.

• Freeden, Michael. Liberalism Divided. Oxford: Clarendon Press, 1986.

• Dutton, D. '1932: A Neglected Date in the History of the Decline of he British Liberal Party'. Twentieth Century British History 14, no. 1 (2003): 43-60.

Some good historiographical reviews (albeit aging):

• Laybourn, Keith. 'The Rise of Labour and the Decline of Liberalism: The State of the Debate'. History 80, no. 259 (1995): 207-226.

• Thompson, J. A. 'The Historians and the Decline of the Liberal Party'. Albion: A Quarterly Journal Concerned with British Studies 22, no. 1 (1990): 65-83.