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What is the cash ratio?
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What Is Cash Ratio
Cash ratio is a financial ratio used to assess a company’s liquidity by comparing its cash, cash equivalents, and marketable securities to the company’s current liabilities.
The idea is to see how well is a company able to use its cash and cash equivalents to pay for its short-term obligations.
Investors, lenders, and financial analysts calculate a company’s cash ratio to see how well is a company able to fund its own operations and pay for its current liabilities.
A company that has a cash ratio greater than 1 means that it has more cash and highly liquid assets to pay for all its current liabilities.
On the other hand, if a company’s cash ratio is below 1, it means that the company has less cash assets for every dollar of current liabilities.
Assessing a company’s cash ratio is useful for investors and lenders to better appreciate the financial health of an organization and its potential to default on debt obligations.
Keep reading as I will explain to you how you can calculate the cash ratio and I will go over an example.
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Why Is Cash Ratio Important
Cash ratio is an important financial ratio used by many to assess a company’s liquidity.
The idea is to see if, at a given point in time, the company will have sufficient cash, cash equivalents, and marketable securities to pay off all its current liabilities.
The cash ratio assumes that the company does not have to sell or liquidate any assets to cover its short-term debt.
In many cases, lenders will be interested in calculating a company’s cash ratio before granting a loan or extending credit.
If a company’s cash ratio is above 1, lenders will perceive less liquidity risk and thus be more willing to grant a loan to the company.
On the other hand, if a company’s cash ratio is below 1, lenders will further investigate the company’s liquidity and default risk to see how much loan can be extended to the company and at what rate of interest.
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Cash Ratio Formula
The cash ratio formula is the following:
Cash Ratio = (Cash + Cash Equivalents + Highly Marketable Securities) / Current Liabilities
Cash includes all money that the company has in its checking accounts, savings accounts, currency, coins, petty cash, and other cash on hand.
Cash equivalents include anything that can be easily converted to cash such as T-bills, money market instruments, commercial paper, money market funds, and government bonds.
Marketable securities are investments that can very quickly be turned into cash like highly liquid stocks.
Current liabilities are all debt payable within twelve months, such as accounts payable, accrued liabilities, wages, etc.
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Cash Ratio Interpretation
The cash ratio is primarily used to measure a company’s liquidity.
The objective of using cash ratio is to see if the company has enough cash on hand or cash equivalents to be able to completely pay off its current liabilities.
When a company’s cash ratio is below 1, it means that the company has less cash and cash equivalents for every dollar of current liability.
Investors and lenders will generally investigate the company’s financial health further in such circumstances.
However, having a cash ratio below 1 does not necessarily mean that it’s a bad thing.
A company that efficiently manages its inventory, does not grant too much credit to its customers, is able to collect its account receivables well, and will be able to remain financially healthy even with a cash ratio below 1.
A cash ratio over 1 means that the company has more cash and cash equivalents to pay for all its short-term debt.
This means that the company has good liquidity.
However, if the cash ratio is too high, it may suggest that the company is not efficiently using its cash to grow the business or may be accumulating funds in anticipation of an adverse business condition.
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Cash Ratio Limitations
Although the cash ratio is probably one of the most common liquidity ratios used, it does have certain limitations that you must be mindful of.
Companies are constantly looking to see where to invest their assets and how to generate more value for their shareholders.
As a result, a company that maintains too much cash on hand may be perceived as a company that is not efficiently using its assets to create value for its shareholders.
Also, when the cash ratio is considered alone, it may not give a good indication of the company’s overall liquidity health.
It’s best to compare the cash ratio to the company’s competitors in the same industry to see where the company stands in the group.
Also, the cash ratio should be considered over a period of time to see if the company’s liquidity level is stable, declining, or improving.
Another limitation is that companies that are aggressively investing to grow their business may use their cash for M&A activities, launch new products, purchase capital assets, and so on.
As a result, their cash ratio may be very low leading investors to believe that the company may have liquidity issues.
However, it’s important to see what is an adequate level of cash ratio, see where the company has been investing, and understand its growth strategy.
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Cash Ratio Example
Let’s look at an example of cash ratio to better understand the concept.
Let’s assume that Company ABC has $1 million in cash on hand and $2 million of marketable securities.
Also, Company ABC has $5 million in short-term debt that is payable within a year.
To calculate Company ABC’s cash ratio, we need to add its cash and marketable securities (giving us $3 million) and divide that by its current liabilities, giving us 0.6.
This means that for every $1 of current debt, the company has $0.60 in cash and marketable securities to pay for it.
At first glance, this may appear that the company may have liquidity issues.
However, if you compare Company ABC to its industry average of 0.5 cash ratio, you’ll see that it’s quite comparable.
Also, you may notice that the company had recently used $1 million for capital investments which is good for the long-term growth of the company.
In this case, although the company’s cash ratio is below 1, it appears that the company is relatively in a comfortable financial position.
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Cash Ratio FAQ
What is a good cash ratio?
A good cash ratio depends on the company and the industry within which it operates.
A cash ratio of 1 means that the company has $1.00 of cash assets to pay for every $1.00 of current liabilities.
Typically, when the cash ratio is below 0.5, lenders and investors may be concerned about the company’s liquidity as the company has two times more short-term debt than it has cash and cash equivalents.
However, a company may have a low cash ratio because it recently invested important sums to launch a new product, acquire another business, or invest in capital assets.
A company may also have a low cash ratio but which is improving over time.
It’s important to assess the cash ratio along with other metrics and the circumstances of the company to better assess liquidity and risk.
How is cash ratio calculated?
Cash ratio is calculated by adding the company’s cash, cash equivalents, and marketable securities and dividing the result by its current liabilities.
The ratio shows how much cash assets a company has to cover its short-term debt.
What is the difference between cash ratio vs current ratio?
Both the cash ratio and current ratio are liquidity measures.
However, cash ratio is more conservative than the current ratio.
The cash ratio will only consider cash, cash equivalents, and marketable securities to see if a company can pay for all its current liabilities.
On the other hand, current ratio will consider all of the company’s current assets such as cash, cash equivalents, accounts receivable, inventory, and other current assets.
Takeaways
So there you have it folks!
What is cash ratio?
In a nutshell, the cash ratio is a liquidity metric that is used to assess a company’s capacity to pay off its short-term debt using its cash and cash equivalents.
The cash ratio is a much more conservative liquidity measure than the current ratio or the acid test.
Creditors, investors, and financial analysts look at a company’s current ratio to see how well they are funded.
A high cash ratio means that the company has the capacity to pay for its short-term debt but may not be efficiently using its assets to grow the business.
A low cash ratio indicates that the company does not have enough cash assets to pay for its short-term debt obligations.
This can be viewed as a red flag and will generally be investigated further.
Now that you know what cash ratio means and how it works, good luck with your research!
I hope you enjoyed this article on Cash Ratio! Be sure to check out more articles on my blog. Enjoy!
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