So, cash ratio is like the strongest measure to to check a company’s liquidity position and is calculated by dividing cash & equivalents like liquid investments to the current liabilities of the company. The higher the ratio, the better the liquidity and low risk.
What is the Cash Ratio?
The cash ratio is a liquidity metric that indicates the company’s obligation to meet its short-term debts with liquid investments equivalents. The cash ratio is stricter compared to other liquidity ratios, such as the current and quick ratios. It has a more conservative measure because only cash and cash equivalents are used in the calculation. The ratio is almost like an indicator of a firm’s value under the worst-case scenario. It indicates the importance of current assets that could quickly be turned into cash and cash equivalents to creditors and analysts. The ratio is beneficial to creditors when they decide how much money they would be willing to loan. The ratio,is more conservative than other liquidity ratios because it only considers a company’s most liquid resources.
The formula for the Cash ratio
The formula for calculating the ratio is as follows:
Cash Ratio =Cash Equivalents/Current Liabilities
Where:
- Cash – Includes legal tender and demand deposits
- Cash equivalents – Assets that can be converted to cash quickly. Cash equivalents are readily convertible and subject to insignificant risk.
- Current liabilities – They are obligations that are due within one year. They include short-term debts, accounts payable, accrued liabilities, etc.
What does the Cash Ratio reveal?
So it is expressed as a numeral greater or less than 1. Upon calculating the ratio, if the result is equal to 1, the company has exactly the same amount of current liabilities as it does with liquid equivalents to pay off those debts.
Less than 1:
If the company has a ratio of less than 1, then there are more current liabilities than liquid equivalents. This means that they have insufficient money on hand to pay off their short-term debts.
Greater than 1:
If the company has a ratio greater than 1, then the company has more cash and cash equivalents than current liabilities. In this situation, the company has the ability to pay off its short-term debts and still have cash remaining.
Example
Company A’s balance sheet lists the following items:
- Cash: $10,000
- Cash equivalents: $20,000
- Accounts receivable: $5,000
- Inventory: $30,000
- Property and equipment: $45,000
- Accounts payable: $12,000
- Short term debt: $10,000
- Long term debt: $20,000
The Cash ratio for company A can be calculated as follows:
Cash Ratio =$10,000 + $20,000$12,000 + $10,000 = 1.36
As the ratio is greater than 1, Company A possesses more than enough cash and cash equivalents to pay their current liabilities. Company A is highly liquid and can easily fund its debt.