Cash Ratio

Cash ratio is a liquidity metric that shows a company's ability to pay short-term obligations with cash. The formula is cash and cash equivalents divided by current liabilities.


What is the Cash Ratio?


The cash ratio is an accounting ratio that shows a company’s ability to pay its short-term obligations with cash and cash equivalents. The formula is cash and cash equivalents divided by current liabilities.
It’s more strict than other liquidity ratios like current ratio and quick ratio. because it only looks at how the cash on hand can cover short-term liabilities. The cash ratio is also referred to as the cash coverage ratio.

The cash ratio formula is:


Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities


Cash refers to legal tender and currency. Examples of cash include: bills, coins, checking accounts, savings accounts, petty cash, money orders, and checks.
Cash equivalents is a balance sheet asset and defined as investment securities that have high credit ratings and are highly liquid. Examples of cash equivalents include: commercial paper, Treasury bills, certificates of deposits, money market instruments, and marketable securities.
Current liabilities are liabilities that must be repaid within 1 year. Current liabilities include the following balance sheet accounts: accounts payable, notes payable, dividends payable, short-term debt, payroll, and taxes.

Cash Ratio Formula


The cash ratio calculation is cash plus cash equivalents divided by current liabilities. Cash and cash equivalents are both assets, whereas current liabilities are a liability.


Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities

The cash ratio formula is cash plus cash equivalents, divided by current liabilities.
On a balance sheet, Cash and Cash Equivalents might be broken out into two accounts or they may be combined in a single entry. It is also important to match the periods when using this formula since the balance sheet is always a reference to a moment in time.

To calculate the Cash Ratio for March, you would want the ending balances for Cash, Cash Equivalents, and Current Liabilities. To calculate the ratio for 2021, you would want to use values from the end of the year.


Examples of Cash Ratio


Here is an example by looking at Company A’s balance sheet.


Company A

Assets

  • Cash: $150,000
  • Cash Equivalents: $100,000
  • Accounts Receivables: $70,000
  • Inventory: $30,000

Liabilities

  • Accounts Payable: $75,000
  • Short-Term Debt: $50,000
  • Long-Term Debt: $180,000

Now let’s use the formula for above. Remember that long-term debt is not a current liability, so it should be included.


Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities

Cash Ratio = ($150,000 + $100,000) / ($75,000 + $50,000)

Cash Ratio = $250,000 / $125,000

Cash Ratio = 2.00x


This second example looks at Company B’s balance sheet, so we can compare the two.


Company B

Assets

  • Cash: $1,500,000
  • Cash Equivalents: $300,000
  • Accounts Receivables: $450,000
  • Inventory: $250,000

Liabilities

  • Accounts Payable: $600,000
  • Short-Term Debt: $500,000
  • Long-Term Debt: $2,550,000

Let’s dig into the cash ratio now for Company B.


Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities

Cash Ratio = ($1,500,000 + $300,000) / ($600,000 + $500,000)

Cash Ratio = $1,800,000 / $1,100,000

Cash Ratio = 1.63x


Despite having 10x more cash, Company B still has a lower cash ratio because Company B has much higher current liabilities.


How is the Cash Ratio Used?


Executives, managers, investors, financial analysts, and shareholders all look at cash ratio to understand whether a company has enough cash and cash equivalents to meet its current obligations.

When looking at a balance sheet, a company’s current liabilities are payments to employees, vendors, and creditors within the operating cycle of the business. For most businesses, this operating cycle is one year (365 days).


Other Liquidity Metrics


There are three common liquidity metrics: current ratio, quick ratio, and cash ratio.
There are three liquidity ratios, with the most strict being cash ratio.
The current ratio formula is current assets divided by current liabilities. This is the least strict liquidity measure as it compares all of a company’s current assets to their current liabilities. Current ratio is also called the working capital ratio.
The quick ratio formula is (current assets - inventory) divided by current liabilities. This is a more strict liquidity measure as it looks at current assets less inventory. The numerator (current assets less inventory) is also called quick assets. The quick ratio is also called the acid-test ratio or acid ratio.
The cash ratio formula is (cash + cash equivalents) divided by current liabilities. This is the most strict liquidity measure as it only references cash and cash equivalents, the most liquid assets, to cover current liabilities. It’s also called the cash coverage ratio.

Final Thoughts


Cash ratio is a useful liquidity metric for a number of stakeholders. Executives and managers reference this accounting ratio to make sure they have a healthy cash balance to fund company day-to-day operations and growth plans.

Cash ratio is a conservative measure of a company’s liquidity as it only looks at the most liquid assets (cash, cash equivalents) against all current liabilities. Remember that the denominator is current liabilities, not total liabilities.

Investors, creditors, and potential creditors will use this liquidity metric to understand whether the available funds are enough to meet obligations, like short-term loans.

From the perspective of a bank or lender, cash ratio is vital to understanding risk. It is common for banks and other lenders to require a cash ratio above a certain threshold. These terms are called debt covenants or simply covenants.

Companies will want to keep a high cash balance to remain in good financial health. A low cash balance (and thus a low cash ratio) might mean a company does not have enough sales or enough margin on its sales.

That said, it is possible to have a cash ratio that is too high. A company with idle cash or excess cash is not as productive as a company that’s efficiently reinvesting in hiring, marketing, inventory, and other useful assets.

Here are the key takeaways:

  • Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities
  • Cash refers to currency, coins, and bank account balances; cash equivalents refer to commercial paper, Treasury bills (T-bills), certificates of deposits (CDs), money market instruments, and other short-term investments
  • Cash ratio is a conversative liquidity measure because it only looks at the most liquid assets against all current liabilities
  • Other liquidity measures include the rurrent and quick ratios
  • Companies need to keep enough cash on hand to cover payments to employees, vendors, and creditors; but too much cash on hand could limit plans for growth and expansion
Cash ratio is a conversation measure of a company’s liquidity, as it only looks at cash and cash Equivalent to cover payments to vendors and creditors. There is no ideal cash ratio, as it determines on company maturity, industry, and its financing structure. That said, a cash ratio below 0.5x is generally deemed as too low and a cause for concern.

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