The cash ratio (also known as the cash coverage ratio) is a measurement of how well can the company pay its short-term debt in the form of cash and cash equivalent (investment items that are immediately available to be turned into cash e.g. treasury bills & short-term government bonds). This ratio is useful for creditors to decide how much money they can loan to a company.
Bad, unexpected things may happen to companies. For instance, they might be on the verge of bankruptcy. If that were to happen, companies can immediately turn some particular assets they have into cash to save themselves. These liquid assets are the key ingredients of the cash ratio formula.
Cash Ratio Formula
The cash ratio is a measurement that is generally expressed as a decimal rather than as a percentage.
To calculate the cash ratio, you need to determine the company’s cash, cash equivalent, and current/short-term liabilities. Items that can be categorized as cash including bills & coins and also deposited funds held in bank checking accounts.
Cash equivalents are assets— in the form of investments—that are promptly available to be converted into cash in the time of need such as money market instruments and saving accounts.
Current liabilities, the denominator, are short-time liabilities that have a maximum due date of one year.
The cash ratio is one of the liquidity ratio measurements. Unlike other liquidity ratio measurement, the cash ratio forces strict evaluation, meaning only cash and cash equivalents—the most readily available—are taken into account to calculate the ratio. In other words, only the most liquid assets are taken into consideration instead of total assets. Not all assets owned by a company can be sold easily when the company needs to. By only using cash and its equivalents, we can better determine if a company can immediately pay its debts.
Please note that the cash ratio does not include accounts receivable—goods or services used by customers who haven’t paid yet. This is the case because accounts receivable carry a certain amount of risk to the company, as customers may be late in payment or don’t pay at all. Cash equivalents, on the other hand, carry little to no risk as they are usually associated with low-risk investment securities.
To make an accurate cash ratio calculation, it’s important to be using the correct numbers from the balance sheet. You need to ascertain that the variables you are using truly represent cash or its equivalents instead of non-liquid assets.
Usually, a healthy company has a cash ratio of 0.5 or more. Below that number, it can be surmised that the company is not using its assets well. On the other hand, if a company has a cash ratio of more than 1, it means that it is able to pay off its debts with ease while still having liquid assets left over.
Cash Ratio Example
A creditor wants to know if a particular company can be trusted to pay its debt when it is asked to have a loan. The creditor decides to have the cash ratio evaluated and presented. The total assets of the company are summed up to be $120,000. Total assets are divided into two categories: current assets and non-current assets.
Non-current assets are non-liquid assets. So, we won’t be looking at those. Instead, we will be looking into current assets, the more liquid ones. Among the current assets listed on the balance sheet, we can see that the company has $15,000 worth of cash—whether in the bank or hand—and also $17,000 worth of savings account and treasury bills.
Currently, the company also has liabilities. Again, liabilities can be divided into two parts: current and non-current liabilities. Non-current liabilities are long-term debts and shareholders’ equity. For estimating the cash ratio, these are not considered. On the contrary, we need to evaluate all of the company’s current liabilities or short-term debts such as short-term bank loans and accounts payable—the amounts owed by the company to creditors or suppliers. The current liabilities of the company are $25,000.
After looking at the explanation and data above, can we evaluate its cash ratio?
Let’s break it down to identify the meaning and value of the different variables in this problem:
- Cash: 15,000
- Cash equivalents: 17,000
- Current liabilities: 35,000
We can apply the values to our variables and calculate the cash ratio:
In this case, the company’s cash ratio would be 0.914.
From this result, we can see that the company is still in a good position. A little less than 1 ratio doesn’t necessarily mean the company is in danger. If needed, it can still rely on the other current assets to pay its left-over debts, even though they are not as liquid as cash and cash equivalents. However, the creditor may need to be careful and pay attention to the track record of the company before giving big loans.
Cash Ratio Analysis
Investors and creditors can take advantage of knowing the cash ratio of a particular company. With the cash ratio, they can determine if a company is in a state of immediate financial difficulty or not. Compared to other liquidity ratio measurements, the cash ratio is a good indicator for a short-term period.
Intuitively, a higher cash ratio means the company has an easier time paying off its debts. There’s no exact figure of how minimum the cash ratio should be for a company to be considered financially healthy. However, a ratio between 0.5 and 1 is generally acceptable. Since the cash ratio only adds cash and cash equivalents from assets into the equation, it provides the most conservative wisdom to the company’s liquidity.
Still, it’s important to keep in mind that a company usually does not hold too much of its assets in the form of cash and cash equivalents. The reason is that cash that only sits does not provide investment for the company, therefore, it does not generate a return. Thus, the cash ratio may not be a good means for an analyst to judge a company’s financial situation in general.
Cash Ratio Conclusion
- The cash ratio is used to measure a company’s capability to pay its short-term debts with its highly liquid assets.
- The formula for cash ratio requires three variables: cash, cash equivalents, and current liabilities.
- The cash ratio provides a stricter and more conservative measure of a company’s liquidity.
- The results of the cash ratio are usually expressed in decimal.
- The acceptable ratio of a company is generally between 0.5 and 1.
- The cash ratio may not be a good judge of general financial analysis for a company, as most companies usually do not keep most of their assets in cash or cash equivalents.
Cash Ratio Calculator
You can use the cash ratio calculator below to quickly calculate and measure a company’s capability to pay its short-term debts with its highly liquid assets by entering the required numbers.
1. What is the cash ratio?
The cash ratio is a liquidity ratio that measures a company’s capability to pay its short-term debts with its highly liquid assets. This ratio is usually expressed in decimal form.
2. What does the cash ratio show you?
The cash ratio gives you a stricter and more conservative measure of a company’s liquidity. For example, if a company’s cash ratio is less than 0.5, it is generally in a state of immediate financial difficulty.
3. How do you calculate the cash ratio?
The cash ratio can be calculated by dividing a company’s cash and cash equivalents by its current liabilities.
The formula is:
Cash Ratio = Cash+Cash Equivalents / Total Current Liabilities
4. What is the difference between a cash ratio and a quick ratio?
The difference between the cash ratio and the quick ratio is that the cash ratio includes cash and cash equivalents while the quick ratio excludes inventory.
Another difference is that the cash ratio is a more stringent and conservative measure of liquidity while the quick ratio is less so.
5. How is the cash ratio used?
The cash ratio is most used as a measure of a company's liquidity. If the company is forced to pay its short-term debts immediately, it will be able to do so with the cash and cash equivalents that are included in this ratio.