A liquidity ratio that measures a company’s ability to pay off short-term liabilities with highly liquid assets
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What is Cash Ratio?
The cash ratio, sometimes referred to as the cash asset ratio, is a liquidity metric that indicates a company’s capacity to pay off short-term debt obligations with its cash and cash equivalents. Compared to other liquidity ratios such as thecurrent ratioand quick ratio, the cash ratio is a stricter, more conservative measure because only cash and cash equivalents – a company’s most liquid assets – are used in the calculation.
Formula
The formula for calculating the cash ratio is as follows:
Where:
- Cash includes legal tender (coins and currency) and demand deposits (checks, checking account, bank drafts, etc.).
- Cash equivalents are assets that can be converted into cash quickly. Cash equivalents are readily convertible and subject to insignificant risk. Examples include savings accounts, T-bills, and money market instruments.
- Current liabilities are obligations due within one year. Examples include short-term debt, accounts payable, and accrued liabilities.
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 & equipment: $50,000
- Accounts payable: $12,000
- Short-term debt: $10,000
- Long-term debt: $20,000
The ratio for Company A would be calculated as follows:
The figure above indicates that Company A possesses enough cash and cash equivalents to pay off 136% of its current liabilities. Company A is highly liquid and can easily fund its debt.
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Interpretation of the Cash Ratio
The cash ratio indicates to creditors, analysts, and investors the percentage of a company’s current liabilities that cash and cash equivalents will cover. A ratio above 1 means that a company will be able to pay off its current liabilities with cash and cash equivalents, and have funds left over.
Creditors prefer a high cash ratio, as it indicates that a company can easily pay off its debt. Although there is no ideal figure, a ratio of not lower than 0.5 to 1 is usually preferred. The cash ratio figure provides the most conservative insight into a company’s liquidity since only cash and cash equivalents are taken into consideration.
It is important to realize that the cash ratio does not necessarily provide a good financial analysis of a company because businesses do not ordinarily keep cash and cash equivalents in the same amount as current liabilities. In fact, they are usually making poor use of their assets if they hold large amounts of cash on their balance sheet. When cash sits on the balance sheet, it is not generating a return. Therefore, excess cash is often re-invested for shareholders to realize higher returns.
Key Takeaways
- The cash ratio is a liquidity ratio that measures a company’s ability to pay off short-term liabilities with highly liquid assets.
- Compared to the current ratio and the quick ratio, it is a more conservative measure of a company’s liquidity position.
- There is no ideal figure, but a ratio of at least 0.5 to 1 is usually preferred.
- The cash ratio may not provide a good overall analysis of a company, as it is unrealistic for companies to hold large amounts of cash.
Related Readings
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FAQs
The cash ratio is a liquidity measure that shows a company's ability to cover its short-term obligations using only cash and cash equivalents. The cash ratio is derived by adding a company's total reserves of cash and near-cash securities and dividing that sum by its total current liabilities.
What does a cash ratio tell you? ›
The cash ratio indicates to creditors, analysts, and investors the percentage of a company's current liabilities that cash and cash equivalents will cover. A ratio above 1 means that a company will be able to pay off its current liabilities with cash and cash equivalents, and have funds left over.
What cash ratio is too high? ›
High current ratio: This refers to a ratio higher than 1.0, and it occurs when a business holds on to too much cash that could be used or invested in other ways. Low current ratio: A ratio lower than 1.0 can result in a business having trouble paying short-term obligations.
What is the difference between quick ratio and cash ratio? ›
The cash ratio looks at only the cash on hand divided by CL, while the quick ratio adds in cash equivalents (like money market holdings) as well as marketable securities and accounts receivable. The current ratio includes all current assets.
What is the formula for the cash asset ratio? ›
The cash asset ratio is calculated by dividing the sum of cash and cash equivalents by current liabilities.
What is a good price to cash ratio? ›
A good price-to-cash-flow ratio is any number below 10. Lower ratios show that a stock is undervalued when compared to its cash flows, meaning there is a better value in the stock.
Is a lower cash ratio better? ›
A: A higher cash ratio means that a company has more liquid capital available and lower short-term liabilities in need of payment, while a lower cash ratio means that there is a higher amount of liabilities and less cash on hand as an asset. Therefore, it is more desirable to have a higher cash ratio than a lower one.
What is the problem with cash ratio? ›
If you have a low cash ratio, you may have trouble paying your short-term obligations, including your credit card bills, payroll, utilities, taxes, and other expenses. You'll likely have to take on debt or sell off some of your business assets to avoid getting into trouble.
What is a good debt to cash ratio? ›
If your debt ratio does not exceed 30%, the banks will find it excellent. Your ratio shows that if you manage your daily expenses well, you should be able to pay off your debts without worry or penalty. A debt ratio between 30% and 36% is also considered good.
What is a bad cash coverage ratio? ›
The higher your cash coverage ratio, the better the financial condition your business is in. But how do you know when you should be concerned? Any time that your cash coverage ratio drops below 2 can signal financial issues, while a drop below 1 means your business is in danger of defaulting on its debts.
While there is no benchmark number that signals a “good” turnover ratio, generally speaking, the higher the better, as that indicates increased efficiency and profitability. However, a higher ratio could also indicate that you are burning through cash too quickly, which could reveal other cash flow management issues.
What is a good operating cash flow ratio? ›
The operating cash flow ratio represents a company's ability to pay its debts with its existing cash flows. It is determined by dividing operating cash flow by current liabilities. A ratio greater than 1.0 indicates that a company is in a strong position to pay its debts without incurring additional liabilities.
What is a good quick ratio? ›
Generally speaking, a good quick ratio is anything above 1 or 1:1. A ratio of 1:1 would mean the company has the same amount of liquid assets as current liabilities. A higher ratio indicates the company could pay off current liabilities several times over.
What is the ideal cash ratio? ›
There is no ideal figure, but a cash ratio is considered good if it is between 0.5 and 1. For example, a company with $200,000 in cash and cash equivalents, and $150,000 in liabilities, will have a 1.33 cash ratio.
What is the rule for cash ratio? ›
A cash ratio equal to or greater than one generally indicates that a company has enough cash and cash equivalents to entirely pay off all short-term debts. A ratio above one is generally favored. A ratio under 0.5 is considered risky because the entity has twice as much short-term debt compared to cash.
What is a good debt to equity ratio? ›
Generally, a good debt ratio is around 1 to 1.5. However, the ideal debt ratio will vary depending on the industry, as some industries use more debt financing than others. Capital-intensive industries like the financial and manufacturing industries often have higher ratios that can be greater than 2.
