Everything You Need to Know About Cash Ratio

Investors often use various metrics to measure the financial position of a company before making an investment decision. Among these metrics, the cash ratio is an important measure of liquidity. This article will provide an overview of what is cash ratio and how to calculate it.

What is Cash Ratio?

Cash ratio is the measure of a company’s liquidity. It indicates the company’s ability to pay off its short-term debt obligations with its most liquid assets, which are cash and cash equivalents.

It is primarily the ratio between the cash and cash equivalents of a company to its current liabilities. The cash ratio is more conservative than other liquidity ratios as it uses only cash and cash equivalents for calculation.

At the most basic, investors, lenders and creditors of a company use cash ratio to determine and evaluate the short-term risk of the company.

What is the Importance of Cash Ratio?

The cash ratio plays a critical role in helping investors gauge the ability of a company to repay its short-term financial obligations with cash or near-cash resources. Thus, it helps determine the ability of a company to pay its current liabilities immediately without having to liquidate or sell other assets.

However, despite its importance, it also has its limitations. The cash ratio is rarely used in a company’s fundamental analysis. This is so because maintaining unsustainable proportions of cash and near-cash reserves to cover current liabilities is not the most practical step for a firm. Usually, holding large cash in a balance sheet can be seen as poor utilization of assets. Thus, although this ratio is useful at times, it is not the sole factor that determines the financial health of a company.

How to Calculate Cash Ratio?

You can manually calculate the cash ratio of a company. To do so, check out the below cash ratio formula:

• Cash Ratio = Cash and Cash Equivalents / Short-Term Liabilities

Here, cash includes the general cash and demand deposits. Cash equivalents are those assets that can be converted into cash quickly. These include savings accounts, money market instruments, T-bills, etc.

Meanwhile, current liabilities are short-term debt obligations that are due within one year. These include accounts payable, accrued liabilities, etc.

Thus, in the formula given above, the numerator depicts the firm’s assets in cash and the denominator shows the firm’s current short-term liabilities. When these two variables are divided, you get a ratio that depicts a company’s ability to cover its short-term debt obligations.

Say, for instance, a company has cash and cash equivalents to the tune of Rs 60,000. The company’s short-term debt is Rs 45,000. If we apply the formula to these numbers, we get the following result:

Cash Ratio = 60,000/45,000 = 1.3

Thus, as per the information above, the company’s cash ratio is more than 1 and can be considered to be in good health.

Interpretation

If the cash ratio of a company is equal to 1, it means the company has the same amount of current liabilities as the cash assets required to pay them off. If it is greater than 1 then the company is likely in good health and has enough funds to cover its short-term debts, while the risk of default is also very low.

If the ratio is less than 1, then it indicates that the company has fewer liquid assets available and may have difficulty meeting its short-term financial obligations.

However, it is to be noted that there is no ideal figure for the cash ratio. A ratio of around 0.5 to 1 is generally preferred by investors and analysts. The cash ratio is a more conservative measure of the liquidity position than the current ratio or quick ratio as it considers only the most liquid assets which are cash and cash equivalents.

The cash ratio may not be reflective of a company’s overall financial health if a large amount of cash needs to be held. This can lead to an unrealistic ratio that fails to provide an accurate assessment of a company’s situation.

In conclusion, the cash ratio is one of the key indicators of a company’s financial health. It is a useful tool for business owners to monitor their company’s ability to meet short-term debt obligations with current cash-based assets. It is recommended that investors take the time to do their own research and use all available resources to make informed decisions when investing.