When evaluating a company's ability to pay down short-term debt, liquidity ratios like the current and quick ratios often come to mind.
However, another means of calculating liquidity is your businesses’ cash ratio. Your cash ratio provides financial planning & analysis teams with the means to determine whether your company has enough cash to pay down current liabilities.
In this article, we'll explore the cash ratio, its formula, and the limitations of its use.
What is the cash ratio?
The cash ratio is a liquidity metric calculated from certain line items on your balance sheet. The calculation results indicate whether your company has enough cash to cover all its short-term liabilities.
The cash ratio differs from other liquidity measures like the quick or current ratio. When evaluating a company's liquidity, the quick and current ratios consider all existing current assets, including accounts receivable and inventory. However, the cash ratio considers only fully liquid assets, such as your company's cash and cash equivalents.
Cash ratio formula
Here’s how to calculate your cash ratio:
Cash ratio = cash and cash equivalents / current liabilities
In this formula, cash includes the balance of all checkings and savings accounts and any available cash on hand.
Cash equivalents include any readily convertible assets. Examples of cash equivalents include money market accounts, marketable securities, and T-bills.
Current liabilities encompass all short-term debts due in one year or less. Current accounts payable, accrued liabilities, and any short-term installment debts are examples of current liabilities.
How to calculate your businesses’ cash ratio
Calculating your cash ratio is a relatively simple exercise. Consider Company XYZ. Company XYZ has the below assets and liabilities on its year-end balance sheet.
- $8M Cash
- $1.5M Cash equivalents
- $7M Accounts receivable
- $1M Inventory
- $2.5M Property and equipment
- $4M Current accounts payable
- $2.5M Accrued liabilities
- $1.5M Installment debt
- $7M Long-term debt
Using the cash ratio formula, we find that Company XYZ has a cash ratio of 1.1875:
Cash ratio = ($8M cash + $1.5M cash equivalents) / ($4M accounts payable + $2.5M accrued liabilities + $1.5M installment debt)
According to the cash ratio formula, Company XYZ has enough cash and cash equivalents to pay for all of its short-term obligations without needing additional means of alternative funding.
Notice that we do not include the value of other assets and liabilities, such as inventory, accounts receivable, property and equipment, and long-term debt in the cash ratio calculation.
The cash ratio does not consider the value of inventory, accounts receivable, and property and equipment as easily convertible liquid assets. Accounts receivable usually take time to collect, and inventory, property, and equipment are not readily convertible to cash.
Companies classify long-term debt as due over a period longer than twelve months. Because of this, organizations do not consider long-term debt when using the cash ratio formula.
What the cash ratio tells you (and what it doesn't)
The cash ratio helps evaluate the overall liquidity of your company. In general, your cash ratio provides analysts and business managers with the following information:
Availability of cash-on-hand to cover short-term debts
The cash ratio indicates the ability of your company to cover all its short-term debts. A cash ratio of 1 or more demonstrates that the organization can cover all its short-term debts without additional financing. If the cash ratio falls below 1, the company will be unable to pay all current liabilities without diving into other resources or obtaining a loan.
Indication of potential growth prospects
Organizations that have large amounts of cash have strong growth potential. Company managers or owners can use the excess money to expand the business or purchase other firms to grow their customer base. Conversely, a company without much cash may find it difficult to grow without a cash influx from a loan or investment.
Conservative measurement of cash
The cash ratio is considered a conservative measure of a company's liquidity since it doesn't include accounts receivables or inventory.
The strictness of the cash ratio is helpful for analysts who only want to consider the actual available funds of the business. They don't want to incorporate the value of accounts receivable, which may decline if customers don't pay their bills, or the value of inventory, which can vary depending on how the company uses it.
Helpful for creditors seeking insight into a company's ability to service a loan
Banks and other financial institutions predominantly use the cash ratio when evaluating a company's repaying loan prospects. Banks are more likely to fund organizations with a more substantial cash ratio. A good cash ratio is between 0.5 to 1.0.
If the company has a cash ratio below 0.5, it may not have enough money to repay its debts. Cash ratios above 1.0 indicate that the company isn't using its cash for growth-generating activities, like expansion or research and development.
Best for long-term financial analysis
The cash ratio doesn't fully tell you how to evaluate a company's financial performance. It's best to calculate the cash ratio over the long term. For instance, a cash ratio measured every quarter can help determine if the company's cash reserves remain stable or are falling.
Comparing the cash ratio among companies in the same industry is also beneficial. An organization with a cash ratio significantly higher or lower than other businesses in the same market sector helps evaluate company performance compared to its peers.
The cash ratio is only one measurement that a company can use to measure liquidity and improve working capital. Using the cash ratio in combination with other financial management strategies and ratios provides the most insights into a company's financial health.
Common challenges of calculating and interpreting cash ratio
The cash ratio is relatively easy to calculate. As long as the company creates a balance sheet that classifies its general ledger accounts into the proper categories, financial analysts can quickly obtain the values necessary for calculating the cash ratio.
Problems arise when general ledger accounts do not properly segregate current liabilities. For instance, the cash ratio may be skewed if accounts payable or accrued liabilities include debts due in periods extending past one year.
Analysts must also be careful not to incorporate assets that are not considered cash equivalents, like inventory or accounts receivables.