How to calculate & interpret cash ratio for your small business

- What is the cash ratio?
- Cash ratio formula
- How to calculate your business’ cash ratio
- What the cash ratio tells you (and what it doesn't)
- Common challenges of calculating and interpreting cash ratio

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 business’ 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 ratio (also known as the acid-test ratio) 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 liabilitiesencompass 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 business’ cash ratio
Calculating your cash ratio is a relatively simple exercise. Consider Company XYZ. Company XYZ has the below total 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 your company's overall liquidity position. In general, this financial 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; in some cases, with short-term assets. 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 with healthy cash flow 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
Cash ratio analysis 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 (like lenders) 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.

FAQs
“We’ve simplified our workflows while improving accuracy, and we are faster in closing with the help of automation. We could not have achieved this without the solutions Ramp brought to the table.”
Kaustubh Khandelwal
VP of Finance, Poshmark

“Our previous bill pay process probably took a good 10 hours per AP batch. Now it just takes a couple of minutes between getting an invoice entered, approved, and processed.”
Jason Hershey
VP of Finance and Accounting, Hospital Association of Oregon

“When looking for a procure-to-pay solution we wanted to make everyone’s life easier. We wanted a one-click type of solution, and that’s what we’ve achieved with Ramp.”
Mandy Mobley
Finance Invoice & Expense Coordinator, Crossings Community Church

“We no longer have to comb through expense records for the whole month — having everything in one spot has been really convenient. Ramp's made things more streamlined and easy for us to stay on top of. It's been a night and day difference.”
Fahem Islam
Accounting Associate, Snapdocs

“It's great to be able to park our operating cash in the Ramp Business Account where it earns an actual return and then also pay the bills from that account to maximize float.”
Mike Rizzo
Accounting Manager, MakeStickers

“The practice managers love Ramp, it allows them to keep some agency for paying practice expenses. They like that they can instantaneously attach receipts at the time of transaction, and that they can text back-and-forth with the automated system. We've gotten a lot of good feedback from users.”
Greg Finn
Director of FP&A, Align ENTA

“The reason I've been such a super fan of Ramp is the product velocity. Not only is it incredibly beneficial to the user, it’s also something that gives me confidence in your ability to continue to pull away from other products.”
Tyler Bliha
CEO, Abode
