Summary: Investors use the cash ratio to analyze if the company is profitable to invest or not or to measure if the company is able to pay off its short-term debts. Also, the cash ratio is considered to be more obstructive one do you know why? And why do investors rely on the cash ratio more than the current ratio and quick ratio? And what is a good cash ratio? Let’s find out.
What Is Cash Ratio?
A cash ratio is known to be the ratio that measures the ability of the company or liquidity to pay off its debts or say total cash and cash equivalents to its current liabilities, which are the short-term debt obligations of the company.
In comparison to the current ratio or quick ratio, the cash ratio is more obstructive to pay off the debts as you can not use any other current assets for their settlement as only cash can be used for their pay-off or settlement.
The cash ratio information is useful for the creditors to analyze if the company is profitable to invest or not depending upon the cash ratio as it tells the investors will the company will be able to pay off its debts or not or it holds enough current assets or not. Therefore, The cash ratio acts as an indicator of a firm’s value. You can calculate this ratio by dividing the company’s total cash and the cash equivalents with the company’s total current liabilities.
Other than the cash ratio there also exists a cash coverage ratio which measures the ability to pay off the amount of cash available to pay for a borrower’s interest expense and to see that if there are sufficient funds available in order to pay for the interest.
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What is cash ratio formula?
The formula for cash ratio can be stated as follows:
- Cash ratio = ( Cash + Marketable Securities ) / Current Liabilities
Where you can calculate the ratio by dividing the company’s total cash and the cash equivalents with the company’s total current liabilities.
Where in the above cash ratio formula:
- Cash includes the following:
- coins and currency
- demand deposits such as demand deposits
- Cash equivalents denoted the assets that you or the company can convert into cash quickly such as savings accounts, T-bills, and money market instruments.
- Current liabilities denote the debts and commitments needed to be paid off within a period of 1 year such as short-term debt, accounts payable, and accrued liabilities.
Interpretation of Cash Ratio
- Cash Ratio > 1: If the cash ratio is more than 1, it means that the company holds enough of cash and cash equivalents to pay off its debts, i.e. Cash & Cash Equivalent > Current Liabilities, which also tells us that the firm has no utilized its current assets to the fullest.
- Cash Ratio = 1: If the cash ratio is equal to one it means that the company has enough cash to pay off the current liabilities, i.e. Cash & Cash Equivalent = Current Liabilities
- Cash Ratio < 1: If the cash ratio is less than 1, it means that the company does not hold holds enough of cash and cash equivalents to pay off its debts, i.e. Cash & Cash Equivalent < Current Liabilities, which tells us that the firm has utilized its current assets to earn more profit.
What is a good cash ratio?
A good cash ratio is the one in which the company or the firm is capable enough of paying off its debts and liabilities with highly liquid assets. Therefore, a good cash ratio lies somewhere between 0.5 to 1. This tells us that company holds enough of cash and cash equivalents to pay off its debts, i.e. Cash & Cash Equivalent > Current Liabilities.
Cash ratio example: Some of the cash ratio calculation examples are as follows:
Example 1:
Company DEF Ltd balance sheet lists down the following items:
- Cash: $ 20,000
- Cash equivalents: $ 40,000
- Accounts receivable: $ 5,000
- Inventory: $ 30,000
- Property & equipment: $ 50,000
- Accounts payable: $ 22,000
- Short-term debt: $ 20,000
- Long-term debt: $ 20,000
Solution: The ratio for Company DEF Ltd would be calculated as follows with the help of cash ratio formula:
- Cash ratio = ( Cash + Marketable Securities ) / Current Liabilities
- Cash ratio = Cash + Cash equivalents / Accounts payable + Short term debt
= $ 20,000 + $ 40,000 / $ 22,000 + $ 20,000
= 1.42
Analysis: As, the cash ratio is greater than one which tells us that company DEF Ltd is capable of paying its debts well.
Example 2: Sara is asking her bank for a loan of $ 200,000. Sara’s balance sheet lists these items:
- Cash: $ 15,000
- Cash Equivalents: $ 6,000
- Accounts Payable: $ 9,000
- Current Taxes Payable: $ 6,000
- Current Long-term Liabilities: $ 22,000
Solution: Sara’s cash ratio is calculated like this:
- Cash ratio = ( Cash + Marketable Securities ) / Current Liabilities
- Cash ratio = Cash + Cash equivalents / Accounts Payable + Current Taxes Payable + Current Long-term Liabilities
= $ 15,000 + $ 6,000 / $ 9,000 + $ 6,000 + $ 22,000
= $ 21,000 / $ 37,000
= 0.56
Analysis: Here, as you notice the cash ratio is 0.56 which is less than one and tells us that Sara can pay of only 0.56 percent of her liabilities.
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What Does Cash Ratio 0.2 Mean?
The cash ratio indicates the amount of cash that the company has on hand to meet its current liabilities. A cash ratio of 0.2 would mean that for every rupee the company owes creditors in the next 12 months it has 0.2 in cash. 0.2 is considered to be the ideal cash ratio.
Is A Quick Ratio Of 0.5 Good?
A quick ratio of 1 or above is considered good. When the ratio is at least 1, it means a company’s quick assets are equal to its current liabilities. This means the company should not have trouble paying short-term debts. The higher the ratio, the better.
What Causes Low Cash Ratio?
A decline in this ratio can be attributable to an increase in short-term debt, a decrease in current assets, or a combination of both. Regardless of the reasons, a decline in this ratio means a reduced ability to generate cash.
Is A Higher Or Lower Cash Ratio Better?
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.
How Is Cash Ratio Calculated?
Cash ratio = (Cash + Marketable Securities) / Current Liabilities. Quick ratio = (Cash + Marketable Securities + Receivables) / Current Liabilities. Current ratio = (Cash + Marketable Securities + Receivables + Inventory)/ Current Liabilities.
Should Cash Ratio Be High Or Low?
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.
What Is Meant By Cash Ratio?
The cash ratio is a measure of the liquidity of a firm, namely the ratio of the total assets and cash equivalents of a firm to its current liabilities. The metric calculates the ability of a company to repay its short-term debt with cash or near-cash resources, such as securities which are easily marketable.
Conclusion:
The cash ratio that measures the ability of the company or liquidity to pay off its debts or say total cash and cash equivalents to its current liabilities, which are the short-term debt obligations of the company. The current ratio and the quick ratio are less conservative in measuring the company’s liquidity position. Therefore, the investors prefer a cash ratio and it should lie somewhere between 0.5 to 1 to be treated as a good cash ratio.