What is cash ratio?
Cash ratio is one of the three major ways to estimate a company’s liquidity – its ability to pay off its short-term liabilities. Specifically, it measures the company’s total cash deposits and cash equivalents to its current liabilities.
Cash ratio shows analysts and creditors the real value of current assets that can be converted easily into cash. It also details what part of the company’s current liabilities can be covered with these cash and near-cash assets.
Where have you heard about cash ratio?
This data is very important to creditors, when they have to decide what amount of money they are ready to loan. Cash ratio is considered a measure of the company’s value in the worst case scenario – when the company is about to declare insolvency.
How to calculate cash ratio
Cash ratio is calculated by adding the company’s total cash reserves and cash equivalents – marketable securities – and dividing this amount by its current liabilities.
Cash ratio formula:
Cash Ratio = (Cash + Cash Equivalents)/Total Current Liabilities
What you need to know about cash ratio
The same as with other liquidity measurements, including the current ratio and the quick ratio, the cash ratio meaning implies current liabilities as the denominator. Current liabilities typically include any obligations, which are due in a year or less, such as short-term debt, accounts payable, or accrued liabilities.
The major difference is that the cash ratio – the most conservative of the three – takes into account only the most liquid assets, including available cash, marketable securities and demand deposits. Inventory, accounts receivable and prepaid assets are excluded from the cash ratio.
Cash ratio vs. Quick ratio
In addition to cash and assets that can be easily converted into cash, the quick ratio also allows receivables among its short-term assets. Although receivables can also become the company’s possession within a short period of time under normal economic circumstances, a financial crisis could make this difference pretty huge.
In a stable economic environment, well-established companies may get their receivables within a short 10-day period from their financially stable clients. Still, in times of a severe recession, many corporations fail to make promised payments to other companies, which may contribute to the collapse of many businesses.
Quick ratio formula:
Quick Ratio = (Cash + Cash Equivalents + Receivables)/Total Current Liabilities
Cash ratio vs Current ratio
The current ratio also adds a fourth component – inventory – to cash, cash equivalents and receivables.
Similarly with receivables the importance of the current ratio depends on the state of the general economy, the health of the company’s business and the type of business.
Inventory includes assets that haven’t been sold yet. For example, if we talk about the restaurant business, where the inventory represents a predictable flow of goods, the additional risk may be not significant. If we talk about unpredictable business, like fashion, the unsold goods can hardly be estimated as near-cash.
Current ratio formula:
Current Ratio = (Cash + Cash Equivalents + Receivables + Inventory)/Total Current Liabilities