What’s it: The cash ratio is a financial ratio to measure a company’s ability to meet its short-term liabilities. It is the most conservative ratio in measuring liquidity compared to the current ratio or quick ratio. This is because it only considers the most liquid assets and compares them to current liabilities.
A higher ratio is better because it reflects better ability. And the company has more funds to cover short-term bills. Conversely, if it is too low, the company may be in financial trouble and find it difficult to meet its short-term obligations.
We should compare how high or low this ratio is with the industry average to provide a more objective insight. In addition, we should explore why the ratio is rising or falling, including examining the strategies the management is currently adopting.
Why does the cash ratio matter?
The cash ratio is used to measure the company’s financial health. It shows us how much of a company’s most liquid assets, namely cash and cash equivalents, can cover short-term liabilities.
If the most liquid assets are sufficient, the company does not have to sell or liquidate other assets. But, if not, the company must raise money from various sources, including collecting accounts receivable, converting inventory, selling its fixed assets, or taking on debt.
The cash ratio is the most stringent metric in evaluating liquidity. It is usually used to measure how well the company’s liquidity position is to deal with stressful conditions. If it has large cash, the company has sufficient cushion to deal with these difficult situations.
Then, creditors usually follow this ratio to decide how much money they can lend to the company. Generally, they like it if the company has large cash because it tends to pay better.
How is the cash ratio calculated?
As with calculating the current ratio and the quick ratio, we use current liabilities as the denominator. Meanwhile, as the numerator, we use cash and cash equivalents. We can find them on the balance sheet.
- Cash represents the most liquid asset a company can immediately use to pay bills.
- Cash equivalents are highly liquid marketable securities, which can be quickly converted into cash with minimum interest rate risk and fairly close to maturity.
- Current liabilities are the portion of liabilities expected to be settled within one year or the normal operating cycle, for example, trade payables.
Here is the cash ratio formula:
- Cash ratio = Cash + Cash equivalents / Current liabilities
The cash ratio excludes other accounts in current assets, such as accounts receivable and inventories. That’s because they take a long time to convert into cash. In addition, accounts such as prepaid expenses are excluded because they do not contribute to cash inflows but only inflows of economic benefits.
How to interpret the cash ratio?
A higher ratio is desirable as it indicates better capability. The company has sufficient cash to cover its bills. For example, a ratio above one means the company has more than enough cash and cash equivalents to pay its short-term bills without selling or liquidating other assets.
Then, the ratio equals one if the company’s most liquid assets are equal to its current liabilities. In other words, the company can pay one hundred percent of its existing bill with cash and cash equivalents.
Meanwhile, if the ratio is less than one, the company’s cash and cash equivalents are insufficient to cover current liabilities. For example, a ratio equal to 0.75 means these assets can only cover 75 percent of the short-term liabilities. This situation could indicate a liquidity problem.
Is a high ratio always good?
The cash ratio may not provide an overall insight into a company’s financial health. For example, a higher cash ratio does not necessarily reflect strong company performance.
On the contrary, it could signal inefficiency in utilizing its cash. The company holds too much cash and may miss the opportunity to use it more productively. For example, a company could use its cash to buy new machinery or acquire another company to support higher future earnings.
And, in a nutshell, holding cash has an opportunity cost. The more cash on hand, the higher the opportunity costs involved. And, investing in projects can be more profitable than letting money stagnate in a bank account.
Is a low ratio always bad too?
Indeed, a lower ratio means less cash and cash equivalents are available to pay bills. Yet, it may not always be bad news or lead to a liquidity crunch. Thus, we must examine the company’s finances more deeply.
Even if there are insufficient liquid assets, the company may take strategic steps to cover its bills. For example, it could intensify efforts to collect accounts receivable or sell inventory for cash. In this case, we need to examine how much potential cash can be collected and how many days will it take to collect it?
Another alternative to improving this ratio is to renegotiate and extend credit terms with its suppliers. If successful, the denominator in the ratio will be lower, and therefore, the ratio will be higher.
Then, management may still tolerate a low cash ratio in specific cases. For example, they choose to have less cash cushion because they drive future business growth. Thus, more cash is invested than held.
