Finance and Lending
What Is a Cash Ratio, and Why Is It Important?
June 7, 2022 |
The C2FO Team
It’s an easy way to measure a company’s liquidity and its ability to pay off short-term debts.
When creditors decide how much money to lend a company, they often consider a company's cash ratio, a metric that calculates its liquidity.
Specifically, the cash ratio measures the relationship between a company's total cash plus cash equivalents, and its current liabilities. Because this metric takes only cash holdings into account, it's considered the most conservative liquidity measurement.
What does a cash ratio consider?
The cash ratio is formulated by dividing a company's cash and cash equivalents by its current liabilities.
A company's cash and cash equivalents include legal tender, demand deposits like checks and bank drafts, and any asset that can be converted to cash quickly, such as Treasury bills, savings accounts and money market mutual funds.
These assets are explicitly restricted to those that can be liquidated almost immediately, usually within 90 days. For that reason, the cash ratio formula doesn't include accounts receivable, inventory, prepaid assets and some investments. This is why the cash ratio is the strictest liquidity measurement.
A company's current liabilities include any debts due within a year, such as accounts payable, income and payroll taxes payable, interest payable, bank overdrafts, accrued expenses and short-term debts.
How to calculate cash ratio
The cash ratio formula will generate a numeral greater than or less than 1.
Let's figure out the cash ratio for Hypothetical Inc. Its balance sheet reads like this:
Hypothetical Inc.'s cash and cash equivalents add up to $100,000. The company's current liabilities — encompassing accounts payable and short-term loans — amount to $175,000. When we apply the formula – $100,000 divided by $175,000 – Hypothetical Inc.'s cash ratio is 0.57. What does this number tell us about the company's finances?
How to interpret the cash ratio
Experts disagree on what is a good cash ratio. Some argue that a cash ratio that’s close to 1 or a little higher is best. Others say that a ratio between 0.5 and 1 is ideal.
The cash ratio demonstrates a company's ability to pay off any short-term debts if it should fold. If a company's cash ratio equals 1, it has precisely the right amount of cash to pay off 100% of its liabilities.
Hypothetical Inc.'s cash ratio of 0.57 means it only has enough cash to pay a little more than 50% of its obligations. This could indicate a solvency issue. Or perhaps the company is having difficulties getting its customers to pay bills on time. A more efficient accounts receivable department might resolve the issue.
Because the cash ratio indicates how much money is available for paying debts, creditors generally prefer a higher cash ratio. However, having a ratio significantly greater than 1 doesn't always indicate that a business is thriving.
If a company has a cash ratio of 1.5, it has enough liquidity to pay its debts, with extra cash to spare. Seems like a pretty responsible strategy, right? However, it also means that perhaps the company isn't maximizing the potential of its profits. Cash that languishes in a regular bank account won't produce additional capital. Money placed in smart investments will.
A cash ratio higher than 1 could also indicate that a company is concerned about its future. Instead of financing additional ventures or products, maybe the company is expecting a rocky road ahead and is holding on to its cash cushion tightly.
Though Hypothetical Inc.'s cash ratio of 0.57 discloses that it doesn't have enough cash reserves to pay off 100% of its debt at this exact moment in time, it is not necessarily a red flag concerning the company's financial health.
Investors and most financial analysts would note a large amount of cash on the balance sheet as a poor use of assets. Perhaps Hypothetical Inc. is using its extra cash to pursue a new product venture. Investors would appreciate that the company is reinvesting its profits so shareholders could realize even higher returns.
The cash ratio offers better information about a company when it is compared with the average cash ratios of both competitors and the industry as a whole. This metric is also more helpful when examining a company's performance over time. If Hypothetical Inc. has had a consistently low cash ratio for several years, this could indicate that the company is struggling to stay profitable.
The bottom line
To calculate cash ratio, divide cash and cash equivalents by current liabilities.
The cash ratio establishes how much money is available for paying all debts if the company goes out of business.
Using the cash ratio alone isn't necessarily the best approach to analyzing a company's cash flow.