To run a business requires cash every day and a business maintains liquidity level at a certain point when compared to its liabilities which helps to grow a business.
The cash ratio is one of the most liquidity ratios, which can help a company to evaluate its current financial position and stability.
The cash ratio is more conservative compared to other important liquidity ratios such as the current ratio & quick ratio since only cash & cash equivalents are compared with current debt obligations.
What is the Cash Ratio?
The cash ratio is also known as the super quick ratio that measures the cash position of the company to pay off immediate short term obligations.
The ratio estimates the ability of a company to pay back its short-term obligation with cash or near-cash reserves, such as securities that are easily marketable.
This data is beneficial when investors infer how much money they will be willing to loan a company if any.
In the worst-case scenario, the cash ratio is almost like an evaluation of a firm's value — say, that the company is about to relinquish the business.
It tells analysts and creditors the value of current assets that could be converted fast into cash, and what percentage of the current liabilities of a company could fill in these cash and near-cash assets.
How do you Calculate the Cash Ratio?
The two major components of the cash ratio involve cash and cash equivalents and current liabilities.
The cash ratio formula is calculated by cash and cash equivalents dividing by current liabilities. The cash ratio formula is following:
Cash Ratio = (Cash & Cash Equivalents / Current Liabilities)
Cash & Cash Equivalents:
The cash lying in the hand and bank accounts can be a form of fixed deposits and current accounts the bank is recorded under this head.
Cash equivalents are those short-term assets or current assets that can be immediately converted into cash and are highly liquid.
For example stocks, bonds, government securities, treasury bills, bank deposits, money market instruments, mutual funds etc.
The cash and cash equivalents comprise those assets whose encashment is easily converted into cash within a very short period say three months.
For this reason, accounts receivable and income from investment does not include cash equivalents while calculating the cash ratio.
Current Liabilities:
Current liabilities are also called short term liabilities and these obligations have to be settled within one year.
Current liabilities imply short term financial health and the position of a company. For example, accrued expenses, short term loans, bills payable, interest payable, tax payable, bank overdraft provision for taxation, proposed dividend, unclaimed expenses, etc.
Cash Ratio Example:
Suppose it is an ABC company. Here is some information about ABC company,
The balance sheet of ABC company as on 31.03.2019
| Particular | Amount (Rs.) |
|---|---|
| Non-current assets | |
| Fixed assets | 425,000 |
| Long term investments | 390,000 |
| Total non-current assets | 815,000 |
| Current assets | |
| Cash in hand | 20,000 |
| Bills receivable | 50,000 |
| Inventory | 250,000 |
| Prepaid expenses | 100,000 |
| Short term loans | 200,000 |
| Total current assets | 620,000 |
| Total assets | 14,35,000 |
| Equity | |
| Share capital | 600,000 |
| Reserve | 330,000 |
| Total equity | 930,000 |
| Non-current liabilities | |
| Debentures | 200,000 |
| Long-term loans | 150,000 |
| Total non-current liabilities | 350,000 |
| Current liabilities | |
| Bills payable | 50,000 |
| Overdraft | 100,000 |
| Short-term loans | 5,000 |
| Total current liabilities | 155,000 |
| Total equity and liabilities | 14,35,000 |
Cash Ratio = { (50000+20000) / 155000 }
Cash Ratio = (70000 / 155000)
Cash Ratio = 0.45 or 45%
The cash ratio is 0.45 means company ABC has signified cash & Cash equivalents to pay off 45% of its current liabilities.
It reflects the company ABC may suffer to pay off its current liabilities.
Cash Ratio Interpretation:
The cash ratio is a liquidity ratio that tells you the immediate Liquid position of the company and the ratio is very conservative. If a company has sufficient cash & cash equivalents will cover current liabilities.
Creditors prefer a high cash ratio because more liquid assets are available to pay off very short term current debts.
There is no ideal figure in cash ratio and most creditors recommend a high cash ratio, as it implies that a company can easily pay off its outstanding obligation.
Greater Than 1:
Generally, a cash ratio greater than 1, reveals that the company will be able to pay off its short term liabilities with its cash & cash equivalents. However, a very higher cash ratio does not mean that a company performs well.
A very high cash ratio indicates that the company is not utilizing its cash efficiently or not the maximum of the probable advantage of low-cost loans.
Less than 1:
A cash ratio of less than 1 reveals the poor short term Solvency position of the company and the more current liabilities than cash and cash equivalents.
It means the company has insufficient cash to pay off its current debts with cash & cash equivalents. A very low cash ratio indicates that the company is not keeping sufficient cash to run the business or operations.
This may not always be a negative aspect because some companies can efficiently handle the condition.
Such as limited credit extended to its customers, effective inventory management and lengthier credit agreements with its suppliers.
Equal to 1:
A cash ratio equal to 1 means cash and cash equivalents are equal to the short term obligations or liabilities. In this situation, the two components of the cash ratio assembly flawlessly.
What is a good cash ratio?
A good cash ratio depends on the nature of business and there is no ideal cash ratio but lenders preferred minimum cash ratio should be 0.5 to 1.
It is important to remark, the cash ratio does not convey an overall snapshot of the company but this ratio helps to understand the liquid position of the company.
The cash ratio conveys the most prudent understanding of a company’s liquidity since only cash and cash equivalents are taken into consideration.
The cash ratio does not matter to the investors but in the banking sectors, the significant cash ratio is a matter very largely.
The cash ratio is more significant when comparing companies in the same sector and as a smart investor better to find out a trend of the last few years of a company's cash ratio.
What are the limitations of the Cash Ratio?
The cash ratio is rarely used to infer the financial strength in the ratio analysis which belongs to the fundamental analysis of a company.
The cash ratio has few limitations that investors should be conscious of this. The limitations are following:
1. It is not rational to sustain a company to unreasonable levels of cash and near-cash assets to fill in current liabilities.
Furthermore, holding a large amount of cash could be dangerous to the business and the idle cash does not add any value to the company's balance sheet.
2. In most cases, the cash ratio is more useful when comparing companies within the industry average and also look at the asymmetrical cash ratio in a similar company over the period.
3. Even a low cash ratio may be expressive of a company sustaining financial disruption, it may indicate a specific strategy that the business pursues.
For instance, if a company is presently looking for expansion it may decide to maintain low cash reserves in favour of spending more on new hires and supply lines.
However, the specific industries tend to operate with higher current liabilities and lower cash reserves, so cash ratios across industries may not be indicative of trouble.
4. It does not consider the effect of the disaster on otherwise easily marketable securities.
Although it is considered the most liquid assets, it is difficult to trade cash equivalents during a difficult situation.
