The cash ratio is a crucial measurement of a company’s liquidity. It evaluates the ratio of a company’s total cash and cash equivalents to its current liabilities, assessing its capacity to repay short-term debt with highly liquid resources, like easily marketable securities. This metric provides valuable insights for creditors determining loan viability.
Key Takeaways
- The cash ratio indicates a company’s ability to cover short-term obligations using only cash and cash equivalents.
- It is derived by adding a company’s cash and near-cash securities and dividing the sum by total current liabilities.
- Being more conservative than other liquidity ratios, the cash ratio only considers the most liquid resources.
- A calculation over 1 suggests more cash on hand than current debts, while under 1 indicates more short-term debt than cash.
- Lenders, creditors, and investors use the cash ratio to gauge short-term financial risk.
Conservative Metric: Cash Ratio Formula
The formula for a company’s cash ratio is strict compared to other liquidity ratios because it adheres solely to cash or cash-equivalent holdings:
Cash Ratio: Cash + Cash Equivalents / Current Liabilities
Importance of Cash Ratio
The cash ratio mainly measures a company’s ability to meet immediate liabilities without liquidating other assets. Expressed as a number over or under 1, it depicts a company’s liquidity. A ratio of 1 signifies the company has equal current liabilities and cash equivalents to cover debts.
Assessing Liquidity
- Calculations Less Than 1: More current liabilities than cash and cash equivalents. This isn’t necessarily negative if the company has efficient inventory management and long credit terms with suppliers.
- Calculations Greater Than 1: More cash and cash equivalents than current liabilities, indicating a company’s capacity to cover all short-term debt with surplus cash remaining.
Real-World Example of Cash Ratio
At the end of 2021, Example Corp had $37.1 billion in cash and $26.8 billion in marketable securities, totaling $63.9 billion available for short-term debt payment. With $123.5 billion in short-term debt, the calculation is:
Cash Ratio = $63.9 billion / $123.5 billion ≈ 0.52
This example shows that despite ample cash, Example Corp has nearly twice as many short-term obligations as it can cover with immediate funds, revealing operational leverage and prioritized growth investments.
Limits of the Cash Ratio
Although useful, the cash ratio is rarely utilized in financial reporting or fundamental analysis due to unrealistic expectations for maintaining excessive cash levels. It’s more effective when compared within industry norms or tracking changes over time. Industry-specific cash management strategies can significantly affect the metric.
Ideal Cash Ratio
A cash ratio equal to or above 1 generally indicates sound financial health, where short-term debts can be repaid entirely from cash reserves. A ratio below 0.5 suggests the entity faces higher risk, aligning with double short-term debts compared to cash.
Measuring Liquidity
The cash ratio provides one measure of a company’s liquidity, reflecting its ability to meet current liabilities. High liquidity signals smooth short-term bill payments, while low liquidity may indicate challenges in covering immediate obligations.
Calculating Cash Ratio
Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities Inclusions in the cash portion account for marketable securities.
High or Low Cash Ratio – What’s Better?
A higher cash ratio generally reflects stronger capability to pay off debts. However, excess cash might indicate inefficient cash management without leveraging low-cost credit terms. Ideally, balance should be pursued.
Improving Cash Ratio
Improvement involves either increasing cash reserves through efficient inventory turnover or reducing short-term liabilities by limiting prepaid expenses or decreasing overall spend.
Optimizing the cash ratio is a balancing act that aligns with specific company strategies, driving growth while maintaining financial stability.
Related Terms: current liabilities, current assets, liquidity ratios, cash and cash equivalents.
References
- U.S. Small Business Administration. “Capacity and Credit”.
- Apple, Inc. “Apple Reports First Quarter Results”.
