What is the 'Cash Ratio'
The cash ratio is the ratio of a company's total cash and cash equivalents to its current liabilities. The metric calculates a company's ability to repay its short-term debt; this information is useful to creditors when deciding how much debt, if any, they would be willing to extend to the asking party. The cash ratio is generally a more conservative look at a company's ability to cover its liabilities than many other liquidity ratios because other assets, including accounts receivable, are left out of the equation.
BREAKING DOWN 'Cash Ratio'The cash ratio is most commonly used as a measure of company's liquidity. The metric calculates a company's ability to pay current liabilities using only cash and cash equivalents on hand. If the company is forced to pay all current liabilities immediately, this metric shows the company's ability to do so without having to sell or liquidate other assets.
Items Omitted From the Cash Ratio
Accounts receivable, inventory, prepaid assets and certain investments are not included in the cash ratio. These items may require time and effort to find a buyer in the market. In addition, the amount of money received from the sale of any of these items may be indeterminable. The cash ratio restricts the asset portion of the equation to only the most liquid of assets.
Cash Ratio Results
If a company's cash ratio is equal to 1, the company has exactly the same amount of current liabilities as it does cash and cash equivalents to pay off those debts.
If a company's cash ratio is less than 1, there are more current liabilities than cash and cash equivalents. In this situation, there is insufficient cash on hand to pay off short-term debt.
If a company's cash ratio is greater than 1, the company has more cash and cash equivalents than current liabilities. In this situation, the company has the ability to cover all short-term debt and still have cash remaining.
Usefulness of the Cash Ratio
The cash ratio is more useful when it is compared to industry averages and competitor averages. A cash ratio lower than 1 does indicate a company is having financial difficulty. A low cash ratio may be an indicator of a company's strategy to have low cash reserves. However, certain industries operate with higher current liabilities and lower cash reserves. In addition, a higher cash ratio does not necessarily reflect a company's strong performance. High cash ratios may indicate that a company is inefficient in the utilization of cash or not maximizing the potential benefit of low-cost loans.