Cash Ratio

What Is the Cash Ratio?

The cash ratio is a measurement of a company's liquidity, specifically 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 with cash or near-cash resources, such as easily marketable securities. This information is useful to creditors when they decide how much money, if any, they would be willing to loan a company.

The cash ratio is almost like an indicator of a firm’s value under the worst-case scenario—say, where the company is about to go out of business. It tells creditors and analysts the value of current assets that could quickly be turned into cash, and what percentage of the company’s current liabilities these cash and near-cash assets could cover.

Key Takeaways

  • The cash ratio is a liquidity measure that shows a company's ability to cover its short-term obligations using only cash and cash equivalents.
  • The cash ratio is derived by adding a company's total reserves of cash and near-cash securities and dividing that sum by its total current liabilities.
  • The cash ratio is more conservative than other liquidity ratios because it only considers a company's most liquid resources.

Understanding the Cash Ratio

Compared to other liquidity ratios, the cash ratio is generally a more conservative look at a company's ability to cover its debts and obligations, because it sticks strictly to cash or cash-equivalent holdings—leaving other assets, including accounts receivable, out of the equation.

The formula for a company's cash ratio is:

Cash ratio = Cash & cash equivalents Current liabilities \text{Cash ratio}=\frac{\text{Cash \& cash equivalents}}{\text{Current liabilities}} Cash ratio=Current liabilitiesCash & cash equivalents

As with other liquidity measurements, such as the current ratio and the quick ratio, the formula for the cash ratio uses current liabilities for the denominator. Current liabilities include any obligation due in one year or less, such as short-term debt, accrued liabilities, and accounts payable.

The key difference lies with the numerator. The numerator of the cash ratio restricts the asset portion of the equation to only the most liquid of assets, such as cash on hand, demand deposits, and cash equivalents, including money market accounts funds, savings accounts, and T-Bills.

Accounts receivable, inventory, prepaid assets, and certain investments are not included in the cash ratio, as they are with other liquidity measurements. The rationale is that 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 assets may be indeterminable.

What Does the Cash Ratio Reveal?

The cash ratio is most commonly used as a measure of a company's liquidity. 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.

A cash ratio is expressed as a numeral, greater or less than 1. Upon calculating the ratio, if the result 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.

Less Than 1

If a company's cash ratio is less than 1, there are more current liabilities than cash and cash equivalents. It means insufficient cash on hand exists to pay off short-term debt. This may not be bad news if the company has conditions that skew its balance sheets, such as lengthier-than-normal credit terms with its suppliers, efficiently-managed inventory, and very little credit extended to its customers.

Greater Than 1

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.

While that sounds responsible, a higher cash ratio does not necessarily reflect a company's strong performance, especially if it is significantly greater than the industry norm. 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: Instead of investing in profitable projects, it's letting money stagnate in a bank account. It may also suggest that a company is worried about future profitability and is accumulating a protective capital cushion.

Limitations of the Cash Ratio

The cash ratio is seldom used in financial reporting or by analysts in the fundamental analysis of a company.

It is not realistic for a company to maintain excessive levels of cash and near-cash assets to cover current liabilities. It is often seen as poor asset utilization for a company to hold large amounts of cash on its balance sheet, as this money could be returned to shareholders or used elsewhere to generate higher returns. While providing an interesting liquidity perspective, the usefulness of this ratio is limited.

The cash ratio is more useful when it is compared with industry averages and competitor averages, or when looking at changes in the same company over time. A cash ratio lower than 1 does sometimes indicate that a company is at risk of having financial difficulty. However, a low cash ratio may also be an indicator of a company's specific strategy that calls for maintaining low cash reserves—because funds are being used for expansion, for example.

Certain industries tend to operate with higher current liabilities and lower cash reserves, so cash ratios across industries may not be indicative of trouble.