Cash Ratio

What Is the Cash Ratio?

The cash ratio is a measurement of a company's liquidity. It specifically calculates the ratio of a company's total cash and cash equivalents to its current liabilities. The metric evaluates 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.

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.
  • A calculation greater than 1 means a company has more cash on hand than current debts, while a calculation less than 1 means a company has more short-term debt than cash.
  • Lenders, creditors, and investors use the cash ratio to evaluate the short-term risk of a company.

Cash Ratio Formula

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

What Cash Ratio Can Tell You

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.

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.

Through the use of this and other liquidity ratios, the U.S. Small Business Administration advises companies on monitoring healthy levels of liquidity, capacity, and collateral, especially when building relationships with lenders. As companies pursue loans, lenders will analyze financial statements to evaluate the health of the company.

Calculations 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 if the company has conditions that skew its balance sheets such as long credit terms with its suppliers, efficiently-managed inventory, and very little credit extended to its customers.

Calculations 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 a higher cash ratio is generally better, a higher cash ratio may also reflect that the company is inefficiently utilizing cash or not maximizing the potential benefit of low-cost loans. Instead of investing in profitable projects or company growth. A high cash ratio may also suggest that a company is worried about future profitability and is accumulating a protective capital cushion.

Example of Cash Ratio

At the end of 2021, Apple, Inc. held $37.1 billion of cash and $26.8 billion of marketable securities. In total, Apple had $63.9 billion of funds available for the immediate payment of short-term debt. Between accounts payable and other current liabilities, Apple was responsible for roughly $123.5 billion of short-term debt.

Short-Term Ratio = $63.9 million / $123.5 billion = Roughly 0.52

Apple's operating structure shows the company leverages debt, takes advantage of favorable credit terms, and prioritizes cash for company growth. Despite having billions of dollars on hand, the company has nearly twice as many short-term obligations.

The current ratio and the cash ratio are very similar. However, the current ratio includes more assets in the numerator; therefore, the cash ratio is a more stringent, conservative metric of a company's liquidity.

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.

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. Certain industries tend to operate with higher current liabilities and lower cash reserves.

The cash ratio may be most useful when analyzed over time; a company's metric may currently be low but may have been directionally improving over the past year. The metric also fails to incorporate seasonality or the timing of large future cash inflows; this may overstate a company in a single good month or understate a company during their offseason.

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.

What Is a Good Cash Ratio?

The cash ratio will vary between industries as some sectors rely more heavily on short-term debt and financing (i.e. sectors that rely on quick inventory turnover). In general, a cash ratio equal to or greater than 1 indicates a company has enough cash and cash equivalents to entirely pay off all short-term debts. A ratio above 1 is generally favored, while a ratio under 0.5 is considered risky as the entity has twice as much short-term debt compared to cash.

What Does Cash Ratio Measure?

The cash ratio is one way to measure a company's liquidity. Liquidity is a measurement of a person or company's ability to pay their current liabilities. If a company has high liquidity, it is able to pay their short-term bills as they come due. If a company has low liquidity, it is going to have a more difficult time paying short-term bills.

How Do You Calculate Cash Ratio?

The cash ratio is calculated by dividing cash by current liabilities. The cash portion of the calculation also includes cash equivalents such as marketable securities.

Is It Better to Have a High or Low Cash Ratio?

It is often better to have a high cash ratio. This means a company has more cash on hand, lower short-term liabilities, or a combination of the two. It also means a company will have greater ability to pay off current debts as they come due.

It is possible for a company's cash ratio to be considered too high. A company may be inefficient in managing cash and leveraging low credit terms. In these cases, it may be advantageous for a company to reduce their cash ratio.

How Can a Company's Cash Ratio Improve?

The cash ratio is calculated by dividing cash and cash equivalents by short-term liabilities. To improve its cash ratio, a company can strive to have more cash on hand in case of short-term liquidation or demand for payments. This includes turning over inventory quicker, holding less inventory, or not prepaying expenses.

Alternatively, a company can reduce its short-term liabilities. The company can begin paying expenses with cash if credit terms are no longer favorable. The company can also evaluate spending and strive to reduce its overall expenses (thereby reducing payment obligations).

Article Sources
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  1. U.S. Small Business Administration. "Capacity and Credit."

  2. Apple, Inc. "Apple Reports First Quarter Results."

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