Cash ratio definition
/What is the Cash Ratio?
The cash ratio compares a company's most liquid assets to its current liabilities. The ratio is used to determine whether a business can meet its short-term obligations - in effect, whether it has sufficient liquidity to stay in business. It is the most conservative of all the liquidity measurements, since it excludes inventory (which is included in the current ratio) and accounts receivable (which is included in the quick ratio). This ratio may be too conservative, especially if receivables are readily convertible into cash within a short period of time.
How to Calculate the Cash Ratio
The formula for the cash ratio is to add together cash and cash equivalents, and divide by current liabilities. Cash equivalents include highly liquid investments having a maturity of three months or less. They should be at minimal risk of a change in value. Examples of cash equivalents are bankers’ acceptances, certificates of deposit, commercial paper, marketable securities, money market funds, short-term government bonds, and treasury bills. A variation that may be slightly more accurate is to exclude accrued expenses from the current liabilities in the denominator of the equation, since it may not be necessary to pay for these items in the near term. The calculation is:
(Cash + Cash equivalents) ÷ Current liabilities = Cash ratio
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Disadvantages of the Cash Ratio
There are several disadvantages associated with reporting a cash ratio, which are as follows:
Requires an excessive cash load. If a company wants to show a high cash ratio to the outside world, it must keep a large amount of cash on hand as of the measurement date, probably more than is prudent.
Only measured as of a point in time. The cash ratio only measures cash balances as of a specific point in time, which may vary quickly, as receivables are collected and suppliers are paid.
Given these concerns, a better measure of liquidity is the quick ratio, which includes accounts receivable in the numerator of the ratio.
Example of the Cash Ratio
ABC Company has $100,000 of cash and $400,000 of cash equivalents on its balance sheet at the end of May. On that date, its current liabilities are $1,000,000. Its cash ratio is:
($100,000 Cash + $400,000 Cash equivalents) ÷ $1,000,000 Current liabilities
= 0.5:1 Cash ratio
Terms Similar to Cash Ratio
The cash ratio is also known as the liquidity ratio.
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