Definition:

Cash Ratio, sometimes called Cash Coverage Ratio, is one of the Liquidity Ratios that use to assess whether the company’s Cash and Cash Equivalence could pay its Current Liabilities.

Cash Ratio is similar to Quick Ratio and Current Ratio, they all are measure and assess the liquidity problems of the entity. However, Cash Ratio is a bit stick to the most liquid assets which is Cash and Cash Equivalence, rather than Quick Ratio and Current Ratios.

Explanation:

In general, the calculation of this ratio eliminates a large number of current assets including inventories, accounts receivable and other kinds of assets like deposit requirement and short-term investments. The main reason is those kinds of assets could not convert immediately into cash.

Most CFO really serious concern about this ratio because it is linked closely with the operation. The simple example is that if the business run of out cash, it will quickly run out of the business.

And just because of the sales growth, it does not mean the business has enough cash to pay for its suppliers,  and employees. That is why managing cash flow and cash ratio is so important.

Related link: Account Receivable Turnover

Formula:

The Formula of Cash Ratio is as Follow: (Cash + Cash Equivalence)/ Current Liabilities

Cash and Cash Equivalences are very easy to find as it is stated very clearly in the entity Financial Statements. I just want to clarify, Cash Equivalences are the most liquid assets just like cash and they are including the commercial papers and marketable security something.

Current liabilities are the total Current Liabilities in the Financial Statements in the same period to Cash and Cash Equivalence.

Example and Calculation:

ABC Company is an accounting firm providing accounting services to the local market. Currently, the need some cash to expand its operation and approach its bank.

In the current year Financial Statements, the year ended 31 December 2015, the total Cash and Cash Equivalence is $500,000 and the Current Liabilities are $600,000.

Assume you are the credit officer in the bank; assess the Cash Ratio of ABC.

Answer:

The Cash Ratio is calculated by total Cash and Cash Equivalence/ Current Liabilities => $500,000 / $600,000. = 0.81

Interpretation:

The Cash Ratio for ABC is 0.81.

As mention above, Cash Ratio is the Liquidity Ratio that uses to measure how the company’s Current Assets could pay its Current Liabilities by mainly focus on Cash and Cash Equivalence. In general, when the Ratio Equal to one meaning that the company’s Current Liabilities are the same as the cash plus cash equivalence.

Or it means that the company could pay its current debt by using its cash. For credit assessment, sometimes banknote that the company might not be able to pay the internal. If the Cash Ratio above one it means that the company’s Cash and Cash Equivalence is higher than Current Liabilities.

And it is okay for the company to pay for debt or interests. However, when assessing, the amount of Cash and Cash Equivalence should be considered because sometimes the ratios high when the current liabilities are small and cash is just a bit smaller.

Yet, it might be significantly different from the interest payment that they expected to pay.

If the Cash Ratio is below one, it means that the Current Liabilities that the company willing to pay is higher than then its Cash and Cash Equivalences, and for the credit assessment. It is likely that the interest and installment not pay on time.

In this case, the Cash Ratio is 0.81 which below one. It means that ABC might not be able to pay the current liabilities by using its current Cash and Cash Equivalences. Therefore, it is hard for the bank to approve the loan to ABC.

Cash Ratio in Performance Management

Controlling cash flow in the company is one of the challenging tasks for the management team especially CFO and it is not only for the internal objective. But for the purpose of external assessment from customers, banks and especially suppliers.

The main reasons why the customer’s concern about the liquidity of our company are when our company is their big suppliers and the result of bankruptcy will significantly affect their operation. For suppliers, what they concern the most is paying the one time. If we have some cash flow problem, they will certainly in supplying additional goods.

Therefore, controlling Cash Ratio is very important and KPI that could make sure cash flow is running well should be set. For example, cash collection, dealing with customers and negotiation with suppliers or banks.

Written by Sinra