A current asset ratio or a current ratio measures a company’s liquidity. It reveals the ability of a business to manage its current liabilities through highly liquid assets.
Creditors and analysts can use this metric to assess short-term solvency. However, critics argue that it overstates a business’s short-term risks by excluding some critical components of current assets such as inventory.
Let us see the definition, working example, and interpretation of the cash ratio.
What is the Cash Ratio?
A cash or asset ratio is a measure of liquidity that evaluates a company’s ability to pay its short-term obligations with its cash and cash equivalents.
It is a similar financial ratio as the current ratio and quick ratio. However, the cash asset ratio is more conservative and stricter as it uses only cash and cash equivalents as an ability to pay short-term obligations.
The cash ratio is the most accurate measurement when a company is headed towards insolvency. It considers the most liquid assets in cash and near-cash items.
Cash Ratio Formula
The cash asset or the cash ratio can be calculated using the following formula.
Cash Ratio = (Cash and Cash Equivalents) ÷ Current Liabilities
- Cash: All hard cash in the form of currency notes and coins the company holds. It includes bank instruments such as demand notes, demand drafts, etc.
- Cash Equivalents: According to the GAAP accounting definition, cash equivalents are instruments that can be turned into cash within 90 days.
These instruments may include saving accounts, checking accounts, T-Bills, and other marketable securities.
Note: Cash Equivalents are also risk-free instruments, for example, the US T-Bills.
- Current Liabilities: Current liabilities are all obligations of a business that become due within one year. These include accounts payable, taxes, salaries, and short-term bank loans.
Understanding Cash Ratio
The cash ratio is one of the key liquidity measures. Creditors and lenders can analyze the company’s financial health using several metrics. The most important one is generating cash and making interest payments on time.
The cash ratio is a stricter measure to analyze the liquidity of a business. Although a business can be certain to receive funds in the form of trade sales, accounts receivable, or through the sale of assets, they are still uncertain.
The cash asset ratio only considers what is certain as of now. It means it considers the worst-case scenario for a business.
Thus, creditors can use this metric to decide on financing appraisals accurately compared to other ratios.
Let us suppose the following data for ABC company is available. We’ll calculate the cash ratio from the given data using the abovementioned formula.
- Cash: $50,000
- Bank Accounts: $450,000
- Demand Drafts: $30,000
- Other Cash Equivalents: $50,000
- Trades Receivable: $45,000
- Inventory (Raw Material): $120,000
- Accounts Payable: $65,000
- Short-term Bank Loans: $400,000
- Taxes Due: $45,000
- Long-Term Liabilities: $1,200,000
We’ll need first to calculate the cash and cash equivalent items.
Cash Equivalents: $450,000 + $30,000 + $50,000 = $530,000
Current liabilities= $65,000 + $400,000 + $45,000 = $ 510,000
Current Ratio = (Cash and Cash Equivalent) ÷ Current Liability
Current Ratio = (50,000 + 530,000) / 510,000 = 1.13.
How to Interpret Cash Ratio?
Like any other financial ratio, the cash asset ratio must also be interpreted carefully. It offers useful information about a company’s financial solvency in the short term.
There can be three possible scenarios after the calculations.
The ratio is equal to 1
A cash ratio of 1 means the company has the same cash and cash equivalents as its current liabilities. It means the company is adequately placed to pay off its short-term liabilities without any external financing.
The ratio is greater than 1
It means the company possesses more liquid current assets in cash and cash equivalents than its short-term obligations.
It presents a secure and favorable position for any business to depict a strong financial position in the short run.
The ratio is less than 1
A lower than 1 ratio means the company cannot meet its short-term obligations through its cash and other liquid assets. Although it does not mean the company cannot repay its liabilities, it does reveal short-term financial problems.
Is a Higher Cash Ratio Always Good?
A cash asset ratio above 1 is a positive sign for any business. The company can repay its short-term liabilities using its most liquid resources.
However, it is important to consider other points as well. If a company has a too high cash asset ratio, it is holding a large sum of cash and cash equivalents.
Thus, the company wastes favorable opportunities to invest cash in investment projects to generate higher returns.
Also, a higher ratio can result due to the sale of a large fixed asset or conversion of a long-term asset into a short-term asset due to liquidation.
Like any other financial ratio, it should also be analyzed carefully. A standalone figure cannot reveal much. Analysts must use trends over several accounting periods to fully depict the company’s financial health.
Cash Ratio v Current Ratio v Quick Ratio
We need first to see the three working formulas for these ratios for comparison purposes.
Cash ratio = (Cash + Marketable Securities) / Current Liabilities
Quick ratio = (Cash + Marketable Securities + Receivables) / Current Liabilities
Current ratio = (Cash + Marketable Securities + Receivables + Inventory)/ Current Liabilities
The denominator of all three ratios is the same; the current liabilities. The difference lies between the numerators of all three equations.
The current ratio considers cash, cash equivalents, accounts receivables, and inventory to repay the current liabilities.
The quick ratio removes inventory from the equation. The cash ratio is the strictest, considering only cash and cash equivalent.
These ratios measure the ability of a company to make short-term obligations. The exclusion of certain items is because it may take time to convert some items to cash, for example, inventory.
Advantages of Cash Ratio
The cash ratio is a reliable and accurate measure of the liquidity of a business. It offers several advantages to analysts.
- It is a simple and reliable measure of the short-term solvency of a business.
- It considers only highly liquid assets that can be used quickly to cover short-term obligations.
- Creditors can use it as a guarantee against the default risk of a business as any business is almost certain to possess other assets as well.
Disadvantages of Cash Ratio
The cash asset ratio comes with some limitations as well.
- It excludes several key components of assets for a business.
- It overstates the short-term risks for a well-run business.
- It emphasizes a business to keep cash idle that can generate higher returns through investments otherwise.
- Financial analysts seldom use this ratio in their financial performance evaluations.
The cash asset ratio is one of the most accurate metrics to measure short-term solvency. It offers key insights into a company’s short-term liquidity.
However, it is not a commonly used metric since it excludes some key components of current assets owned by a business.