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Does your company have enough Liquidity?

Created on 03 Sep 2019

Wraps up in 4 Min

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Updated on 09 Oct 2020

Importance of liquidity assets

Your company’s revenue figures are great to flaunt, but they don’t ultimately mean much if your cash flow is out of whack. Profit offers peace of mind, surely, but it doesn’t indicate that your business financials are sound. Only stable, reliable cash flows can truly demonstrate success. 

Companies maintain numerous liquid assets to pay for the contingencies or to provide for the current assets. However, the most liquid of all, the current assets are cash in hand/bank and the cash equivalents which can also be termed as near-cash assets because they can be easily converted into cash when the need arises.
In order to find out how well the company maintains its liquidity in terms of cash, companies usually find out the cash ratio.
Let us understand this ratio in detail to know about its working and go through some of the examples.

Cash Ratio

Cash ratio is a kind of ratio that measures the liquidity of the company. It helps to determine the ability of a company to pay off its short-term debt obligation by its cash and cash equivalents. This ratio is stricter as compared to other liquidity ratios such as the current ratio and quick ratio because it uses the most liquid assets of the company, i.e., cash and cash equivalents. 
This ratio is also used by creditors to observe the paying capacity of the firm and risks associated if any credits are given to them.

Calculation of cash ratio
Formula 
Cash ratio= cash and cash equivalents/current liabilities

Where,

Cash and cash equivalents include bank accounts, marketable securities, commercial paper, Treasury bills, government bonds, etc. with a maturity date of three months or less. 

Current liability includes accrued taxes, outstanding expenses, loans payable, etc.

Interpretation

The cash ratio helps the creditors to estimate whether the company has enough cash resources to pay off its short-term liabilities or not.

  • A ratio that is equal to 1 shows that the cash and cash equivalents are just equal to pay off its current liabilities and that there exist no idle cash resources with the company.

  • A ratio of below 1 will show that the cash reserves of the company are insufficient to pay off its short-term obligations. However, it is not necessary that this is taken to be bad news on the part of the company because it might be possible that the credit period to pay off these debts is longer than usual or very less credit is provided to its customers or they have a well-managed inventory system.

  • There can also be a case wherein the company has a cash ratio which is above 1, which implies that the cash and cash equivalents are in excess to the current liabilities. Though this seems to be a good situation for the company it may not always be comforting because it implies that there exists inefficiency in utilizing the cash and its potential. The cash is kept idle in the accounts instead of investing in projects which may be profitable and bring growth. 

Example 

  1. Rooftop Palace is a restaurant that is looking to remodel its dining room. Its owner is asking the bank for a loan of Rs 100,000. The balance sheet lists the following items:

Cash: Rs 10,000

Cash Equivalents: Rs 2,000

Accounts Payable: Rs 5,000

Current Taxes Payable: Rs 1,000

Current Long-term Liabilities: Rs 10,000

 The cash ratio can be calculated as follows:

Cash ratio= cash+ cash equivalents/ total current liabilities

                  = 12000/16000

 Cash ratio= 0.75

Since the cash ratio in the above example is less than 1, it implies that the company is short of cash reserves and might not be able to repay all the current debts by its existing value of cash in hand.

Limitations
  • Limited usefulness

Cash ratio is not used that often by companies because it is not thought to be realistic to keep a large amount of cash or near cash assets to pay-off the current liabilities. These cash balances which are required to be maintained under this ratio could be reinvested in places that would generate better returns for the company.

  • Comparative usage

The cash ratio is useful when it is compared with industry and competitor’s ratio, or when studying changes in the same company over time. Considering the cash ratio of a company alone doesn’t produce significant results. A cash ratio of less than 1 indicates that a company is at risk of having financial difficulty. However, a low cash ratio can also be an indicator of a company's specific strategy wherein it maintains low cash reserves.

 Advantages

  • The ratio can be used to determine how cash-rich is the company. 

  • It helps to gain knowledge about the financial strength of the company for a short period in terms of its most liquid assets. 

  • The higher the ratio, the more stable is the company.

  • It can also be measured in order to understand the growth strategies adopted by the company and future aspirations. A higher value of the ratio would indicate that the company holds significant growth potential through mergers and acquisitions and vis-à-vis.

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Deb P Samaddar

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Deb is a keen learner and eager to learn about the finance world. He is that person who would never stop talking, but my oh my, the words he uses, are not something a normal human would in a regular conversation. While the conversations are well, interesting, the write-ups are faultless. With an increased proclivity towards tech and language, he aims to capitalise on his interests as a content writer at Finology.

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