What is Cash Ratio?

People who are involved in the finance and stock market industry often get to hear about Cash Ratio. However, quite often, people tend to get confused about what exactly the Cash Ratio is all about.

The cash ratio is a liquidity measure that shows the company's ability to cover its short-term obligations. It helps analysts and creditors to understand the company's asset value in case of a financial emergency or worst-case scenario, like when a company is going out of business.

Let's dive into the basics and understand all about the cash ratio.

Understanding Cash Ratio

The cash ratio is the ratio which measures a company's ability to repay its short-term obligations with cash and cash equivalents. The cash Ratio is calculated by dividing the company's total cash and cash equivalents by its total current liabilities.

The creditors use this information to analyze how much they should lend to a company. The cash ratio tells analysts and creditors the cash value of a company's current asset and how much of this cash value can cover the company's current liabilities.

• If the cash ratio is more than 1, then it would indicate a company's inefficiency in employing the cash to earn more profit, or it might mean that the market is saturating.
• If the ratio is less than 1, it would indicate that the company has utilized the cash accurately or their sales are not good enough to earn extra cash.

Cash Ratio Formula

In the formula of cash ratio, we divide cash and cash equivalents with current liabilities.

Cash Ratio = Cash & Cash Equivalents/Current Liabilities

Let's try to understand cash and cash equivalents and current liabilities that any company considers to enter it into the Balance Sheet.

Cash and Cash Equivalents: According to GAAP, cash equivalents are the investments and other assets which can be converted into cash in under 90 days. 

Cash holdings of a company include paper money, coins, undeposited receipts, money order, and transactional accounts, while cash equivalents include mutual funds, treasury securities, preferred stock with a maturity of up to 90 days, bank certificates, and commercial paper.

Current Liabilities: Current liabilities are the liabilities which need to be settled in 12 months or less. Under current liabilities, the company includes bank overdrafts, interest payable, short-term loans, accrued expenses, income tax payable, etc.

Interpretation of Cash Ratio

• When Cash and Cash Equivalent > Current Liabilities, it suggests that the firm has more cash (more than 1 in terms of ratio) than what they require to pay the current liabilities. It is not a good situation; it shows the firm's incompetency to properly utilize its assets to their full potential.
• When Cash and Cash Equivalent = Current Liabilities, it will be interpreted that firm has enough liquidity to pay off the current liabilities.
• When Cash and Cash Equivalent < Current Liabilities, it suggests that the firm has utilized its assets well enough to earn a profit, and it's a fine situation for a firm.Click here to read about more liquidity ratios.

Cash Ratio Example

Let's take an example to illustrate the concept. In the below-given example, our core concern will be to see the liquidity situation of the firm from two perspectives.

Firstly, we will try to understand which company is in a better condition to pay off its short-term obligations, and secondly, we will try to understand which company has better utilized its short-term assets.

From the above example, we can conclude that Company X has a better cash ratio of 0.55 than the cash ratio of 0.19 of Company Y. So, Company X will be in a better position to pay off its obligation as compared to Company Y.

If we include the current ratio into the scenario (current ratio = current assets / current liabilities), then Company Y, with a current ratio of 0.81, will be in a better position to pay off its short-term obligation (assuming accounts receivable and inventories can turn into cash in a short period) as compared to Company X which has a current ratio of 0.63.

Now, we will see which company has better utilized its short-term asset. 

So, from the above example, even though Company X has more cash, they have lesser accounts receivables and inventories. From one perspective, it is in a good position as nothing is locked up, and the major part has been liquidated. 

However, from a different perspective, a higher cash ratio and a lower current ratio of Company X as compared to Company Y means that Company X could have better utilized its cash for asset generation. So from this perspective, Company Y has better utilized its cash than Company Y.                                 

Relevance and Use of Cash Ratio

1. The cash ratio is more useful to creditors than investors as it guarantees whether the firm can pay off its debt. Since the ratio does not include inventory and accounts receivables, the creditors are assertive that their debt will be paid if it exceeds 1.
    
2. Accounts receivables and inventory may take weeks or months to be converted into cash; on the other hand, cash is a good asset to pay off liabilities. Therefore, creditors take relief and provide loans to companies with better cash ratios.
    
3. Even though creditors prefer a higher cash ratio, the firm does not keep it too high. A cash ratio greater than 1 means that the firm has too many cash assets and cannot use them for profitable actions. Hence, they try to use it for different projects, mergers and acquisitions, research, and development processes to generate better profits. That's why a cash ratio in the range of 0.5-1 is considered a good cash ratio.
    
4. The investors are in a better position if the company pays off its obligation in time and uses its sitting cash to reinvest in the business activities and generate better profits.

Limitations of Cash Ratio

From the above discussion, it's obvious that the cash ratio could be one of the best ways to check a firm's liquidity. But this ratio has some limitations, which may become the basis for its ill-famed nature.

1. Many companies think that the benefits of the cash ratio are very limited. Even though a company shows a lower cash ratio, it may show a much higher current and quick ratio at the end of the year.
    
2. A cash ratio of less than 0.2 is considered good enough in some nations.
    
3. Since the cash ratio portrays two perspectives, it is very difficult to understand which perspective has to be given more importance. Suppose, if the cash ratio of a company is less than 1, what would you interpret? Has it utilized its cash well enough? Or does it have more capacity to pay off short-term debt? This is why most financial analysts use cash and other ratios like Quick and Current ratios.

The Bottom Line

Just like any other financial ratio and figures, the cash ratio also has its own share of merits and demerits. After analyzing its limitations, it can be said that the cash ratio is less useful than other liquidity ratios.

However, if used along with other financial ratios, such ratios can paint a much clearer picture of a company's financial performance and wellbeing and help facilitate better investment decisions.