What Is The Cash Ratio? (With Formula And How To Calculate)
By Indeed Editorial Team
Published 12 October 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
A company can use various financial metrics to indicate the success of its operations. One of these metrics is the cash ratio, which informs business leaders how much cash a company has compared to its liabilities. Understanding how to calculate the cash ratio can help a decision-maker determine a company's liquidity and make informed business decisions regarding the organisation's future.
In this article, we explain what cash ratio is, why it is important, how to interpret it and how to calculate it.
What Is The Cash Ratio?
Learning the answer to 'What is the cash ratio?' can help you make informed business decisions relating to a company's operations. The cash ratio measures a business' liquidity. It considers how a company's current cash reserves and cash equivalents compare to its current liabilities. This metric assesses how effectively a business can repay the short-term debts it currently has. The formula for cash ratio is:
Cash ratio = (Cash + Cash equivalents) / (Current liabilities)
Importance Of The Cash Ratio
The cash ratio is important because it can indicate a business' financial health. If a company is seeking a loan, it may have to present creditors with specific information about its finances. If a company has a high cash ratio, a creditor may be more willing to approve a loan for the organisation. The company can use this loan to improve its operations and expand into new markets, which can further contribute to its growing cash reserves. A creditor may deny a company that has a low cash ratio or approve a loan with a higher interest rate.
Another reason that the cash ratio is an important metric is that it is one of the most conservative liquidity metrics available. There are two other types of liquidity metrics, which are the quick ratio and the current ratio. The quick ratio includes a company's current accounts receivable with cash and cash equivalents, while the current ratio considers all current assets, regardless of their liquidity, in the first number of the ratio. The cash ratio may more accurately reflect how easy it is for a business to repay liabilities, as it only accounts for a company's most liquid assets.
Interpreting The Cash Ratio
Calculating the cash ratio for a company results in a value that is less than one, greater than one or equal to one. Here is what each of these results means for the company:
Calculations greater than one
When a company has a cash ratio that is greater than one, it has fewer liabilities than it has cash and cash equivalents. This means that a company can easily pay for all short-term debt. After paying off its debt, a company that has a cash ratio greater than one still has extra cash remaining.
Calculations less than one
When a company has a cash ratio that is less than one, it has less cash than it has liabilities. This means that a company does not have enough cash to pay off current liabilities. While a cash ratio that is greater than one is usually favourable for most companies, a company can still be in a good financial position with a cash ratio of less than one.
A cash ratio that is less than one can indicate that a company uses the cash it receives to invest in profitable ventures. If a cash ratio is less than one, it is ideal for it to be between 0.5 and 1. A cash ratio of less than 0.5 indicates that a company has more than twice the amount of debt in comparison to its cash reserves.
Calculations equal to one
When a company has a cash ratio that is equal to one, it has the same amount of cash equivalents and liabilities. It can use all of its current cash and cash equivalents to pay off its short-term debts and accounts payable. It is rare for a company to have a cash ratio of exactly one, so the cash ratio is typically above or below one.
How To Calculate The Cash Ratio
Here is a list of steps on how to calculate the cash ratio:
1. Find all cash and cash equivalents a company has
The first step to calculating the cash ratio is to determine all the cash and cash equivalents a company has. Cash equivalents are assets that a company can easily and quickly convert to cash. A few examples include marketable securities like short-term bonds, treasury bills and commercial papers. Add all of a company's cash and cash equivalents together.
2. Find all current liabilities and add them together
The next step in calculating the cash ratio is to find all current liabilities. Current liabilities do not include long-term debts. Instead, they include debts like dividends payable, taxes payable, accrued expenses and trade accounts payable.
3. Divide the total cash equivalents by the total liabilities
To finish the calculation, divide the total cash equivalents by the total liabilities. Use a calculator to perform this calculation, as you may end up with a decimal number. Ensure to put the cash equivalents as the numerator, or the top number in your ratio. After dividing the cash equivalents by the liabilities, you produce the company's cash ratio.
Example Of Calculating The Cash Ratio For A Company
Here is an example of calculating the cash ratio:
Himmat is a financial analyst for Bluesky Mobile, a company that sells cellphones, tablets and other electronic devices. He receives the above table from one of the company's accountants. He wants to determine the cash ratio so that he can help the company secure a loan to expand its operations. Himmat begins by adding all of the cash and cash equivalents together. The cash ratio does not consider accounts receivable, so he ignores this portion of the table. Instead, he adds ₹200,000 and ₹100,000 together to get ₹300,000. ₹300,000 is the sum of the company's cash and cash equivalents.
Then, Himmat calculates the company's current liabilities. He includes accounts payable and short-term debt because both of these figures consist of current liabilities. He ignores the ₹80,000 figure that represents long-term debt because the cash ratio does not consider long-term debt as part of its liabilities. Himmat adds ₹170,000 and ₹220,000 together to get ₹390,000. Then, he divides ₹300,000 by ₹390,000 to get a cash ratio of 0.769. This ratio is below one but above 0.5, so a creditor may consider Bluesky Mobile a trustworthy borrower.
Limitations Of The Cash Ratio
The cash ratio may indicate a company's financial health, but a company can also use other metrics to gain a better understanding of how well it is performing. The quick ratio and the current ratio provide a more accurate representation of a company's assets in comparison to its liabilities. The average cash ratio can vary between different industries, so it is important to consider the industry in which you work and whether it relies on the use of short-term debt and quick inventory turnover rates.
Note that a company that has a high cash ratio may not be successful. For instance, a company with a cash ratio of two may be hoarding cash because its leadership is concerned with the company's profitability in the future. A high cash ratio may also indicate that a company is not taking advantage of low-cost loans or pursuing profitable projects. Alternatively, a low cash ratio does not necessarily indicate financial shortcomings. For example, a company with a cash ratio of 0.46 may extend minimal credit to its customers or have long-term credit deals with its suppliers.
Please note that none of the companies, institutions or organisations mentioned in this article are associated with Indeed.
Explore more articles
- What Does A Back End Developer Do? (With Average Salary)
- 11 Essential SIEM Tools (With Definition And Benefits)
- 16 Practical Tips On How To Be A Successful Business Leader
- Zoom Vs. Webex: Differences, Business Uses And How To Choose
- 14 Tips To Improve Presentation Skills (With Importance)
- What Is Brand Identity? With Elements And How To Develop It
- What Are Business Expenses? (With Types And Examples)
- What is BATNA? (With Ways To Identify It And Examples)
- What Are Painting Skills? (Examples And How To Develop Them)
- 10 Digital Marketing Certifications To Expand Your Skills
- What Is A Pareto Chart? (And How To Construct One)
- A Guide To Using AI For Recruitment (With Benefits)