What is the Cash Ratio?
The cash ratio is a ratio of a company's liquidity, mainly the ratio of a company's total cash and cash equivalents to its current liabilities.
The measured calculates a company's capacity to pay back its short-term debt with cash or near-cash resources, such as easily marketable securities.
This article is valuable to creditors when they assume how much money, if any, they would be willing to loan a company.
The cash ratio is nearly like an indicator of a company’s value under the worst-case scenario—say, where the company is about to go out of business. It informs creditors and analysts of the importance of current assets that could quickly be turned into cash, and what percentage of the company’s current liabilities these cash and near-cash assets could cover.
Explaining the Cash Ratio
Compared to other liquidity ratios, the cash ratio is mostly a more conservative view of a company's ability to cover its debts and obligations, because it sticks exactly to cash or cash-equivalent holdings—leaving other assets, including accounts receivable, out of the function.
• The cash ratio is come about by adding a firm's total cash and near-cash securities and dividing that sum by its total current liabilities.
• The cash ratio is a liquidity estimate that shows a firm's ability to cover its short-term debts using only cash and cash equivalents.
• The cash ratio is more conservative than other liquidity ratios because it only analyzes a company's most liquid resources.
The formula for a firm's cash ratio is:
Cash ratio = Cash & Cash equivalent/ Current Liabilities.
As with other liquidity ratios, such as the current ratio and the quick ratio, the formula for the cash ratio uses current liabilities for the denominator. Current liabilities include any debt due in one year or less, such as short-term debt, accrued liabilities, and accounts payable.
The key disagreement lies with the numerator. The numerator of the cash ratio limits the asset sector of the equation to only the most liquid of assets, such as cash on hand, demand deposits, and cash equivalents (sometimes referred to as marketable securities), like money market accounts funds, savings accounts, and T-bills. Accounts receivable, inventory, prepaid assets, and certain investments and properties are not contained in the cash ratio, as they are with other liquidity measurements. The explanation is that these items may require time and action to find a buyer in the market. Furthermore, the amount of money received from the sale of any of these assets may be indeterminable.
What Does the Cash Ratio Reveal?
The cash ratio is most generally used as an estimate of a company's liquidity.
If the company is forced to pay all current liabilities shortly, this measure shows the business's ability to do so without having to sell or liquidate other assets.
A cash ratio is reflected as a numeral, greater or less than 1. Upon computing the ratio, if the result is equal to 1, the firm has the same amount of current liabilities as it does cash and cash equivalents to pay off those debts.
If a company's cash ratio is less than 1, there are more current liabilities than cash and cash equivalents. It means insufficient cash on hand exists to pay off short-term debt. This may not be bad news if the company has limitations that skew its balance sheets, such as lengthier-than-normal credit terms with its suppliers, efficiently-managed inventory, and very little credit extended to its customers.
If a company's cash ratio is greater than 1, the company has more cash and cash equivalents than current liabilities. In this situation, the company can cover all short-term debt and still have cash remaining. While that sounds trustworthy, a higher cash ratio does not certainly reflect a company's strong performance, especially if it is significantly greater than the industry norm. High cash ratios may indicate that a company is inadequate in the utilization of cash or not maximizing the possible benefit of low-cost loans: Rather than investing in profitable programs, it's allowing money to stagnate in a bank account. It may also indicate that a company is worried about prospective profitability and is accumulating protective capital support.
Restrictions of the Cash Ratio & how to use it.
The cash ratio is hardly used in financial reporting or by analysts in the fundamental analysis of a company. It is not logical for a company to maintain unnecessary levels of cash and near-cash assets to cover current liabilities. It is often seen as poor asset utilization for a company to hold large amounts of cash on its balance sheet, as this money could be paid back to shareholders or operated elsewhere to create higher returns. While giving an interesting liquidity attitude, the efficacy of this ratio is limited.
The cash ratio is more beneficial when it is compared with industry averages and competitor averages, or when looking at changes in the same company over time. A cash ratio lower than 1 does sometimes reflect that a firm is at risk of having financial trouble.
But, a low cash ratio may also be an indicator of a company's specific strategy that calls for maintaining low cash reserves—because funds are being used for growth, for example.
Special industries tend to operate with higher current liabilities and lower cash budgets, so cash ratios across industries may not be indicative of a crisis.
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