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Cash Ratio Definition – Interpretation – Analysis – Example

What Is the Cash Ratio?

Cash RatioThe cash ratio is a liquidity measure that indicates a company’s ability to pay off short-term debt with its cash and cash equivalents.

The ratio provides a quick glimpse at a company’s liquidity.  Specifically, the ratio of a company’s total cash and equivalents to its current liabilities. The metric lays bare a company’s ability to repay its short-term debt with cash or near-cash resources, for example, marketable securities. This information is useful to creditors when deciding if and how much money they would be willing to loan a company.

The cash ratio compares a company’s cash and other liquid assets to its current liabilities. It is a handy tool to quickly estimate a company’s ability to pay off its short-term debt. It tells creditors and analysts the value of current assets that could quickly be turned into cash.  Also, what percentage of the company’s current liabilities these cash and near-cash assets could cover.

Cash Ratio Formula

Compared to other liquidity ratios, the cash ratio is generally a more conservative look at a company’s ability to cover its debts and obligations.  This is because it adheres strictly to cash or cash-equivalent holdings.  As a result, it leaves other assets, including accounts receivable, out of the equation. The formula for a company’s cash ratio is:

Other liquidity measurements such as the current ratio, the quick ratio, as well as the cash ratio, use current liabilities for the denominator. Current liabilities include any obligation due in one year or less, such as short-term debt, accrued liabilities, and accounts payable.  The key difference in each of these measures is the numerator. The numerator of the cash ratio restricts the asset portion of the equation to only the most liquid of assets.  This includes cash on hand, demand deposits, and cash equivalents.  Equivalents are money market accounts funds, savings accounts, and T-Bills.

Not included in the cash ratio equation are accounts receivable, inventory, prepaid assets, and certain investments.  These are assets that are considered in other liquidity measurements. The reasoning is that these items may require time and effort to find a buyer in the market. In addition, the amount of money received from the sale of any of these assets may be variable due to market conditions.

Cash Ratio Example

For example, consider Johnson & Jackson’s balance sheet with the following line items:

  • Cash: $1,000,000
  • Cash equivalents: $2,200,000
  • Accounts receivable: $5,000,000
  • Inventory: $30,000,000
  • Property & equipment: $50,000,000
  • Accounts payable: $1,200,000
  • Short-term debt: $1,000,000
  • Long-term debt: $20,000,000

The ratio for Johnson & Jackson Corp is calculated as follows:

Cash Ratio = ($1,000,000 + $2,200,000) / ($1,300,000 + $1,000,000) = 1.39

The figure above indicates that Johnson & Jackson Corp has enough cash and cash equivalents to pay off 139% of its current liabilities. J&J is highly liquid and can easily fund its current debt.

What Does the Cash Ratio Reveal?

The cash ratio is commonly used as a quick measure of a company’s liquidity. If the company was required to pay all current liabilities immediately, could it?  This metric shows the company’s ability to do so without having to sell or liquidate other assets. A cash ratio is expressed as a number greater than, less than, or precisely equal to 1. If the result is equal to 1, the company has exactly the amount of cash and cash equivalents to pay off those debts.

Less Than 1

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 conditions in place to deal with the condition.  This might include lengthy credit terms with its suppliers, efficiently-managed inventory, and very little credit extended to its customers.

Greater Than 1

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 has the ability to cover all short-term debt and still have cash remaining.

While that sounds responsible, a higher cash ratio does not always translate into a company’s strong performance.   Different industries have different standards for what is reasonable and necessary.  As a result, this measure should always be compared to the industry norm. High cash ratios may indicate that a company is inefficient in utilizing its cash.  Instead of investing in profitable projects, it’s letting money sit idle in a bank account. It may also suggest that a company is worried about future profitability and is accumulating a protective capital cushion. (Source: investopedia.com)

Cash Ratio vs Quick Ratio vs Current Ratio

Here’s how the formula for the cash ratio compares to the quick ratio and the current ratio:

  • 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 Quick Ratio – Cash and equivalents are assets that are capable of being turned into cash in a day or two.  However, the quick ratio includes receivables among its short-term assets. Adding receivables as short-term assets depends on the particular circumstances of the business involved. A well-established business may regularly collect its receivables in a shorter than an average timeframe.  For example, 10 days, for instance, and from financially stable longstanding clients. Prompt collection of receivables means there is limited risk in adding them to the short-term assets side of the equation.  Even though they are not actually within the company’s possession, it is a reasonable assumption is that they soon will be.
  • The Current Ratio – Going a step further than the quick ratio, the current ratio includes inventory. The significance of this depends on a number of factors.  Things like the direction of the general economy, the overall health of the company’s business, and the particular industry the company is in. Inventory consists of assets that have not yet been sold. In some industries, goods flow from supplier to ultimate customers quickly.  For example a restaurant’s food inventory.  In that case, including inventory is appropriate and a reasonable asset to consider.  However, there are industries where it does not make sense to include inventory.  Consider fashion, for instance.  It may be unwise to include assets goods that may sell slowly, or at discounts, or perhaps never sold at all.  (Source: thebalancesmb.com)

Limitations of the Cash Ratio

The cash ratio is a useful tool to get a quick estimate of a company’s liquidity.  It is seldom used in financial reporting or by analysts in the fundamental analysis of a company.  It is not realistic for a company to maintain excessive levels of cash and near-cash assets to cover current liabilities. Too much cash is often seen as poor asset utilization.  Especially for a company to hold large amounts of idle cash on its balance sheet.  This money could be returned to shareholders or used elsewhere to generate higher returns. While providing a quick liquidity perspective, the depth of insight is limited.

The ratio is more useful when it is compared with industry averages and competitor averages.  Or, when looking at changes in the same company over time. A ratio lower than 1 does sometimes indicate that a company is at risk of having cash flow difficulty. However, a low ratio may also be an indicator of a company’s specific strategy that calls for maintaining low reserves.  For example, maybe the funds are being used for expansion and growth. Certain industries tend to operate with higher current liabilities and lower cash reserves.  As a result, low cash ratios across certain industries may not indicate trouble.

Up Next: What Is the Holding Period Return?

Holding Period ReturnThe holding period return is the total return or yield received over the period of time an investment is held by an investor.  It is usually expressed as a percentage.

HPR is a measure of the total yield received from holding an asset or portfolio of assets over a specific period of time.  This is referred to as the holding period. Holding period return is calculated based on the total returns from an asset or portfolio considering all income plus changes in value. It is particularly useful for comparing returns between investments held for different periods of time. For example, investors can measure the return over very short time periods such as days, or much longer periods spanning decades.

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