Businesses follow various methods to determine their liquidity at a certain point in time when compared against the liabilities. Cash ratio calculation is one such measurement, which can allow a company to assess or gauge its current financial standing and security. As the term ratio denotes, the cash ratio compares one factor against another to derive the results.
What is Cash Ratio?
Cash ratio refers to the measurement, which compares a business’s cash and equivalents against its short-term financial obligations, which are otherwise known as current liabilities. Lenders often study this ratio of a business to determine whether offering credit to that enterprise is a profitable decision.
To understand cash ratio meaning better, one needs to consider the worst possible situation for business. At such a time, companies tend to liquidate any immediate assets and use the same to service some of the outstanding liabilities. Cash ratio considers only such assets, which can be converted into cash almost immediately.
Components of Cash Ratio
Cash ratio has two main components, namely, cash and cash equivalents and current liabilities. However, these two factors can be divided into sub-groups. Here is a look at some of the types of equivalents and current liabilities –
1. Cash equivalent
- Demand deposits
- Money market funds
- Savings account balance
2. Current liabilities
- Short term debts
- Accounts payable
- Dividends payable
- Taxes outstanding for the year
- Interest payable on existing credits
The primary difference between cash ratio calculation and other such calculations for a business is that the former only considers the immediate liquid assets. This is why one cannot consider accounts receivable and income from investments under equivalents in the calculation of this ratio. These assets take considerable time and effort to convert into cash during a financial emergency for the enterprise.
How to Calculate Cash Ratio?
One can follow a simple formula to determine the cash ratio for a company.
Cash ratio = Cash and Equivalents/Current Liabilities
The outcome compares a company’s immediate liquefiable assets against all of its short-term liabilities.
Example of Cash Ratio
Simply learning the cash ratio formula is not sufficient. Refer to the following table to understand how this calculation works in effect.
|Total Cash and Equivalents||Rs.780000|
|Tax payments outstanding||Rs.24000|
|Total Current Liabilities||Rs.666000|
Suppose the table above is the balance sheet of an established company. From the above details, one can determine the following –
Current liabilities = Rs.6,66,000
Cash & equivalents = Rs.7,80,000
As per the formula for cash ratio,
Cash ratio = Cash and cash equivalents/current liabilities
Significance of Cash Ratio
A cash ratio of more than one indicates a favourable financial condition for any business. Such a result shows that a company owns enough liquid assets to handle all of its short-term liabilities. Not just that, cash ratio greater than 1 also indicates that a firm will have cash and cash equivalent assets remaining even after fulfilling all of the outstanding liabilities in the market.
Cash ratio figures lower than 1 means that a business needs to acquire more cash and equivalent assets. However, this is not always a negative aspect since some companies can manage such situations effectively. For instance, limited credit extended to customers, effective inventory management and lengthier credit agreements with suppliers is some cases where cash ratio of lower than 1 does not necessarily hurt the business.
Lastly, cash ratio can be equal to 1 as well. Such a situation arises when the amount of cash and cash equivalents is equal to that of current liabilities. In simpler terms, when cash ratio is 1, the business in question has just enough cash and other immediate liquid assets to fulfil its short-term liabilities. While such an instance is rare, in some cases, the two components of cash ratio calculation line up perfectly.
Limitations of Cash Ratio
Cash ratio is seldom used to determine the financial stability of a company. This is because it is not always feasible to hold cash or near-cash assets equal to or more than the business’s current liabilities. Additionally, holding large amounts of cash may even be harmful to the overall business since this cash does not add any value to the company’s accounts by sitting idle.
Instead, companies are more likely to use such surplus money to fulfil their requirements to shareholders. Alternatively, such cash can also be invested in certain market instruments, where it can generate hefty revenues for the business, adding to its overall worth.
In most cases, cash ratio analysis is effective when a comparison is performed with industry averages. One may also look at the varying cash ratios for a company over a period. For instance, studying the cash ratio of a firm every year for the last 10 years can give credit providers an idea about the business’s trajectory.
While lower cash ratio can be indicative of a company undergoing financial turmoil, it may also represent certain conscious strategies that the business follows. For example, if a company is currently looking to expand, it may choose to maintain low cash reserves in favour of spending more on fresh hires and supply lines. Moreover, some industries operate with lower cash ratio than others. Therefore, in such cases, a ratio lower than 1 does not indicate financial trouble for the firm in any way.
An investor or creditor must, thus, keep the above factors in consideration, when taking a business’s cash ratio as a measure of its overall financial standing.