The cash asset ratio reveals a lot about the financial situation of a business.
As one of the three common ways to calculate liquidity, cash ratio is often used to determine if a company has the ability to pay off its current liabilities.
If you’re a company owner, an investor, or a financial analyst, cash ratio is one of the basic concepts to achieve success in your field.
Want to learn more? Read on to find out how to:
- Compute the cash coverage ratio
- Conduct cash ratio analysis
- Understand its importance in real-life scenarios
About Liquidity Ratios
Before zeroing in on cash ratios, you should first understand the bigger picture: Liquidity ratios.
Simply put, a liquidity ratio shows if a company has the ability to pay its short-term debt.
Now let’s take that further.
When computing for the cash ratio, the current ratio, and the quick ratio, both the current assets and the current liabilities are taken into account to arrive at an accurate liquidity measure.
However, there are some significant differences among the three liquidity ratios in terms of calculation.
Cash Ratio
The cash ratio or cash coverage ratio is the MOST CONSERVATIVE way to assess a firm.
This is because it only considers the most liquid assets of the company—cash reserves, demand deposits, and marketable securities—as current assets.
What are marketable securities?
Marketable securities are short-term investment products that include common stock, treasury bills (T-bills), savings accounts, and money market account funds, among others.
These types of investments don’t have high returns, but marketable securities are relatively safe, and they can be liquidated to cash quickly.
Evidently, these short-term assets are the most accessible sources of cash and cash equivalents that a company can use to pay its financial obligations.
This means that out of the three types of ratios, the cash ratio is usually expected to be the lowest figure.
Cash Ratio Formula
To compute cash ratio, cash is added to cash equivalents (demand deposit and marketable securities) then divided by total current liabilities.
- (Cash + Cash Equivalents) / Current Liabilities
Quick Ratio
Now, the quick ratio or the acid-test ratio, on the other hand, is a little less conservative.
When computing the quick ratio, the cash is accompanied by both marketable securities and receivables to arrive at total short-term assets.
The keyword here is receivables.
So while cash ratio includes cash + cash equivalents, quick ratio includes cash + cash equivalents + receivables.
However…
It still leaves out inventory, prepaid expenses, and other less liquid assets in the formula.
Some companies find quick ratio to be a more accurate measure of liquidity or its ability to pay off short-term debt.
In fact, adding receivables into the mix is a common practice for a company with regular, prompt collections.
After all, as long as the company does business with trusted clients, it shouldn’t incur a lot of bad debts expense in its accounting.
Quick Ratio Formula
To compute the quick ratio, cash is added to cash equivalents (demand deposit and marketable securities) as well as receivables, then divided by your current liabilities.
- (Cash + Cash Equivalents + Receivables) / Current Liabilities
Current Ratio
The last and least conservative ratio is current ratio.
Unlike cash ratio and quick ratio, the current ratio includes ALL the current assets of the company—cash, cash equivalents/marketable securities, receivables, and even inventory—to determine liquidity.
In accounting, inventory includes all unsold assets, so the risk level when using this type of data analysis DEPENDS on the company and its business environment.
To illustrate this further, let’s use an example:
If Company X is in the grocery store industry, it will have a much quicker inventory turnover than Company Y, which is in the automotive industry.
In this example, it is very likely for Company X’s inventory to bring in cash soon compared to Company Y’s.
Based on the example, it makes sense to include inventory in Company X’s current assets, as it will still provide a pretty accurate measure of its ability to pay back its short-term debt.
Current Ratio Formula
To compute the current ratio, cash is added to cash equivalents (demand deposit and marketable securities), receivables, as well as inventory, then divided by your current liabilities.
Basically, you’re dividing all your current assets by your current liabilities in this equation.
- (Cash + Cash Equivalents + Receivables + Inventory) / Current Liabilities
- Current Assets / Current Liabilities
Interpreting the Cash Ratio
Now that you know what goes into the cash ratio, how do you interpret the resulting data?
That probably fried your brain, right?
It happened to me the first time too. So, let me explain and break it down into 4 points.
First Point
Remember that while all three ratios involve current liabilities, cash ratio only accounts for the most liquid assets—cash and marketable securities.
Thus, you should expect a LOWER figure for cash ratio compared to the other two.
Second Point
A cash ratio lower than 1 indicates the company DOES NOT have enough cash to cover all of its current liabilities and financial obligations.
For creditors, this can be a warning sign the company may not be able to pay back a potential loan in time.
Third Point
A cash ratio of 1 means the company’s cash is sufficient to cover its liabilities—the two amounts are equal.
In this example, the company won’t have any extra cash, but it will be able to totally erase its debt if needed.
Fourth Point
Lastly, a cash ratio higher than 1 shows the company has more cash than it does liabilities.
In fact, if the company had to pay off all current liabilities now, it would still have cash left over.
Generally, a cash ratio of 0.5 to 1 is still ACCEPTABLE for most companies, as this is the most conservative reporting method to determine one’s liquidity position.
The Importance of the Cash Ratio
For creditors, the cash ratio is one of the best pieces of information to determine trustworthiness.
Here’s the answer you’re looking for:
Considering the company’s current liabilities, cash ratio will reveal if a company can pay back all of those short-term obligations at a certain point in time—and if not, to what extent they’re able to.
A high cash ratio based on the balance sheet will also make it significantly LESS RISKY for creditors to extend credit to them. As a result, better loan terms will probably be offered as well.
Ultimately, the cash ratio shows how a company will perform in the absolute worst-case scenario such as balance sheet insolvency, where it does not have enough assets to pay off its short-term debts.
Using the Cash Ratio in Fundamental Analysis
With that said, the cash ratio has its LIMITATIONS too, especially in fundamental analysis.
Because the cash ratio only accounts for cash and cash equivalent items on the balance sheet, a high figure (usually greater than 1) will actually indicate poor asset utilization on the company’s part.
The reason why?
Because the cash could be put towards investments or other money-making opportunities for the business instead of staying stagnant in the bank.
Even if it is earning interest there, this percentage is so low that it probably won’t even cover inflation!
With that said, investors usually like to see more of a balance—while the business should have enough for bills and emergencies, more money should be strategically used to generate higher returns.
Conclusion
Now that you’ve read through our entire article on the cash ratio, it’s really not that complicated, right?
Just remember, for more accurate predictions, consider the other measures of liquidity along with the cash ratio when analyzing the financial state of a company!
