Cash Ratio Definition, Formula & Example
When you operate a business there are often going to be certain things that come with the territory. Things like purchasing assets and keeping expenses down are some of the most common. When performing some of these business practices, your business is likely going to incur liabilities.
Having certain liabilities means that you’re going to have to pay them off at some point or another. This is where cash coverage, or cash ratio, comes into play. But what exactly is the cash ratio and how does it work?
If you’re unsure, you have come to the right place. Keep reading our guide to find out how the cash ratio works and what it means. We also included a breakdown of the formula to calculate it, as well as an example.
Table of Contents
- Determining the cash ratio of your business is an effective liquidity measurement. It shows how well you might be able to pay off certain short-term liabilities.
- It’s a more conservative approach compared to other types of liquidity ratios. This is since the ratio only considers cash and cash equivalents.
- To calculate the cash ratio, you divide the sum of cash and cash equivalents by current liabilities.
What Is the Cash Ratio?
To keep things as simple as possible, the cash ratio of your business is a certain type of liquidity metric. It’s the ratio of how much cash your business has, including cash equivalents, compared to your current liabilities.
Determining the cash ratio is a way to help calculate your ability to repay any short-term debts. And this can get done with certain things such as with cash or even near-cash resources.
Creditors use this financial analysis to help figure out how much money they might be willing to provide with a business loan. It’s a way for analysts and creditors to find out the value of your current assets and when they can turn them into cash. Plus, it finds out the percentage of your current liabilities.
From here, finding out the percentage of current liabilities will help show if your cash or near-cash assets can cover them. The cash ratio is a pretty conservative measure since only your most liquid assets get used in calculating it.
What Is the Cash Ratio Formula?
Calculating the cash ratio can be fairly straightforward as long as you have a few bits of information. You need to know your current liabilities and your cash and cash equivalents. The cash ratio calculation would look like this:
But what actually gets included within these pieces of information?
- Cash would be any type of legal tender or demand deposits, such as bank drafts, checks, or a checking account
- Cash equivalents are any asset you have that can get converted into cash. This would include things like savings accounts and money market instruments.
- Current liabilities are any type of obligation you have due within a single year. For example, accounts payable, accrued liabilities, and any short-term debt obligations.
Example of Cash Ratio
Let’s say that your business has $20,000 in cash and $30,000 in cash equivalents. You’re also able to determine that you have $18,000 in current liabilities.
All you need to do to calculate the cash ratio is input these amounts into the formula. It would look something like this:
$20,000 + $30,000 / $18,000 = 2.77
Basically, this cash ratio figure means that your business would have enough cash and cash equivalents to pay off 277% of any current liabilities. So, your business would be considered highly liquid, which means you can easily pay off debts.
Advantages and Disadvantages of Cash Ratio
While the cash ratio does assist in measuring a businesses ability to sort out their current liabilities, there are some advantages and disadvantages worth understanding. Let’s take a closer look.
- It provides more meaning:
When comparing the cash ratio to other ratios, such as quick ratio or current ratio, its main advantage is its reliability. This is because it only uses cash instead of current assets. This can play an important role since some current assets aren’t converted into cash easily.
- It highlights liquidity position:
The cash ratio gives insights into a company’s cash balance to help measure its financial health. This means that it’s one of the most effective ways to determine the liquidity position of the company.
- It doesn’t consider non-cash current assets:
By ignoring these types of assets, the cash ratio helps eliminate any risk where current assets don’t convert to cash.
- It could lead to keeping too much cash on hand:
Having more cash on hand can lead to maintaining a good cash ratio. However, this could lead to missed opportunities for investment. And when the cash balance is too high, it can impact long-term profitability.
- It doesn’t provide a clear outlook:
When a company has a higher cash ratio it typically means strong financial health. Yet, different companies in different industries can benefit from varying ratio levels.
- It ignores certain assets:
Some current assets get ignored using the cash ratio, like marketable securities and inventory.
Knowing how the cash ratio works and how to calculate it can be important for your business. It’s a liquidity measure that can show insights into how well you can cover certain short-term obligations. And this is done only using cash and cash equivalents your business has.
To calculate the cash ratio, you simply add your cash and cash equivalents together. Then, you divide this total number by your current liabilities. The figure you end up with is your cash ratio.
The higher the cash ratio, the better. This means that your business is considered more liquid and can handle paying off any debts you might have. It’s a more conservative ratio since you’re only considering your most liquid resources.
FAQs About Cash Ratio
What Is a Good Cash Ratio?
There isn’t a perfect cash ratio that you should aim for as there are different factors taken into account. That said, a cash ratio can be considered good if it ends up between 0.5 and 1.
Why Does Cash Ratio Decrease?
Usually when a cash ratio begins to decrease it indicates that a business is having or is at risk of financial difficulty. However, having a lower cash ratio could be part of a company’s strategy to maintain low amounts of cash reserves.
How Useful Is the Cash Ratio?
When it comes to finding out the liquidity of your business, the cash ratio is useful. That said, any type of accounting ratio is going to help identify any strengths and weaknesses. This helps with making future business decisions.
What Does the Cash Ratio Reveal When Calculated?
It’s a conservative way to find out the measure of liquidity. If your business has a higher cash ratio it means you can easily pay off any debts you might have. If your business has a lower cash ratio it means that you’re going to have a harder time paying off debts
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