When analysing a company, one of the many aspects that financial experts and investors focus on is liquidity. A company that has enough liquidity to meet its short-term obligations is often viewed favourably compared to one that has little to no liquidity.
Among the many metrics that are used to determine a company’s liquidity, very few are as powerful as the cash ratio. In this article, we are going to delve into the meaning of cash ratio, explore the formula that is used to calculate it, and analyse its significance and limitations.
What is the Cash Ratio?
The cash ratio is a fundamental metric used in financial analysis to assess the liquidity position of a company. The ratio indicates a company’s ability to pay off all of its short-term liabilities using its most liquid assets. Here, liquid assets refer to cash and cash equivalents, which include the following:
- Physical cash
- Bank deposits
- Marketable securities
- Money market funds
- Short-term government bonds
Among the different liquidity ratios, the cash ratio is often considered to be the most conservative estimate since it only takes cash and cash equivalents into account. The ratio is an important indicator of a company’s financial health and its capacity to handle immediate financial obligations.
Read More About What is Liquidity Ratio?
What is the Formula Used to Calculate the Cash Ratio?
Calculating the ratio is a straightforward process. All you need to do is use the cash ratio formula mentioned below.
Cash Ratio = Cash and Cash Equivalents ÷ Current Liabilities
By using the above-mentioned cash position ratio formula, you can quickly get a snapshot of a company’s immediate liquidity position. A ratio of 1 or higher is often considered to be desirable since it would essentially mean that the company has enough cash and cash equivalents to immediately pay off all of its short-term liabilities and obligations without having to resort to selling its inventory or any other assets.
Cash Ratio Calculation: An Example
To better understand how the cash ratio formula is used, let us consider a hypothetical example.
Assume you wish to calculate the cash ratio of XYZ Limited. From the company’s balance sheet, you get the following information:
- Cash: ₹5,00,000
- 91-day T-Bills: ₹2,00,000
- Bank deposits: ₹10,00,000
- Money market funds: ₹3,00,000
- Income tax: ₹2,00,000
- Dividends payable: ₹1,80,000
- Short-term debt: ₹2,20,000
Now, before we use the cash ratio formula, let us first determine the available cash and cash equivalents.
Cash and Cash Equivalents = ₹20,00,000 (₹5,00,000 + ₹2,00,000 + ₹10,00,000 + ₹3,00,000)
Next, let us determine the current liabilities of the company, which are as follows:
Current Liabilities = ₹6,00,000 (₹2,00,000 + ₹1,80,000 + ₹2,20,000)
Using the cash ratio formula, we can now determine the liquidity position of XYZ Limited.
Cash Ratio = 3.33 (₹20,00,000 ÷ ₹6,00,000)
A cash ratio of 3.33 essentially means that the company has three times more cash than all of its current liabilities. If a situation were to arise where XYZ Limited had to pay off all of its current liabilities immediately, the company would be able to do so without any major hindrance.
Read More About What is Price-to-Cash Flow (P/CF) Ratio?
Importance of the Cash Ratio
The primary significance of the cash ratio is in its ability to assess the liquidity position of a company, which can be very helpful when planning for worst-case scenarios. In addition to liquidity assessment, the ratio is also very useful for the following:
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Ascertaining Financial Stability
A high cash ratio indicates better financial stability and a robust position to handle unexpected financial challenges. Strong cash reserves allow companies to fare well even during economic downturns or sudden market changes.
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Evaluating Creditworthiness
Creditors and lenders often evaluate the cash ratio to assess the creditworthiness of a company and to determine its ability to repay its loan obligations. A higher ratio means low risk and can inspire more confidence, which could potentially prompt the lenders to offer better credit terms or lower interest rates.
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Determining Investment Worthiness
Investors widely use the cash ratio, along with other financial metrics, to make informed decisions about potential investments. A company that has a strong cash ratio is often seen as a safe investment option compared to one that has a weak ratio.
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Establishing Comparisons
One of the major significances of the cash ratio is that it allows for comparisons between companies within the same industry. Such comparative analysis provides insights into the financial strength and liquidity management practices of the company relative to its peers.
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Assessing Management’s Efficiency
By evaluating the cash ratio of a company, you can get insights into the efficiency of its management. For instance, a consistently low ratio may indicate the need for improved cash management, whereas a consistently high ratio may signify inefficient use of excess cash.
Limitations of the Cash Ratio
Although the cash ratio is a useful metric, it has its share of limitations that should be considered. Here is a quick overview of some of the key drawbacks of the ratio.
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Overly Conservative
By only considering cash and cash equivalents, the ratio could understate a company’s true liquidity position, especially for businesses with inventory that can be easily liquidated.
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Ignores Timing
The cash ratio does not take into account when the current liabilities are due. A company might have a low cash ratio but still be able to meet its obligations if the timing of the cash inflows aligns with the due dates of its liabilities.
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Can be Manipulated
Companies can potentially manipulate their cash ratio by timing certain transactions around their reporting date. This could lead to a misrepresentation of the company’s true liquidity position.
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Ignores Cash Flow
The cash ratio is a static measure and does not consider the company’s ability to generate cash flow. A company with strong, predictable cash flows can operate safely even with a lower cash ratio.
Conclusion
The cash ratio is a powerful tool in financial analysis. It offers a conservative and clear picture of a company’s immediate liquidity position. By focusing on just cash and cash equivalents, the ratio provides valuable insights into a company’s ability to meet short-term obligations without relying on other, less liquid assets.
However, like all financial metrics, the cash ratio should not be used in isolation. It is most effective when used in conjunction with other liquidity ratios, such as the current ratio and quick ratio.
FAQs
What is considered a good cash ratio?
Generally, a cash ratio of 1 or higher is considered good, as it indicates that a company can pay off all its short-term liabilities with its cash and cash equivalents. However, the ideal ratio depends on the company’s specific circumstances and industry norms.
How is the cash ratio different from the current ratio?
The cash position ratio formula only considers cash and cash equivalents in relation to current liabilities. The current ratio, meanwhile, considers all current assets, such as cash, accounts receivable, and inventory, in relation to current liabilities.
Is a higher cash ratio always better?
Not necessarily. Although a high cash ratio is always preferred, an excessively high ratio indicates inefficient use of idle cash and that the company might be missing out on potential investment or growth opportunities.
Can the cash ratio be negative?
No. The cash ratio can never be negative since it is not possible to have negative cash or cash equivalents. The lowest that the ratio can be is zero.
How often is the cash ratio calculated?
Usually, companies calculate their cash ratios on a quarterly or annual basis to coincide with their financial reporting periods. That being said, the ratio may be calculated more frequently for internal accounting purposes.
