What is Cash Ratio? Formula, Calculation, and Examples

Introduction 

Keeping a business up and running means you need to allocate and position cash carefully to meet numerous transaction needs every day, right from purchasing inventory to paying payrolls and interest on debts. To ensure operations as well as scale up, businesses need to often incur liabilities, which need to be paid at a certain point in time, without affecting their liquidity position. This is where the cash ratio comes into play. 

The cash ratio is used to evaluate a business’s current financial position and security and measures its ability to pay off short-term liabilities while maintaining strong liquidity. It is considered as a stricter way to assess liquidity and is different from the quick ratio or current ratio.

In this blog, you will gain a holistic overview of this liquidity ratio – the cash ratio definition, how to calculate and analyze cash ratio, and challenges to navigate when computing the cash ratio. 

What is Cash Ratio: Diving Into The Cash Ratio Meaning

The cash ratio is a method of measuring liquidity of a company. It compares the cash and cash equivalent position against short-term borrowings, also called current liabilities. It helps determine if a business can repay its short-term borrowings only by using cash and cash equivalents.

To delve deeper into the cash ratio explanation, it is important to understand and consider worst-case scenarios for business liquidity. This is mainly because it is during these times that a business tends to liquidate assets at hand and use them to settle outstanding debts, and cash equivalents as the only asset that can be liquidated in a short time. 

More importantly, the cash ratio is critical to analyzing your cash flow, giving you opportunities to boost your cash flow management with accurate cash projections. It also helps analysts and creditors figure out the creditworthiness of a company, its financial health and its actual cash positions. 

Why is the cash ratio important? 

The importance of cash ratio goes beyond just measuring the liquidity of a business. It gives crucial insights into cash flow management and helps you make better liquidity decisions. 

• Monitoring liquidity 

  By comparing cash reserves to short-term liabilities, you can determine how much you have to cover immediate financial obligations. This insight will help you maintain a stable cash flow while ensuring your business has enough cash to meet day-to-day expenses. To ensure sound liquidity of your business it is important to improve cash management efficiency.

• Forecasting cash needs 

  A higher cash ratio means your business has enough liquid assets to cover short-term borrowing requirements. This will help you create a provision for a buffer to manage critical fluctuations in cash flow, like seasonal variations in revenue or unexpected expenses. 

• Managing working capital 

  Cash ratios play an important role in determining the working capital of your business. A lower cash ratio means you need to implement strategies to improve your cash flow, such as optimizing accounts receivables, extending accounts payable terms, reducing inventory levels, etc. On the other hand, a higher cash ratio means your business can consider deploying cash more efficiently to generate returns and reduce financing costs. 

• Investment decisions

  The cash ratio has a direct impact on the allocation of cash reserves, which in turn affects your investment decisions. Businesses that have higher cash ratios can invest excess cash in short-term investments or other income-generating assets to optimize returns. A lower ratio, conversely, means you have to prioritize retaining cash to maintain liquidity and mitigate risk. 

  

How to Calculate Cash Ratio: Cash Ratio Formula 

The cash ratio formula is the sum of cash and cash equivalents divided by current liabilities. Cash and cash equivalents are the sum of cash, demand deposits and short-term marketable securities. Short-term debts, accounts payable, accrued liabilities, and deferred revenues make up the current liabilities.

Unlike other liquidity ratios, the cash ratio is a straightforward and conservative approach to determining a company’s financial potential. It strictly sticks to only cash and near cash assets, leaving other tangible or intangible assets out of the equation. To understand this better, let’s have a closer look at the cash ratio components. 

Components of the cash ratio formula 

The cash ratio formula comprises cash and cash equivalents and current liabilities. Cash and cash equivalents are computed by adding all the money available with your business on demand. It includes: 

• Cash: It is the total of currencies, coins, and petty cash. 
• Demand deposits: These include deposits, bank drafts, or checks in your business checking accounts. You can withdraw them anytime without giving any prior notice to your banks.
• Cash equivalents: Otherwise called marketable securities, refer to any highly liquid assets you can exchange for cash with little to no risk. Savings accounts, T-Bills, and commercial papers are some examples. 

Current liabilities are business obligations that need to be paid within one year. It includes: 

• Short-term debt: These are debts with a repayment period of a year, like short-term bank loans, notes payable, etc.
• Accounts Payable (AP): When you purchase goods from a supplier or vendor but are yet to pay, it is called accounts payable.
• Accrued liabilities: It includes expenses that your business incurs but is yet to be paid, like wages payable, interest or taxes payable, etc.
• Deferred revenue: Deferred revenue is when you realize the income in advance but are yet to deliver goods or services to the customers.

Let’s take an example

Suppose a business has the following current assets and current liabilities. 

Cash and cash equivalents = Cash + Demand deposits + Short-term marketable securities

Current Liabilities = Short-term Debts + Accounts Payable + Accrued Liabilities + Deferred Revenue 

Using the cash ratio formula mentioned above we get: 

A cash ratio of 0.46 means the business may face difficulties in repaying its current liabilities and needs to improve their liquidity. 

Cash Ratio Calculation With an Example

Let’s take another detailed cash ratio example to understand how cash ratio works. Suppose Anex Ltd, a garment manufacturer, has the following balance sheet. 

Now, to calculate cash ratio, we first need to find out cash and cash equivalents and current liabilities. The balance sheet of Anex Ltd. already shows the current liabilities amount, that is $186,000. 

For cash and cash equivalents, we need to add up: 

Now the cash ratio is cash and cash equivalents divided by current liabilities. So the cash ratio for Anex Ltd. stands at: 

A cash ratio of 1 means Anex Ltd. has adequate cash reserve to pay off its current liabilities. A cash ratio of 1 is an indication of a healthy financial position where an organization is capable of settling all its short-term obligations. 

How To Interpret Cash Ratio? 

The higher the cash ratio, the greater the financial strength of your business to pay off its short-term obligations. If a business has enough cash and near cash assets, it will be more capable of covering its current liabilities. Creditors usually prefer a higher cash ratio because it implies that a business has more liquid assets and will pay off its debts without any delays. 

If the cash ratio is equal to or greater than one, it means your business can navigate the risks of default and has sufficient liquidity and short-term assets to cover debts. 

However, a cash ratio of less than one means your business does not have enough cash or liquid assets to cushion cash outflows and cover short-term debts. 

• A cash ratio equal to 1 

  This is the ideal cash ratio. A cash ratio equal to 1 means you are not holding excess cash but also not falling short of reserves to pay off your current liabilities. The two components of the cash ratio work in sync. 

• A cash ratio greater than 1 

  A cash ratio greater than one means you can pay off your short-term obligations with your available cash and cash equivalents. However, remember that a very high cash ratio is not a good indicator of business performance. It means your business is holding cash more than it should and is paying more on borrowings than on earnings and interest. 

• A cash ratio of less than 1

  A cash ratio of less than one means your business has short-term solvency issues and more liabilities than cash and liquid assets. Here, the business has to utilize the cash or cash equivalents to settle current debts. A low cash ratio means your business cannot generate and keep sufficient cash to run business operations. 

However, a lower cash ratio is not always a negative indicator if your business can steer the situation efficiently by extending credit lines, effective inventory management, and longer borrowing agreements with suppliers.

What can the cash ratio tell you? 

The cash ratio helps you analyze and determine valuation of your business. This is especially important during periods of financial distress such as when a business goes bankrupt and cannot continue operations, analyst will use the cash ratio to find out: 

– What is the value of your current assets? 

– Can the assets be turned into cash? 

– How much of your current liability can you settle using your cash or liquid assets? 

Apart from this, the cash ratio helps determine the relationship with lenders and stakeholders, as they often use cash ratios to assess and monitor a company’s liquidity risk, challenges, collaterals, and capacity to pay debts and unexpected expenses. This also enables them to determine creditworthiness of the company as well as enables them to make informed investment decisions.

Let’s take an example of two companies – Company A with a cash ratio of 0.5 ($0.50 in cash and cash equivalents for every $1 of short-term liabilities). And Company B has a cash ratio of 2.0 ($2.00 for every $1 of short-term liabilities).

Here, Company B has a higher cash ratio compared to Company A, and a stronger liquidity position. They have enough cash and near cash assets to cover short-term borrowings, providing a cushion against downturns in cash flows.

Contrarily, Company A has a lower cash ratio, indicating a lower cash reserve. It means the company may have a hard time meeting its short-term liabilities. This also signals potential liquidity risks and requires close monitoring of cash flow management and working capital. 

What Is A Good Cash Ratio? 

There are no specific numbers to determine an ideal cash ratio. It depends on the nature of your business. However, lenders prefer a cash ratio that ranges from 0.5 to 1. A cash ratio below 0.5 means your business has equal to or twice the short-term liabilities compared to cash and is considered risky. 

The cash ratio is widely used by banks when lending and by investors when comparing companies belonging to the same sector. Also, the cash ratio does not give a holistic picture of a business, but helps analyze their liquidity position. But a higher cash ratio is not always good and is not an indicator of a business performing well. In fact, it indicates that you are making an inefficient utilization of your assets and your cash sits idle in your balance sheet.

Having a high cash ratio often reflects a negative situation because when cash sits for a longer period on your balance sheet, it means you are not generating enough returns from your investments and are on the verge of reinvesting the excess cash for stakeholders to realize higher returns. Holding more cash also means you are borrowing more and paying more interest, which is a risky situation given the ever-increasing interest rate. 

One of the best ways to ensure an accurate cash ratio is to deploy a robust cash flow projection mechanism and drive better borrowing and investment decisions. Accurate cash flow projection helps you streamline your debt repayments while ensuring you have sufficient cash reserves to meet your daily business needs easily.

How Is Cash Ratio Different From Quick Ratio And Current Ratio?

Compared to the quick and current ratio, the cash ratio is considered a stricter and more conservative measure of a business’s liquidity position. Unlike the cash ratio, the other two ratios also rely on inventory and accounts receivables, apart from cash. 

Quick Ratio vs. Cash Ratio 

The quick ratio, otherwise known as the liquidity ratio or acid test, helps determine if a business is capable of paying its short-term debts using its marketable securities, cash, and account receivables. These three components are called “quick assets” since you can exchange them for cash in little to no time. The quick ratio is calculated as: 

Quick Ratio = (Cash + Cash Equivalents + Receivables) / Current Liabilities

One of the major differences between the cash and quick ratio is that the latter includes accounts receivable in short-term assets. This metric helps get a more accurate view, especially when a business can regularly and efficiently acquire receivables in a short time from long-standing customers. A higher quick ratio would mean the business has lower liquidity risk and indicates a history of quick collections even when the receivables are not in possession. 

Current Ratio vs. Cash Ratio 

The current ratio, otherwise called the working capital ratio, helps you determine if a business is capable of paying its current liabilities within one year. Similar to the other two ratios, the current ratio measures a business’s total current assets against its total current liabilities. It is calculated as: 

Current Ratio = (Cash + Cash Equivalents + Receivables + Inventory) / Current Liabilities

The current ratio, like the quick ratio, includes receivables but also considers inventory in the computation. Inventory here includes raw materials, finished goods, work in process, manufacturing supplies, prepaid expenses, etc. While a current ratio of 1.5 or higher is considered healthy, a business with a very high ratio means it has unproductive working capital tied up in inventory and account receivables. This is where the cash ratio comes into play. 

Limitations of Cash Ratio

The cash ratio is used to evaluate the financial stability of a business. It is mostly helpful when you compare it against industry averages. You can also consider looking at the changing cash ratios over a period of time. For example, you can analyze the cash ratio of a business for the last ten years to find out the growth trajectory and decide how much credit can be approved. Still, analysts rarely rely on it. Here’s why: 

• An inflated cash balance is not always a good sign

  It is not always possible for a business to hold cash or cash equivalents just as much to surpass current liabilities. Moreover, holding too much cash often has a reverse impact as it doesn’t generate any returns or add any value to the business’ accounts. It also means a business is using that excess cash only to settle shareholders’ requirements instead of utilizing it for potential market instruments that could have given better returns. 

• A lower cash ratio is not always bad

  On the other hand, while a lower cash ratio usually points towards a weak financial position, in some cases it could also reflect the conscious business strategies of a company. For instance, a company can choose to maintain lower cash reserves to support expansion plans. It could also spend more on hiring or extending supply lines. Therefore, a lower cash ratio in these scenarios does not reflect any financial instability. 

• Inaccurate timing of recording cash flows

  While the cash ratio provides a comprehensive analysis of a business’s liquidity over a particular point in time, in some cases, the time of recording cash flows does not align with that of payments. This creates a mismatch between reporting periods, which is often not reflected in the actual financial analysis. This mostly happens when a business: 

  • Receives cash before the date of debt repayments.
  • Needs to clear outstanding balances right after the closing of a reporting period.
  • Prefers looking at varying cash ratios over successive quarters instead of considering a single point in time, which helps more in accounting for timing issues while identifying growth trends. 

• Leveraging cash forecasting to navigate cash ratio challenges 

  Navigating cash ratio challenges like inflated cash flows or lower cash reserves calls for precise cash forecasting and treasury management. By ensuring accurate projections of cash inflows and outflows, you can better manage your business’s liquidity position while maintaining enough cash at hand to meet your liabilities as well as effectively utilize excess cash.

In addition, cash forecasting will help drive effective investment and borrowing decisions. Given the ever-rising interest rates, reliable cash forecasts will help improve returns on short-term investments by letting you invest more money for a longer period of time and reducing the impact of excess cash. Further, it also helps you decide if you want to reduce borrowing costs by borrowing less money for shorter periods of time, thereby improving your cash ratio. 

How Does HighRadius Treasury Management Solutions Help?

Fast, accurate, and automated cash forecasting and treasury management are critical to businesses more than ever before.To help you achieve an ideal cash ratio driven by accurate cash forecasting and better cash decisions, HighRadius brings you its suite of treasury management solutions for cash forecasting and cash management. This AI/ML based cash forecasting software enables you to make smarter cash management decisions, maximize returns, and reduce borrowing costs. 

Our advanced AI-ML-powered forecast empowers you to automate daily forecasts, optimize cash flows, borrow at lower costs, and streamline investments, ensuring a 50% reduction in idle cash. By leveraging AI for high-accuracy forecasts, you can redefine cash decisions while maintaining a robust cash ratio.

FAQs

1) How can a company’s cash ratio improve?

A company can improve its cash ratio in many ways. It includes measures like streamlining cash flows by improving profitability and sales, ensuring timely collection of receivables, freeing up the cash blocked by excess inventory, restructuring short-term debts, repaying debts on time, etc.

2) How to find cash coverage ratio?

The cash coverage ratio (CCR) is calculated by dividing cash (cash at hand or bank and demand deposits) and cash equivalents (marketable securities like T-Bills) by total current liabilities (short-term debts, accounts payable, deferred revenue, accrued income, and interest expense).

3) What is the current ratio?

The current ratio determines a company’s ability to pay short-term debts within a year and analyzes ways to maximize current assets to settle current liabilities. To calculate the current ratio, divide current assets (Cash + Cash Equivalents + Account Receivables + Inventory) by current liabilities.

4) What is a quick ratio?

The quick ratio, or acid test ratio, measures a business’s short-term liquidity position and determines its ability to pay short-term debts using liquid assets. To calculate the quick ratio, divide current assets (Cash + Cash Equivalents + Account Receivables) by current liabilities.