Cash Ratio: Definition and Analysis

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What is Cash Ratio?

A cash ratio is the ratio that measures a company’s ability to pay off its current liabilities with cash and cash equivalents. The cash ratio is different from quick ratio and current ratio in the sense that the cash ratio considers current assets that are only cash and nothing else. Therefore, the cash ratio is more restrictive in nature than the current and the quick ratio.

As the cash ratio looks only at cash, creditors. like to consider this ratio more than anything else. This ratio shows the ability of the company to shed off its current debt, and whether the company has enough cash to do so. As inventories and accounts receivables (AR) are left off in this ratio, the creditors. consider it to be a more efficient measure to check a company’s ability to pay off debt. Inventories can take years. to get sold and receivables may take several weeks to sell. Therefore, their absence shows the liquidity position of a company in terms of cash and cash equivalents.

Formula 

The formula for calculating Cash Ratio is the following −

$$\mathrm{\mathrm{Cash\: Ratio}\:=\:\frac{\mathrm{\left ( Cash\:+\:Cash\:Equivalents \right )}}{\mathrm{Current\: Liabilities}}}$$

It is notable that most companies club cash and cash equivalents as one item, whereas some companies may list them separately. Cash equivalents are items that can be converted into cash within a very short span of time.

Cash Ratio Analysis

The cash ratio is the measure of a company’s capability to pay off its current liabilities with cash. It offers. a view of its current liabilities as a percentage of its cash.

A cash ratio of 1 shows that the company has just equal the amount of cash to meet its debt requirements. Therefore, it can be risky for a company to have a cash ratio of 1 because it can go down at any instant. A ratio of more than 1 is good because it shows the reservoir of cash that is more than the current liabilities. A cash ratio of less than 1 shows the availability of cash that is less than the company’s current liabilities. So, it is undesirable for a company.

A higher cash ratio means that a company can meet its debt more easily. Creditors prefer a higher cash coverage ratio because it shows the ability of the company to pay off the loans in time. A company to be stronger in finances, therefore, must have a cash ratio that is more than 1.

Example 

Suppose ABC is a travel agency that needs a loan of Rs. 100 crore for expansion. It asks a bank to offer the loan.

ABC’s balance sheet has the following items listed −

Cash = Rs. 10 Crore

Cash Equivalent = Rs. 2 Crore

Accounts Payable = Rs. 5 Crore

Current Taxes Payable = Rs. 1 Crore

Current Long-term Liabilities = Rs. 10 Crore

$$\mathrm{\mathrm{ABC's\: Cash\: Ratio}\:=\:\frac{\mathrm{\left ( Rs.10 \:Crore \:+\: Rs.2\: Crore \right )}}{\mathrm{\left (Rs.5\: Crore\: +\: Rs.1\: Crore\: +\: Rs.10\: Crore \right )}}\:=\:0.75}$$

ABC has a cash ratio of 75% which is good. That means ABC can fund 75% of its current liabilities. So, ABC has a fair chance of obtaining the loan.

Conclusion

The cash ratio is a measure of efficiency. It measures the ability of a company to repay the current liabilities within the foreseeable future. As the cash ratio is easy to calculate and does not require too much knowledge of accounts to calculate, it is a fairly popular ratio for calculating a company’s efficiency.

However, while calculating the ratio, one must be aware to include only short-time items. Any item that is payable or receivable beyond a year should be omitted from the calculation of the cash ratio. That is also why the cash-only ratio is also considered a true measure of a company’s financial strength in the shorter term.

raja
Updated on 12-May-2022 06:39:30

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