Cash Ratio (Definition)
The idea is same as that of Quick Ratio i.e. to check the company’s solvency in terms of most liquid assets included in current assets. This is a measure of satisfying current liabilities from cash and cash equivalents (cash equivalents are highly liquid investments) of the company. The definition can best be explained with example and interpretation.
Formula and calculation technique
Cash Ratio =
Cash & Cash equivalents + Marketable Securities
The calculation technique can best be explained with the following example followed by interpretation.
Example of ratio
Cash Ratio is calculated by dividing the SUM of highly liquid assets (cash & bank, short term highly liquid investments for example Term Deposit Receipts or treasury bills) appearing under current assets presented on face of statement of financial position with Current Liabilities of the company.
Cash Ratio =
92,748 + 23,187
Cash Ratio =
Data used in calculating ratio is extracted from Hypothetical Financial Statements.(See Hypothetical Financial Statements used in calculation).
Cash ratio can either be measured in times or in currency units (dollars).
Using the above example the company can 0.146 times satisfy its current liabilities with cash and cash equivalents or the company has 0.146 dollars in form of cash and cash equivalents for each 1 dollar current liability.
How to interpret the ratio?
Cash ratio is a measure of short term solvency, short term solvency as we know checks the ability of the company to pay its short term debts as and when fall due.
Current assets are comprised of different assets e.g. inventory, trade debts, prepayments, cash in hand and at banks, short term investments. These all will take a bit of time (say 15 to 30 days) to realize into cash. However cash and short term investments do not take the time at all since they are cash in first place thus Cash ratio is used to check the extent to which liabilities can be settled immediately.
Financial Analysts normally do not give much importance to cash ratio while considering the short term solvency of the company since it is neither practicable nor advisable to have sufficient cash & cash equivalents for all the current liabilities however cash ratio gives the indications whether the company is in short term payment problems or not.
A high cash ratio e.g. 1 or more indicates that management is not using its cash resource efficiently. Management should put this extra cash in operating cycle to generate profits.
On the other a very low cash ratio indicates that management might face short term cash problems for paying its bills falling due immediately.
Users’ needs addressed by the ratio (Cash Ratio)
Creditors are most common users of short term solvency ratios as they are making transactions with the company on short term credit (10 days to 3 months). A very short term creditor (3 to 10 days) might be interested in Cash ratio since he cannot wait for realization of other current assets and would like to confirm that company has enough short term cash to pay his debt.
Management monitors the cash ratio to avoid short term payment problems as well as investing surplus cash for profit generation.
(You must have an understanding of users’ needs of financial statements; please refer the topic 1- financial statement users for details).