Cash ratio is the mostliquid financial ratioin accounting. It is used to know if the company hascash and cash equivalentto repay its current obligations. Here, we do not add any stock, prepaid advance payments, marketable securities andaccounts receivableto arrive at Cash Assets. As accounts receivable take sufficient time to recover, you cannot pay your current obligations through them. So, you have only one option left and that is Cash. That is why it is regarded as the most conservative liquidity ratio.
Cash Assets = Cash + Cash Equitable Securities
After calculating cash assets, we divide it by current liabilities to calculate Cash Ratio.
Cash Ratio = Cash asset / current liabilities
What is Good Cash Ratio
Normally, a ratio of 1:1 is considered as the good indicator. But, to better evaluate the performance of a company, we need tolook around. In this regard, competitor analysis is worth conducting exercise. It might possible that certain industries use high level of current liabilities. So, in this case if you maintain a cash ratio of 1 ore more than that means you are inefficient in investing your cash resources to generate income.
Good cash ratio is an appealing factor for the creditors and loan providers because they want to see whether the borrower would be able to repay the principal amount and interest therein regularly.
On the other hand, a high cash ratio is not good because it may be an indicator of inefficiency in using cash.
Low Cash Ratio – it is regarded as bad indicator in the eyes of banks and creditors. However, it may be considered good if the company is using the majority of cash to generate more profit or expand the business.
Shareholder’s Perspective– Shareholders of the company wants the management to use little cash and resources to generate profit. However, if they see high amount of cash in the balance sheet, they would ask this money to be returned to them. So, this is a major challenege for the management of the company.
Growth and Expansion– On the other hand, if company has high cash ratio, it means that it is holding high level of cash. Questions may be asked from the management why it has not used that money for the growth or expansion of the existing business using the available cash.
Example
Calculate cash ratio from the following data of XYZ Co:
Accounts receivable = $50,000
Cash = $90,000
Notes Receivable = $12,000
Marketable securities = $10,000
Stock = $20,000
Prepaid advance payments = $18,000
Accounts Payable = $20,000
Notes Payable = $22,000
Accrued Expenses = $24,000
Sales tax payable = $17,000
Solution
First we will calculate total cash assets and current liabilities:
Cash assets= Cash and cash equivalent
= $90,000
Current liabilities= accounts payable + notes payable + accrued expenses +sales tax payable
= 20,000 + 22,000 + 24,000 + 17,000= $83,000
Cash Ratio = Cash assets / current liabilities
Cash ratio = 90,000 / 83,000 = 1.08