The cash ratio, also known as the cash asset ratio or cash coverage ratio, measures a company’s ability to pay off its current liabilities (short-term debts). This measurement compares the total value of highly liquid assets (cash and cash equivalents) to the amount in short-term liabilities. It is one of several measures of a company’s liquidity.
It is one of several ratios (financial ratios) that managers, shareholders, creditors and analysts use when comparing a company to others, the industry in general, or its own past figures.
The cash ratio is a much more restrictive way of seeing whether a business can pay off its short-term debts than the quick ratio or current ratio, because only the most liquid portion of its assets can be included in the formula. The quick ratio also includes inventories in the mix.
Creditors monitor a business’ cash ratio closely. They need to determine whether it has enough of a cash balance to meet its current obligations as they come due.
When the cash ratio is high (>1), shareholders may complain that not enough was allocated to dividends.
Money due from customers (accounts receivable) may take several weeks to collect, while inventory would take considerably longer to convert into cash. The only things that truly matter if a company suddenly had to meet all its short-term obligations would be the company’s cash and cash equivalents.
According to the Nasdaq Business Glossary, cash asset ratio is:
“Cash and marketable securities divided by current liabilities.”
Cash ratio formula
The cash ratio is calculated by adding all the cash and cash equivalents and dividing it by the total amount of current liabilities of a firm.
Cash Ratio = Cash & Cash Equivalents ÷ Total Current Liabilities
Given that assets are typically listed in order of liquidity, cash and cash equivalents will appear as the first items in the list of current assets. Cash equivalents are assets that can be turned into cash rapidly, i.e. within 90 days, they include money market funds, short-term government bonds, Treasury bills, marketable securities, foreign currency and commercial paper.
Example 1: XYZ Inc. has $200,000 in cash, $250,000 in cash equivalents, and $450,000 in current liabilities.
XYZ’ cash ratio is 200,000 + 250,000 ÷ 450,000 = 1.
With a cash ratio of 1, XYZ could pay off its short-term debts if it used all its cash and cash equivalents.
Example 2: BCAMM Ltd. has ₤250,000 in cash, ₤100,000 in cash equivalents, and ₤700,000 in current liabilities.
BCAMM’s cash ratio is 250,000 + 100,000 ÷ 700,000 = 0.5.
With a cash ratio of 0.5, BCAMM would be unable to pay off its current liabilities using just its cash and cash equivalents.
Put simply, a ratio of 1 or greater means current liabilities could be paid off from cash and cash equivalents, while a ratio of less than 1 means they couldn’t.
Experts say a ratio of more than one usually means a company is not using its cash efficiently – it should look for uses for the excess cash, or pay it out to shareholders in the form of dividends.
Video – Cash Ratio