Introduction to Cash Ratio
The term “Cash Ratio” refers to the liquidity ratio that assesses whether a company has the ability to pay off its current liabilities with only cash and cash equivalents. It is a stricter and more conservative liquidity ratio as compared to the current ratio and quick ratio because it restricts the ability to repay the short-term liabilities with cash or near-cash resources only. The existing or prospective creditors find this information very useful as they are able to assess how much money they can loan the company.
Typically it is expressed in terms of numbers which is either greater than, equal to or less than 1. If the ratio is greater than 1, then it indicates that the company has more than enough cash and cash equivalent to pay off the current liabilities if required to be paid immediately. However, very few companies end up with such a situation as it is practically not advisable to maintain such high liquid reserves. On the other hand, if the ratio is equal to 1, then it indicates that the company has just the adequate amount of cash and cash equivalents to pay off the current liabilities. If a company has a cash ratio of less than 1, then it means that the company has more current liabilities than what it can pay off with its cash and cash equivalents.
Formula:
The Cash Ratio formula can be derived by dividing the sum of cash and other cash equivalents (treasury bonds, bank deposits, etc. that can be quickly converted to cash) by the total current liabilities. Mathematically, it is represented as,
Cash Ratio = (Cash + Cash Equivalents) / Total Current Liabilities
Examples of Cash Ratio (With Excel Template)
Let’s take an example to understand the calculation of Cash Ratio formula in a better manner.
Example – #1
Let us take the example of Dixie’s Palace which is a restaurant and currently it is planning to remodel his dining room. The restaurant’s owner has applied for a bank loan worth $200,000 for funding the remodeling. The following information is available from its balance sheet:
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Solution:
Total Current Liabilities is calculated as:
Total Current Liabilities = Accounts Payable + Tax Payable + Current Portion of Long-Term Debt
- Total Current Liabilities = $10,000 + $2,000 + $8,000
- Total Current Liabilities = $20,000
It is calculated by using the formula given below
Cash Ratio = (Cash + Cash Equivalents) / Total Current Liabilities
- CR= ($20,000 + $4,000) / $20,000
- CR= 1.20
Therefore, the cash ratio for Dixie’s Palace stood at 1.20 which is a fairly high cash reserve and seems to be at a comfortable level for the bank.
Example – #2
Let us take the example of Apple Inc. to understand the concept of cash ratio in real life. As per the annual report for the year ended on Sep 29, 2018, the following information is available:
Solution:
Total Current Liabilities is calculated as:
Total Current Liabilities = Accounts Payable + Other Current Liabilities + Deferred Revenue + Commercial Paper + Current Portion of Long-Term Debt
- Total Current Liabilities = $55,888 + $32,687 + $7,543 + $11,964 + $8,784
- Total Current Liabilities = $116,866 million
It is calculated by using the formula given below
Cash Ratio = (Cash + Cash Equivalents) / Total Current Liabilities
- CR= $25,913 / $116,866
- CR = 0.22
Therefore, the cash ratio for Apple Inc. stood at 0.22 as on Sep 29, 2018.
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Advantages and Disadvantages
Advantages and Disadvantages of Cash Ratio are as follows:
Advantages
- It helps in the assessment of the cash richness of a company. It helps in determining the financial strength of a company in the near term based on its most liquid form of assets i.e. cash. As such, it is clear that the higher the ratio, the more stable is the company.
- It also helps in understanding the growth strategy or prospects of a company. A higher value of the ratio indicates that the company holds significant growth potential through mergers and acquisitions. On the other hand, a lower value indicates limited growth potential.
- It is considered to be more conservative and stricter than other liquidity ratios, like the current ratio and quick ratio, because it measures liquidity based on the assets that can be most easily converted into cash – cash and cash equivalents.
Disadvantages
- There is great ambiguity regarding the instruments that can be considered to a cash equivalent. Such confusion can end up giving misleading results.
- It does not take into account the impact of the crisis on otherwise easily saleable securities. Although it only considers the most liquid form of assets, during the crisis even the cash equivalents are difficult to trade.
- Since it is not practically advisable for a company to maintain such high levels of cash and cash equivalent assets to cover current liabilities, the cash ratio is seldom used in any kind of financial analysis.
Conclusion
So, it can be seen that it is a liquidity measure that helps the creditors to assess the liquidity position of the company. However, most investors would prefer less cash on the balance sheet and would want them to invest in business activities to generate higher returns.
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