Cash Ratio Calculator
Meaning of Cash Ratio
Let us first understand the meaning of Cash Ratio. Then we will see the formula and try to understand the ratio in detal with help of three beautiful examples.
The cash ratio is a financial metric that measures a company’s ability to cover its short-term liabilities with its cash and cash equivalents. It is a more conservative liquidity ratio compared to the more commonly used current ratio, as it excludes other current assets such as accounts receivable and inventory.
Formula of Cash Ratio
Based on the definition above, we can formulate following formula to compute cash ratio.
Cash Ratio = (Cash and Cash Equivalents) / Short-Term Liabilities
Where:
- Cash and Cash Equivalents typically include physical currency, demand deposits, and highly liquid investments with maturities of three months or less.
- Short-Term Liabilities are the obligations that a company is expected to pay within a year, such as short-term debt, accounts payable, and other current liabilities.
Example of Cash Ratio
Now, Let us look into an example to understand cash ratio more nicely.
Example 1: Company A
- Cash and Cash Equivalents: $100,000
- Short-Term Liabilities: $50,000
Cash Ratio = $100,000 / $50,000 = 2.0
In this example, Company A has a cash ratio of 2.0, which means it has twice as much cash and cash equivalents as its short-term liabilities. This indicates a strong liquidity position, suggesting that the company can easily cover its short-term obligations.
Example 2: Company B
- Cash and Cash Equivalents: $30,000
- Short-Term Liabilities: $40,000
Cash Ratio = $30,000 / $40,000 = 0.75
In this case, Company B has a cash ratio of 0.75, indicating that it has less cash on hand than its short-term liabilities. This may suggest that Company B might struggle to meet its immediate financial obligations solely from its cash reserves, and it might need to consider other sources of funds or better cash management.
Example 3: Company C
- Cash and Cash Equivalents: $200,000
- Short-Term Liabilities: $200,000
Cash Ratio = $200,000 / $200,000 = 1.0
Company C has a cash ratio of 1.0, meaning it has exactly enough cash and cash equivalents to cover its short-term liabilities. While this may indicate a reasonably stable financial position, it doesn’t leave much room for unexpected expenses or economic downturns. Companies often aim for a cash ratio greater than 1.0 to ensure a more comfortable liquidity cushion.
Keep in mind that acceptable cash ratio values can vary significantly between industries and depend on a company’s specific circumstances and risk tolerance. Companies with highly predictable cash flows and low risk may have lower cash ratios, while those in more uncertain industries may prefer higher cash ratios to mitigate risk
Conclusion
The cash ratio provides insight into how well a company can meet its immediate financial obligations using its readily available cash resources. A higher cash ratio indicates a stronger ability to pay off short-term debts and suggests greater liquidity and financial stability. However, an extremely high cash ratio may also mean that the company is not efficiently utilizing its cash and could potentially invest it to generate better returns.
It’s essential to consider the industry norms and the company’s specific circumstances when evaluating the significance of its cash ratio. Different industries and business models may have varying ideal cash ratio ranges.
