Cash Ratio

The cash ratio is the ratio of a company's total cash and cash equivalents to its current liabilities. The metric calculates a company's ability to repay its short-term debt with readily-liquidated cash resources.

This information is useful to parties such as creditors when they decide how much debt, if any, they would be willing to extend to the asking party. The cash ratio is generally a more conservative look at a company's ability to cover its liabilities than many other liquidity ratios because other assets, including accounts receivable, are left out of the equation.

The numerator of the cash ratio restricts the asset portion of the equation to only the most liquid of assets, such as cash on hand, demand deposits, and cash equivalents such as money market accounts, savings accounts, and T-bills.

Accounts receivable, inventory, prepaid assets, and certain investments are not included in the cash ratio. These items may require time and effort to find a buyer in the market. In addition, the amount of money received from the sale of any of these items may be indeterminable.

For the ratio's denominator, current liabilities include any obligation due in one year or less, such as short-term debt, accrued liabilities, and accounts payable. Liquidity ratios that factor in non-cash items include the current ratio, quick ratio and operating cash flow ratio.

The cash ratio is most commonly used as a measure of a company's liquidity. The metric calculates a company's ability to pay its current liabilities using only its cash and cash equivalents on hand. If the company is forced to pay all current liabilities immediately, this metric shows the company's ability to do so without having to sell or liquidate other assets.

Upon calculating the ratio, if the result is equal to 1, the company has exactly the same amount of current liabilities as it does cash and cash equivalents pay off those debts.

If a company's cash ratio is less than 1, there are more current liabilities than cash and cash equivalents. In this situation, there is insufficient cash on hand to pay off short-term debt. This may not be bad news if the company has conditions that skew its balance sheet accounts, such as lengthier-than-normal credit terms with its suppliers, efficiently-managed inventory and very little credit extended to its customers.

If a company's cash ratio is greater than 1, the company has more cash and cash equivalents than current liabilities. In this situation, the company has the ability to cover all short-term debt and still have cash remaining. However, if the cash ratio is very high, this may also indicate that a company is not using its capital for its best use, since it could be invested in profitable projects instead of stagnating in the company's bank account.

The cash ratio is more useful when it is compared with industry averages and competitor averages, or when looking at changes in the same company's cash ratio over time. A cash ratio lower than 1 does sometimes indicate that a company is at risk of having financial difficulty. However, a low cash ratio may also be an indicator of a company's specific strategy to have low cash reserves.

Certain industries tend to operate with higher current liabilities and lower cash reserves, so cash ratios across industries may not be indicative of trouble. In addition, a higher cash ratio does not necessarily reflect a company's strong performance. High cash ratios may indicate that a company is inefficient in the utilization of cash or not maximizing the potential benefit of low-cost loans. It may also suggest that a company is worried about future profitability and is accumulating a protective capital cushion.