What is the Cash Ratio?
The Cash Ratio compares a company’s cash and cash equivalents to its current liabilities and short-term debt obligations with upcoming maturity dates.
- What is the formula for calculating the cash ratio?
- What type of metric is the cash ratio?
- How does the cash ratio compare to the current and quick ratio?
- What are the advantages and disadvantages of using the cash ratio?
Table of Contents
How to Calculate the Cash Ratio
The cash ratio formula consists of:
By dividing a company’s most liquid cash and cash-like assets by the value of its short-term debt (i.e. coming due within the coming year), the cash ratio depicts a company’s ability to cover its near-term debt burden.
While cash is straightforward, cash equivalents include the following:
- Commercial Paper
- Marketable Securities
- Money Market Funds
- Short-Term Government Bonds (e.g. Treasury Bills)
Cash Ratio Formula
The formula for calculating the cash ratio is as follows.
Cash Ratio Formula
Cash Ratio = Cash & Cash Equivalents / Short-Term Liabilities
Interpreting the Cash Ratio
If the cash ratio is equal to or greater than one, the company is most likely in good health and not at risk of default — as the company has sufficient cash to cover its short-term liabilities.
But if the cash ratio is less than one, that means the cash and cash equivalents are not enough to cover upcoming cash outflows, which creates the need for easily liquidated assets (e.g. inventory, accounts receivable).
- Low Cash Ratio → Company might have taken on too much of a debt burden, creating more risk of default.
- High Cash Ratio → Company appears more capable of paying off short-term liabilities with its most liquid assets
Cash Ratio Advantage/Disadvantage
The distinct advantage to the cash ratio is how the metric is one of the most conservative out of the commonly used liquidity measures.
Since the quick ratio excludes inventory, it is widely considered to be more a strict variation of the current ratio — yet the cash ratio takes it a step further by exclusively including cash and equivalents.
Despite being relatively liquid, inventory and A/R still come with some degree of uncertainty, as opposed to cash.
On the other hand, the disadvantage is that companies that hold onto cash are going to appear more financially sound than their peers that have re-invested their cash into funding future growth plans.
Thus, the cash ratio can be misleading if the re-investments by a company are neglected and the ratio is taken at face value.
With that said, the cash ratio should be used in conjunction with the current ratio and quick ratio to grasp a better picture of the liquidity position of the company.
Cash Ratio Calculator – Excel Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Cash Ratio Example Calculation
In our example, we’ll assume our company has the following financials:
- Cash & Cash Equivalents: $60 million
- Accounts Receivable (A/R): $25 million
- Inventory: $20 million
- Accounts Payable: $25 million
- Short-Term Debt: $45 million
Since we are calculating the cash ratio, we can ignore the accounts receivable and inventory accounts.
Here, our company has a short-term debt of $45 million and $25 million in accounts payable, which shares certain similarities as debt (i.e. vendor financing).
The cash ratio for our hypothetical company can be calculated using the formula shown below:
- Cash Ratio = $60 million / ($25 million + $45 million)
- Cash Ratio = 0.86x
Based on the calculated cash ratio, the cash and cash equivalents are inadequate to cover the liabilities with near-term maturity dates.
A cash ratio of 0.86x means that the company can cover ~86% of its short-term liabilities with the cash and cash equivalents on its balance sheet.
However, considering the accounts receivable balance of $25 million and inventory balance of $20 million, the company does not seem likely to default on its debt obligations or payments to its vendors in a worst-case scenario.