What is Cash Ratio?
The Cash Ratio is a financial measure that assesses a company's capacity to repay current debt using cash and cash equivalents. As no other liquid assets may be used to pay off existing debts, the cash ratio is far more restricted than the other liquidity ratios.
Understanding Cash Ratio
The cash ratio measures how efficiently to pay down current liabilities using solely liquidity position. Cash and equivalents are shown as a proportion of current liabilities in this measure.
- If somehow the ratio is greater than one, this implies that there really is low efficiency in using funds to create additional profits and that the marketplace is dowsing
- If a ratio is smaller than one, this implies that the business has ensured the efficiency or it has not earned sufficient orders to have additional cash
- Assume that Cash & Cash Equivalent > Current Liabilities; this signifies that the company seems to have more cash than is made to pay off the current obligations. It's not usually a favorable scenario to be in because it indicates that the company's assets haven't been used to their maximum potential
- If the scenario is Cash & Cash Equivalent = Current Liabilities, the company has adequate cash to pay off its current liabilities.
- In respect of the company's standpoint, if Cash & Cash Equivalent < Current Liabilities, then that's the optimal condition to be in. Because it indicates that the company's assets were properly utilized in order to increase profit.
A high cash ratio is preferred by creditors since it suggests that a firm can quickly repay its debt. While there is no optimal ratio, a ratio of at least 0.5 to 1 is commonly desired. Because only cash transactions are considered, the cash ratio number gives the most conservative insight into a firm’s liquidity.
Formula
It is calculated by adding cash and cash equivalents and dividing by current liabilities. A somewhat more realistic variant is to eliminate accumulated costs from the current liabilities in the base of the calculation, as these things may not need to be paid for in the immediate term. The formula is as follows:
(Cash + Cash equivalents) ÷ Current liabilities = Cash ratio
Practical Example
At the end of December, TruBlue Company had $200,000 in cash and $600,000 in cash equivalents on its financial account. Its current obligations are $2,000,000 as of that time. The cash ratio is as follows:
($200,000 Cash + $600,000 Cash equivalents) ÷ $2,000,000 Current liabilities
= 0.4:1 Cash ratio
In Sentences
- The cash ratio is considered insignificant in the basic examination of a firm by financial information or consultants.
- A larger cash ratio does not really indicate a firm's core success.