Cash Ratio

Cash Ratio

Definition

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.

Description

The metric assesses a company's ability to repay its short-term debt using cash or near-cash resources, such as readily marketable securities. This information is useful to creditors when determining how much money, if any, they are willing to provide to a company.
 

• The cash ratio is a liquidity metric that measures a company's capacity to meet its short-term obligations only with cash and cash equivalents.
• The cash ratio is calculated by adding a company's total cash and near-cash securities and dividing the result by its total current liabilities.
• The cash ratio is more cautious than other liquidity measures because it only looks at a company's most liquid assets.
• A computation greater than 1 indicates that a corporation has more cash on hand than current indebtedness, whereas a calculation less than 1 indicates that the company has more short-term debt than cash.
• Lenders, creditors, and investors use cash ratios to assess a company's short-term risk.
   

The cash position ratio, or cash coverage ratio, is computed by dividing a company's cash and cash equivalents by its total current liabilities.

The mathematical formula for the cash position ratio is as follows:

Cash Position Ratio = (Cash and Cash Equivalents)/(Total Current Liabilities)

This ratio reveals the percentage of a company's short-term liabilities that can be covered by available cash and cash equivalents, indicating its liquidity situation and capacity to satisfy urgent financial obligations.

Importance of Cash Coverage Ratio 

Here are the key points highlighting the importance of the Cash Coverage Ratio:

1. Liquidity Assessment: The Cash Coverage Ratio evaluates a company's liquidity status by displaying its capacity to meet short-term liabilities with readily available cash and cash equivalents.
2. Financial Stability: A higher Cash Coverage Ratio indicates stronger financial stability because it shows the company has enough liquid assets to satisfy its immediate obligations without excessively borrowing or selling other assets.
3. Creditworthiness: Lenders and creditors sometimes use the Cash Coverage Ratio as one of several factors to determine a company's creditworthiness. A greater ratio indicates a lesser chance of default, increasing the company's appeal to potential lenders and creditors.
4. Risk Management: Monitoring the Cash Coverage Ratio allows businesses to proactively manage financial risk. A strong ratio indicates the firm is better prepared to deal with unexpected financial challenges or market downturns.
5. Investor Confidence: Investors use the Cash Coverage Ratio to assess a company's financial health and sustainability. A high ratio reassures investors about the company's ability to manage its finances effectively, enhancing investor confidence and shareholder value.
6. Strategic Decision Making: Understanding the Cash Coverage Ratio allows management to make more educated strategic decisions about capital allocation, investment opportunities, and financial planning. It gives information on whether the company has the resources to sustain growth projects or weather economic downturns.

How to calculate cash ratio?

Here are the steps for when to use the cash ratio:
 

1. Assess Liquidity Needs: Determine the need to examine the company's liquidity condition, particularly its capacity to meet short-term obligations using available cash.
2. Financial Analysis: Decide to undertake a full financial analysis of the company, including an assessment of its liquidity and other financial measures.
3. Short-term planning: It ensures that the organisation has enough cash reserves to address impending expenses or liabilities.
4. Credit Evaluation: Determine the company's creditworthiness in the eyes of lenders or creditors, who may seek information on its ability to satisfy obligations with cash on hand.
5. Investment Decision-Making: Evaluate the company's liquidity strength before investing or lending to it.
6. Risk management: It involves assessing the company's ability to deal with unforeseen cash flow issues or economic downturns.
7. Comparative Analysis: Conduct a comparative analysis within the industry or against competitors to assess the company's liquidity situation and suggest opportunities for improvement.

Cash Coverage Ratio-Limitations

These are the limitation of the cash coverage ratio:
 

• The cash ratio is rarely utilised in financial reporting or by analysts conducting fundamental analysis of a company. It is impractical for a company  to keep an excessive amount of cash and near-cash assets to pay present liabilities. Holding huge quantities of cash on a company's balance sheet is frequently considered poor asset utilisation, as this money may be returned to shareholders or employed elsewhere to generate higher returns.
• The cash ratio is more informative when compared to industry and competition averages, or when examining variations within the same organisation over time. Certain industries tend to have higher current liabilities and lesser cash reserves.
• The cash ratio statistic fails to account for seasonality or the timing of substantial future cash inflows, which may overestimate a company in a single successful month or understate it during the offseason.
• A cash ratio less than one can signal that a corporation is facing financial difficulties. A low cash ratio, on the other hand, may indicate a company's special strategy that requires keeping low cash reserves—for example, because money is being spent for expansion.

Example

Let's say a company has INR 500,000 in cash and cash equivalents, and its current liabilities amount to INR 250,000.

Cash Ratio = Cash and Cash Equivalents / Current Liabilities

Cash Ratio = 500,000 / 250,000

Cash Ratio = 2

So, the cash ratio of the company is 2, indicating that it has twice as much cash and cash equivalents as its current liabilities.

FAQ

What is a good cash ratio?

A good cash ratio is often determined by the circumstances of the industry and company. However, in general, a cash ratio greater than one is regarded as favourable. This indicates that a corporation has sufficient cash and cash equivalents to pay its short-term liabilities. 

A ratio significantly greater than 1 indicates a good liquidity situation, but a ratio less than 1 may signal possible liquidity issues. When determining what makes a "good" cash ratio for a specific firm, industry standards, company size, and specific business needs must all be taken into account.

What is the cash reserve ratio formula?

The cash reserve ratio (CRR) formula calculates the percentage of a bank's total deposits that it must hold as reserves in the form of cash with the central bank. The formula is:

CRR = (Reserve Requirement / Total Deposits) * 100

Why is the cash reserve ratio important?

The cash reserve ratio is crucial because it helps central banks regulate the economy by controlling the amount of money banks can lend. By adjusting the CRR, central banks influence the liquidity in the banking system, manage inflation, and stabilise the economy.