When a company is figuring out how to meet its short-term liabilities, expected future cash flows might not make a big difference in their decision-making.
In other words, if the team has an immediate need for cash, it may not matter that they expect to collect a big payment from a client later that month, or see sales increase by the end of the year.
In certain cases, businesses need to know what they’re able to cover using the cash that’s already available, which the aptly-named cash ratio helps measure.
In this guide, we’ll provide an overview of the cash ratio definition and formula, and the important insights that this metric provides to business leaders.
What is cash ratio?
The cash ratio is a liquidity ratio that reflects a company’s ability to meet its near-term obligations with just cash and cash equivalents.
In this context, the cash is what the company has readily available on hand or in a bank account.
Cash equivalents refer to any investments or assets that can quickly be converted into cash, like a certificate of deposit (CD) or money market account. They may also be referred to as marketable securities.
Compared to other liquidity ratios, as we’ll cover in further detail below, the cash ratio provides a more conservative look at a company’s liquidity. It doesn’t consider other short-term assets the company may be able to turn into cash in a relatively short time frame, like inventory or accounts receivable. It’s only focused on the most liquid assets.
How to calculate the cash ratio
Cash ratio formula
The cash ratio has a simple formula, and you only need the most recent balance sheet to use it. To calculate this ratio, divide cash and cash equivalents by short-term liabilities. The formula is as follows:
Oftentimes, cash and cash equivalents are reported as one single value on the balance sheet. However, they may also be reported separately, in which case, they’ll need to be added together for use in the cash ratio formula.
The value for short-term liabilities is also found on the balance sheet, which may also be reported as short-term debts or obligations.
Step-by-step instructions to calculate cash ratio
The cash ratio is an important metric for business decision-making. Fortunately, it’s not too complicated to calculate. Here’s a quick overview of the few steps needed to use this formula.
Step 1: Identify the cash and cash equivalents value
The first step is to find the cash and cash equivalents, which will be reported under the current or short-term assets section of the balance sheet.
Again, these may be listed as two separate values instead of one combined figure. If so, simply add them up to find the total value.
Step 2: Identify the short-term liabilities value
Using the same financial statement, find the value for short-term liabilities. This value will be the denominator.
Short-term liabilities are debts that are due within one year, and may include a number of different accounts, such as:
- Accounts payable
- Taxes payable
- Wages payable
- Unearned revenues
- Accrued expenses
- Short-term loans
Step 3: Divide the cash and cash equivalents by short-term liabilities
With both values identified, calculate the cash ratio by taking the cash and cash equivalents and dividing it by short-term liabilities.
Common pitfalls with the cash ratio calculation
Though the cash ratio formula is relatively simple and straightforward, there are some common pitfalls when calculating and evaluating the metric, such as:
- Including other short-term assets like inventory or accounts payable in the calculation (which would produce the current or quick ratio instead)
- Only using the cash ratio to assess a company’s liquidity, which provides a very strict view of the business’s ability to cover short-term debts
- Ignoring potential seasonality, getting a misleading read of a company’s liquidity during peak or slow periods
Interpreting the Cash Ratio
What does the cash ratio tell you?
To reiterate, the cash ratio reflects whether a company could pay off its short-term debts using just its cash and cash equivalents.
It helps teams understand if they’ll be able to meet near-term obligations without selling off its assets, potentially pointing to any insolvency issues.
Going further, the ratio may help internal teams make decisions about capital allocation and taking on additional debts. It can also guide decision-making for investors and creditors, giving them a way to compare companies within the same industry in terms of liquidity.
What is a healthy cash ratio?
A cash ratio of 1.0 signifies that the company has just enough cash available to completely cover near-term obligations, meaning the two values are equal to one another. For example, this would be the case if the company had $255,000 in cash and cash equivalents, and the same amount in short-term liabilities.
However, it’s more likely that one value would be greater than the other. A cash ratio above 1.0 means the company has more cash than it needs to meet its obligations. It could pay off all debts due for the year, and still have some cash left over. A ratio below 1.0 means that its short-term debts outsize the cash on hand, which could point to potential insolvency.
Thus, a “healthy” cash ratio is typically anything between 0.5 and 1.0, meaning the company could at least pay for half of its short-term debts using liquid resources. Generally speaking, the higher the ratio, the greater the company’s ability to meet its current obligations.
However, having too high of a cash ratio isn’t necessarily a good thing. It may indicate that the company is mismanaging its capital, and could allocate the excess cash elsewhere to support growth and profitability.
Industry benchmarks for cash ratio
What’s considered a “good” cash ratio can vary widely between industries given the differing capital requirements and business models found across sectors.
Thus, it’s typically not helpful to perform a ratio analysis of a company and compare its cash ratio against businesses in other industries.
Instead, be sure to compare a company’s cash ratio against industry averages or similar peers to gauge its financial positioning.
Cash ratio example
A local cafe is interested in using cash to purchase a new espresso machine. However, the owner first wants to get a better understanding of its liquidity, ensuring they have enough cash on hand to meet short-term obligations in the first place.
Using the most recent balance sheet, the business reported $15,000 of cash and $12,000 of marketable securities under current assets, and $8,000 in accounts payable, $2,500 in unearned revenue, $5,000 in wages payable, and $6,000 in taxes payable under current liabilities.
To find the cash ratio, first total cash and cash equivalents:
= $15,000 + $12,000
= $27,000
Then, find the total value of short-term liabilities:
= $8,000 + $2,500 + $5,000 + $6,000
= $21,500
Dividing the cash and cash equivalents figure by short-term liabilities gives us the cash ratio:
= $27,000 / $21,500
= 1.26
A cash ratio of 1.26 indicates that the cafe has more than enough cash currently on hand to take care of its short-term liabilities. Thus, the owner may consider investing in a new espresso machine without worrying about a pinch in liquidity.
Cash Ratio vs. Other Liquidity Ratios
The cash ratio isn’t the only liquidity ratio stakeholders can use to evaluate a company’s ability to meet near-term obligations.
Similar ratios include the current ratio and the quick ratio. While all three ratios have some overlap in their formulas and input values, they each offer a distinct measure of liquidity. As such, they’re often used side by side to help teams get a more comprehensive picture of the business’s liquidity.
Cash ratio vs. current ratio
Compared to the cash ratio, the current ratio takes a wider view of a company’s liquidity.
Instead of just considering the cash and cash equivalents in comparison to short-term debts, the current ratio takes all current assets into account. This includes accounts like inventory, pre-paid expenses, and accounts receivable.
Put differently, the current ratio assesses whether a company could pay off all current liabilities by liquidating all current assets.
The current ratio formula is:
Cash ratio vs. quick ratio
The quick ratio, also known as the acid ratio, is more conservative than the current ratio, but still has a wider lens than the cash ratio.
It measures the company’s liquidity by comparing cash, cash equivalents, and accounts receivable to its short-term liabilities. The formula for the quick ratio is as follows:
Practical applications of the cash ratio
Both internal and external stakeholders can assess a company’s cash ratio to drive decision-making and evaluate its financial health. Here are some of the practical reasons for using the cash ratio.
Informing investment decisions
Investors may compare the cash ratios for two or more companies to gauge their liquidity and understand their ability to meet short-term obligations.
Every investor will have their own philosophy regarding what they look for in a cash ratio. However, they may see a company with a low cash ratio as unable to cover short-term liabilities, and therefore unable to invest in growth initiatives that will generate a return on their investment.
On the other hand, investors may not be interested in a company that has too high of a cash ratio, which may indicate that it’s holding onto too much cash and not willing to invest in growth or expansion.
Helping with business strategy
The cash ratio can also help internal decision makers drive business strategy. It’s an important metric for liquidity management, providing teams with a clear measure of their ability to cover obligations in the near future.
A low ratio might be a warning signal for the company, causing the team to investigate the source of the cash shortage and potentially cut back on spending. In contrast, a high ratio might give the team confidence in their liquidity and encourage them to create a lucrative strategy for the cash surplus.
Enhance liquidity management with BILL
The cash ratio is just one metric businesses can use to evaluate their financial health and drive strategic decisions.
Teams that want a more comprehensive view, including incoming and outgoing cash flows, budgeting, and invoicing, can use BILL’s integrated financial operations platform.
The platform helps businesses automate key financial workflows, sync real-time data to accounting software, and provide visibility into urgent to-do’s.
