Meaning of Cash Ratio
The cash ratio is a measure of the liquidity of a firm, namely the ratio of the total assets and cash equivalents of a firm to its current liabilities. The metric calculates the ability of a company to repay its short-term debt with cash or near-cash resources, such as securities which are easily marketable. This information is useful when investors determine how much money they will be willing to loan a company if any.
In the worst-case scenario, the cash ratio is more like a measure of a firm's value — say, that the company is about to quit the business. It tells analysts and creditors the worth of current assets that could be converted quickly into cash, and what percentage of the current liabilities of a company could cover those cash and near-cash assets.
Understanding Cash Ratio in Detail
Compared to other liquidity ratios, the cash ratio is generally a more conservative look at a company's ability to cover its debts and obligations, because it sticks strictly to cash or cash-equivalent holdings—leaving other assets, including accounts receivable, out of the equation.
Importance of Cash Ratio
Most commonly, the cash ratio is used as a measure of the liquidity of a firm. This measure indicates the willingness of the company to do so without having to sell or liquidate other assets if the company is required to pay its current liabilities immediately.
A cash ratio is expressed as an amount, larger or smaller than 1. When the ratio is determined, if the outcome is equal to 1, the corporation has exactly the same sum of current liabilities as assets and cash equivalents are paying off those debts.
Cash Ratio Limitations
The cash ratio is seldom used in a company's fundamental analysis by financial statements or analysts. Maintaining unsustainable amounts of cash and close cash reserves to fund current liabilities is not practical for a firm.
A company holding large amounts of cash on its balance sheet is often seen as poor utilisation of assets since this money could be returned to shareholders or used elsewhere to generate higher returns. Although offering an interesting prospect for liquidity, the utility of this ratio is minimal.
The cash ratio is more useful when compared to market averages and competitor averages, or when looking at improvements over time within the same business. A cash ratio below one sometimes indicates a firm is at risk of financial difficulty. But a low liquidity ratio may also be an indication of a company's particular policy that allows for low cash reserves to be maintained because, for example, funds are being used for growth.
