Each of the methods calculates the ratio of a company’s short-term assets to its short-term liabilities. Learn how the cash method ratio is used and how it varies from other methods.
Definition and Examples of the Cash Ratio
Liquidity measurements, such as the cash ratio, compare a company’s cash and other liquid assets to its current liabilities. This helps estimate its ability to pay off its short-term debt. If a company is tipping into insolvency, the application of the cash ratio might be the most realistic of the three liquidity ratios. For this reason, lenders sometimes use the cash ratio to understand what the worst case might be.
How Do You Calculate the Cash Ratio?
To calculate the cash ratio for a company, start by looking at the value of its cash and marketable securities. Then, divide that by the current liabilities.
How the Cash Ratio Works
When using the cash ratio, a cash ratio above 1 means that the company has the ability to pay off its debts while still having cash leftover. A company with $100,000 in cash and marketable securities, and $75,000 in liabilities, has a cash ratio of 1.33. That means the company can pay off its current liabilities with money to spare. However, a company with $1.5 million in cash and marketable securities, and $1.75 million in liabilities, has a cash ratio of about .85. While there are two other methods of liquidity measurement—the quick ratio and the current ratio—the cash ratio is the most conservative. That’s because it compares only considers cash and liquid assets when calculating the ratio. The quick ratio, on the other hand, includes the value of receivables; the current ratio includes receivables as well as inventory.
Differences Between the Cash Ratio, Quick Ratio, and Current Ratio
Here’s how the formula for the cash ratio compares to the quick ratio and the current ratio:
Cash ratio = (Cash + Marketable Securities) / Current LiabilitiesQuick ratio = (Cash + Marketable Securities + Receivables) / Current LiabilitiesCurrent ratio = (Cash + Marketable Securities + Receivables + Inventory)/ Current Liabilities
The Quick Ratio
In addition to assets that are already cash or capable of being turned into cash in a day or two, the quick ratio also allows receivables to count among its short-term assets. The significance of adding receivables as short-term assets is to some extent dependent on the particular circumstances of the business involved. A well-established business may regularly collect its receivables in a short period of time—10 days, for instance—from financially stable longstanding clients. This history of the prompt collection of receivables means there is limited risk in adding them to the short-term assets side of the equation, even though they are not actually within the company’s possession. The reasonable assumption is that they soon will be.
The Current Ratio
Adding on to the quick ratio formula, the current ratio includes inventory. The significance of this depends on the direction of both the general economy, the overall health of the company’s business, and the particular business the company is in. Inventory consists of assets that have not yet been sold. If the inventory represents a predictable flow of goods from suppliers through the company to its customers—a restaurant’s food inventory, for example—then the added risk may not be significant. If the inventory consists of goods in an unpredictable industry—fashion, for instance—it may be unwise to count as assets goods that may be sold quickly, sold slowly, sold slowly at discounts, or perhaps never sold at all.
How Useful Is the Cash Ratio?
In general, most analysts don’t use the cash ratio. Not only does it presume a degree of risk that is fairly uncommon, but it also gives value to cash and short-term securities that overestimates their utility in a well-run company. Until you do something with cash, it has little ability to generate a reasonable return. In some economic environments, short-term marketable securities don’t even keep up with the real loss in value caused by inflation. A company with too much cash and heavily weighted in short-term securities is unlikely to be highly profitable.
