What is Cash Ratio and Cash Ratio Formula – Cash Ratio or often referred to as Cash Asset Ratio is a ratio used to compare the total cash and cash equivalents of a company with its current liabilities.
The Cash Ratio is basically a refinement of the quick ratio that is used to identify the extent of funds (cash and cash equivalents) available to pay off current liabilities or short-term debt. Prospective creditors use this ratio as a measure of company liquidity and how easily the company can cover its short-term debt obligations.
This Cash Ratio is the most strict and conservative liquidity ratio to the company’s ability to cover its debt or short-term liabilities when compared to other liquidity ratios (current ratio and fast ratio). This is because the Cash Ratio only calculates the most short-term liquid assets or, namely cash and cash equivalents, which are the easiest and fastest assets to be used in paying off current debts.
Please to also read What is Liquidity Ratio Analysis and its types.
Cash Ratio Formula
The Cash Ratio is calculated by distributing the most liquid current assets, namely cash and cash equivalents with its current liabilities. The following below is the Cash Ratio formula:
Cash Ratio = (Cash + Cash Equivalent) / Loan Debt
- Cash is all payment instruments that can be used immediately such as coins, banknotes, and current or savings account balances at the bank.
- Cash Equivalents are highly liquid, short-term investments that can be turned into cash in a fast amount of time without any risk of significant value changes.
- Current liabilities are corporate debt that must be paid in cash within one year or in the company’s operational cycle.
Example of Calculating Cash Ratio
The ABCD company has current assets of $ 10 million of which $ 3 million is in cash and $ 2 million is a checking account at a bank. While the current debt is $ 7 million. What is the Corporate Cash Ratio of ABCD company?
- Cash and Cash Equivalents = $ 5 million ($ 3 million + $ 2 million)
- Current debt = $ 7 million
- Cash Ratio =?
- Cash Ratio = (Cash + Cash Equivalents) / Current
- Debt Cash Ratio = $ 5 million / $ 7 million
- Cash Ratio = 0.71 times
So the cash ratio at the company ABCD company is 0.71 times
Valuation of Cash Ratio
From the example above, it is known that the cash ratio of ABCD company is 0.71 times, this means that ABCD company only has cash and cash equivalents to pay 75% of its current liabilities. This cash ratio is quite high because it shows a relatively high cash balance throughout the year.
Cash ratios are actually not very popular in liquidity analysis such as current ratios and fast ratios because their use is also very limited. Basically, there is no general assessment of this cash ratio. In some countries, a cash ratio of 0.2 is considered acceptable. A cash ratio that is too high can indicate the use of assets that are not optimal for the company because it holds too much cash on its balance sheet.