Cash ratio is the ratio of very liquid current assets such as cash and short-term marketable securities of a company to its current liabilities.
Cash ratio is the most conservative liquidity ratio because it takes only the near-cash current assets and compare them with current liabilities. This ratio is most relevant for companies in crisis situations. Since cash and cash equivalents are readily available and short-term marketable securities can be easily converted to cash in very short time, cash ratio assesses a company's liquidity position in worst-case scenario, a scenario in which it is unable to generate any cash from receivables and inventories and must pay current liabilities out of very liquid assets.
Cash ratio is calculated using the following formula:
|Cash Ratio =||Cash + Marketable Securities|
Cash includes cash in hand and cash at bank while marketable securities are very short-term investments which can be converted to cash quickly without any significant loss of value.
A high cash ratio is preferred by creditors because it means that more liquid assets are available to pay current liabilities when they become due all at once. However, it is naive to expect companies to maintain a cash ratio of close to 1. It is because cash and short-term marketable securities generate very little return when compared with long-term investments and expansion projects. Hence, businesses tend to minimize their idle cash balance. This means that a normal value of cash ratio is well below 1.00.
Even cash ratio is not fail-safe in all situations. In financial crises, liquidity generally dries up which means that companies are not able to sell their short-term marketable securities without significant loss of value. It means that in distress situations, a smaller proportion of current liabilities can be effectively paid out of the liquid assets than otherwise projected by the cash ratio.
Example 1:A company has following assets and liabilities at the year ended December 31, 20X9:
|Total Current Liabilities||73,780|
Calculate cash ratio from the above information:
|Cash ratio =||34,390 + 12,000||=||46,390||= 0.63|
Example 2: Calculate cash ratio from the following information.
|Total Current Liabilities||82,960|
Since treasury bills are marketable securities thus we will calculate cash ratio as follows:
|Cash ratio =||21,720 + 18,500||=||40,220||= 0.48|
by Irfanullah Jan, ACCA and last modified on