As a creditor, investor, or analyst, evaluating a company’s financial health is highly important. How can you tell if the company can pay off its debts? How do you compare its liquidity and solvency with other companies? One key ratio helps answer these questions: the cash ratio.
The cash ratio measures a company’s ability to pay off its short-term obligations with its most liquid assets.
In this blog post, we will explore everything about the cash ratio.
Let us begin!
What is the Cash Ratio?
The cash ratio indicates how well a company can pay short-term obligations with liquid assets.
In simple terms, the cash ratio is a measure used to assess how well a company can cover its short-term liabilities (debts due within one year) with its cash and cash equivalents.
Cash Ratio Formula
The formula for the cash ratio is:
Cash ratio = (Cash + Cash equivalents) / Current liabilities
To calculate the cash ratio, you must divide cash and cash equivalents by total current liabilities.
Here’s a breakdown of the cash ratio formula:
1. Cash and Cash Equivalents: It includes actual cash on hand and assets that are easily convertible into cash within a short period, typically within three months or less.
Examples include cash in bank accounts, Treasury bills, and short-term certificates of deposit.
2. Short-Term Liabilities: These are debts or obligations that a company needs to repay within the next year.
Using the cash ratio formula, you can tell how capable a company is of paying off its short-term debts using the cash it has on hand.
A higher cash ratio indicates a stronger ability to meet short-term obligations, which can be seen as a positive sign of financial health.
Cash Ratio Example
Let us take the example of Indian Spice Traders Ltd. It has the following financial information:
- Total Cash and Cash Equivalents: ₹1,00,000
- Current Liabilities: ₹50,000
To calculate the cash ratio, we divide the total cash & cash equivalents by the total current liabilities:
Cash Ratio = Total Cash and Cash Equivalents / Current Liabilities
For Spice Traders, the calculation would be:
Cash Ratio = ₹1,00,000 / ₹50,000 = 2
So, Spice Traders has a cash ratio of 2.
Now, what does this mean?
The cash ratio tells us how capable Spice Traders is of meeting its short-term liabilities with its readily available cash and cash equivalents.
In this case, a cash ratio of 2 means that for every ₹1 of current liabilities, Spice Traders has ₹2 of cash available.
Cash Ratio Importance
The cash ratio is important for creditors, investors, and analysts, as it provides a conservative estimate of a company’s liquidity and solvency.
Importance for Creditors, Investors, and Analysts
- The cash ratio provides an estimate of a company’s liquidity and solvency.
- Cash ratio Indicates how much cash a company can use to pay current liabilities without relying on slower-to-convert assets.
Implications of High Cash Ratio
- Strong liquidity position.
- Low risk of debt default.
Implications of Low Cash Ratio
- Potential cash flow problems.
- Possible need for borrowing or asset selling to meet financial obligations.
- Comparative Analysis
Allows comparison of cash ratios across different companies or industries to assess relative liquidity and financial health.
Cash Credit Ratio
The cash-credit ratio is a term used in the Indian banking system. It shows the ratio of a borrower’s cash credit limit to the value of the collateral or security pledged to the lender.
Cash credit is a short-term loan allowing a borrower to withdraw money up to a set limit, decided by the lender based on creditworthiness and collateral value.
Collateral can be inventory, receivables, or other current assets.
The cash credit ratio is often a percentage, indicating how much credit a borrower can get against the collateral.
For instance, if a borrower’s cash credit limit is ₹50,000 and collateral value is ₹100,000, the ratio is 50%.
A higher ratio means more funds available against collateral, while a lower ratio means less borrowing capacity.
Remember – Lenders consider the cash-credit ratio when granting loans.
Conclusion
Understanding the cash ratio is crucial for assessing a company’s financial health. This ratio measures a company’s liquidity, revealing its capability to cover short-term obligations with readily available assets. Overall, maintaining a balance between cash reserves and investment opportunities is key, as excessively high cash ratios may indicate underutilised resources.
FAQs| Cash Ratio
The cash ratio measures a company’s liquidity, indicating its ability to cover short-term obligations with its most liquid assets, like cash and cash equivalents.
A cash ratio of not less than 0.5 to 1 is generally preferred, although what’s considered good varies across industries. A ratio above 1 signifies having more cash than current liabilities, while below 1 suggests more liabilities than cash.
The cash ratio is calculated by dividing the sum of cash and cash equivalents by total current liabilities. This reflects the proportion of liquid assets to short-term obligations.
A high cash ratio indicates a company has ample cash to meet immediate financial obligations and may suggest a low risk of default. However, it could also imply inefficient cash usage, potentially missing out on growth opportunities.
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Disclaimer: Investments in the securities market are subject to market risks; read all the related documents carefully before investing.