Cash ratio is yet another variation of current ratio which is even stricter than quick ratio and only considers highly marketable securities (investments) and cash / cash equivalents. Cash ratio provides gives a reliable insight on entity’s liquidity position especially when entity is facing financial crunch.
Cash ratio is calculated using the formula:
Cash ratio = Cash & Cash equivalents + Highly marketable securities / Current liabilities
Analysis and Interpretation
As one can notice from the formula above it is even more restrictive than quick ratio and excludes even receivables and essentially leaving us with cash and highly liquid short term investments. Just like current ratio and quick ratio, higher the cash ratio better the entity’s liquidity strength. However, it is hardly the case that entity holds cash and cash equivalents equal to its current liabilities all the time.
A cash ratio of 1 means that entity has enough cash and cash equivalents to pay its short term liabilities. But its highlight unlikely that entity holds cash in such large volumes that cash in hand and cash at bank alone can payout liabilities. Simple reason is that entity need not to hold it all the time and even if entity holds it the opportunity cost would be so high that it will be detrimental for entity’s profit and growth as entity can invest such valuable cash in projects and buying fixed assets.
Example
| inventory | 100,000 |
| receivables | 80,000 |
| prepaid rent | 20,000 |
| commercial paper | 20,000 |
| cash at bank | 55,000 |
| cash in hand | 34,880 |
| current assets | 309,880 |
| ` | ` |
| Accounts payable | 65,000 |
| Tax payable | 54,000 |
| Interest accrued | 15,000 |
| Current liabilities | 134,000 |
Solution:
Cash ratio = [Cash / Cash equivalents + Highly marketable securities] / Total current liabilities
Commercial papers are considered highly liquid unless stated otherwise therefore we are assuming the same.
= [ 55,000 + 34,880 + 20,000 ] / 134,000
= 0.82:1 or simply 0.82
In words, entity holds 82 cents in highly liquid assets for every dollar of current liabilities.