Cash Ratio

Cash ratio is the ratio of cash and cash equivalents of a company to its current liabilities. It is an extreme liquidity ratio since only cash and cash equivalents are compared with the current liabilities. It measures the ability of a business to repay its current liabilities by only using its cash and cash equivalents and nothing else.

Formula

Cash ratio is calculated using the following formula:

Cash Ratio = Cash + Cash Equivalents
Current Liabilities

Cash equivalents are assets which can be converted into cash quickly whereas current liabilities are those liabilities which are to be settled within 12 months or the business cycle.

Interpretation

A cash ratio of 1.00 and above means that the business will be able to pay all its current liabilities in immediate short term. Therefore, creditors usually prefer high cash ratio. But businesses usually do not plan to keep their cash and cash equivalent at level with their current liabilities because they can use a portion of idle cash to generate profits. This means that a normal value of cash ratio is somewhere below 1.00.

Examples

Example 1: A company has following assets and liabilities at the year ended December 31, 2009:

Cash$34,390
Marketable Securities12,000
Accounts Receivable56,200
Prepaid Insurance9,000
Total Current Liabilities73,780

Calculate cash ratio from the above information:

Solution
Cash ratio = ( 34,390 + 12,000 ) / 46,390 = 102,590 / 73,780 = 0.63

Example 2: Calculate cash ratio from the following information.

Cash$21,720
Treasury Bills18,500
Accounts Receivable35,930
Total Current Liabilities82,960

Solution
Since treasury bills are marketable securities thus we will calculate cash ratio as follows:
Quick ratio = ( 21,720 + 18,500 ) / 82,960 = 40,220 / 82,960 = 0.48

Written by Irfanullah Jan