MSG Team's other articles

12895 An Overview of Contracts and Why They are Important to Business and Society

Contracts govern all transactions whether they are between firms or between firms and private individuals. Indeed, in most of the developed world, any transaction or commercial exchange is usually not undertaken without a contract. This trend is also catching up in the developing world where contracts are increasingly becoming the norm. The importance of contracts […]

11031 Risk Management in Financial Modeling

Financial models were widely used by corporations, even in 2008. However, the severity of the 2008 crash forced financial institutions to rethink their approach towards modeling. Many assumptions which are inbuilt in a financial model were being changed to imbibe the lessons learned in the great recession. One such lesson learned was about risk management. […]

9621 How Green Bonds Work?

Stakeholders all over the world are concerned about the irreversible damage being caused to the ecosystem of the earth. There is a common belief amongst people that the natural habitat on planet Earth has been irreversibly damaged. It is true that climate change affects all of us. It is also true that very soon the […]

11856 What are Demergers: Its Pros and Cons

Mergers and acquisitions are often used by conglomerates to create value. However, in some cases, demergers have also been effectively used. While the workings of mergers and acquisitions are well known to many people, demerger is still considered somewhat of a mystery. In this article, we will have a closer look at what a demerger […]

9343 Financial Models for Startups

Planning is an essential function that the founder of a startup company needs to perform. However, this planning is often done informally. If a startup founder is not reaching out to investors to raise funds, there is a very low chance that they will have a well-documented financial model in place. However, empirical data shows […]

Search with tags

  • No tags available.

The cash ratio is limited in its usefulness to investors and financial analysts. It is the least popular of the liquidity ratios and is used only when the company under question is under absolute duress. Only in desperate circumstances do situations arise where the company is not able to meet its short term obligations by liquidating its inventory and receivables and this is when the cash ratio comes handy.

Formula

Cash Ratio = (Cash + Cash Equivalents + Marketable Securities) / Current Liabilities

Meaning

The cash ratio indicates the amount of cash that the company has on hand to meet its current liabilities. A cash ratio of 0.2 would mean that for every rupee the company owes creditors in the next 12 months it has 0.2 in cash. 0.2 is considered to be the ideal cash ratio.

Assumptions

The cash ratio is the most stringent of all liquidity ratios. Hence there are no assumptions made. The cash and cash equivalent figures stated on the balance sheet are facts and so are the current liabilities stated on the balance sheet. Hence there is no assumption about future events that need to occur as per the company’s plan.

The nearest the cash ratio gets to an assumption is that it believes that marketable securities and cash equivalents can be quickly liquidated. Under normal circumstances this is always the case. The only case where liquidation of these securities would be an issue would be the complete failure of the economic system.

Wrong Interpretations

  • A high cash ratio may not be a good thing for a company. Cash is an idle asset. It does not earn a sufficient rate of return. Therefore companies must constantly work towards keeping the cash locked up in gainfully employed investments. A large amount of cash on the balance sheet may be an indicator that the company is running out of investment opportunities.

  • Wild fluctuations in the cash ratio may not be such a bad thing either. It is not uncommon for companies to keep accumulating cash and then using it at one go when a profitable opportunity arises. It is this nature of the cash ratio that makes its usefulness limited. The cash ratio usually creates more questions than it answers for the financial analysts. Given the fact that analyst may not access to inside information to answer these questions, the usefulness of these ratios remain limited.

  • Moreover, cash received is not necessarily cash earned. The cash can be in the form of payments received in advance. Moreover, third parties may have the right to demand the payment of that cash. These rights do not appear on the balance sheet in the current liabilities but are present in the footnotes and hence are not used in the calculation of the ratio.

Article Written by

MSG Team

An insightful writer passionate about sharing expertise, trends, and tips, dedicated to inspiring and informing readers through engaging and thoughtful content.

Leave a reply

Your email address will not be published. Required fields are marked *

Related Articles

What are Common Size Statements ?

MSG Team