Cash Ratio - Meaning, Formula and Assumptions

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.


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