Cash Ratio: Measuring the Cash Strength of a Company

Ravi had been on a journey to understand various financial metrics and their impact on a company’s stability. He was now curious to learn about a more conservative metric — the Cash Ratio, which would help him gauge a company's ability to cover short-term liabilities solely through cash. He recognised that for creditors and investors, this ratio is crucial in evaluating a company's resilience.

What is the Cash Ratio?

The Cash Ratio is a liquidity metric that measures a company's ability to meet short-term liabilities using cash or near-cash assets. It is more conservative than other liquidity ratios as it excludes receivables and inventory, focusing strictly on cash. This ratio essentially answers: "If a company had to repay its debts tomorrow, would it have enough cash to do so?"

The formula for the cash ratio is:
Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities

• Example: Calculating the Cash Ratio Let’s say Company ABC has the following financials:
  • Cash on Hand: ₹8 lakh
  • Marketable Securities: ₹2 lakh
  • Current Liabilities: ₹15 lakh

The cash ratio can be calculated as follows:
Cash Ratio = (8,00,000 + 2,00,000) / 15,00,000 = 0.67

A cash ratio of 0.67 means Company ABC can cover 67% of its short-term obligations with cash, raising some concerns but requiring further industry context to draw conclusions.

What the Cash Ratio Reveals

• Liquidity Strength: A cash ratio of 1 or higher shows that a company can meet its short-term obligations comfortably. This assurance appeals to lenders and creditors.
• Conservative View: The cash ratio is strict, as it excludes receivables and inventory. For this reason, it provides a more cautious view of a company's liquidity.

Interpreting a Cash Ratio less than 1

A cash ratio below 1 means the company cannot fully cover its short-term obligations with cash alone. However, it doesn’t always signal financial trouble; it could suggest efficient cash use.

Example: A lower cash ratio might indicate efficient cash management if the company has favourable credit terms with suppliers or a well-managed inventory, ensuring funds are used for growth rather than lying idle.

Interpreting a Cash Ratio greater than 1

A cash ratio above 1 indicates surplus cash, which suggests high liquidity but could also imply inefficiency if not used effectively. Example: If a company has a cash ratio of 1.5, it has 50% more cash than needed to cover liabilities, possibly as a buffer or due to underutilised resources that could otherwise generate returns.

Limitations of the Cash Ratio

1. Not Commonly Used for Reporting: Analysts prefer ratios that consider receivables and inventory, as the cash ratio’s conservativeness may not be representative.
2. Industry Differences: The acceptable cash ratio can vary significantly across industries. For example, supermarkets might have a low cash ratio but remain liquid due to high inventory turnover.
3. Misses Broader Financial Health: The cash ratio doesn’t account for receivables or inventory, which play crucial roles in a company’s working capital.
4. Resource Utilisation: A high cash ratio may indicate inefficiency, where a company is holding cash that could potentially be better invested.

Conclusion

The Cash Ratio gave Ravi a conservative perspective on a company's liquidity, helping him understand if a company could meet obligations even in challenging situations. With this knowledge, Ravi is ready for the next chapter on Working Capital Management, where he will learn to manage liquidity for smoother business operations.