Cash Ratio Definition
Cash ratio defines the relationship of cash, cash equivalents and current liabilities. This ratio is worked out by using most liquid assets of the company against current liabilities to know the liquidity position. This ratio indicates the ability of a company to pay off its current debts out of most liquid assets. Cash ratio is basically a more traditional look at the company’s capability to cover its current liabilities through cash and cash equivalents only. This is the reason that short term creditors take serious interest in this ratio. This ratio makes them think about the extent to which they may extend loans or financial assistance to the entities.
Cash Ratio Formula
From the above introduction, it clearly appears that only cash and cash equivalents are taken against all the current liabilities while calculating cash ratio. In other words we can easily infer that not all the current assets are considered in the equation of cash ratio. Following is the calculation formula
Cash includes both cash in hand and cash at bank. Cash Equivalents would mean and comprise of short-term highly liquid investments that are readily convertible to known amount of cash and which are subject to an insignificant risk of changes in value. You may make note of the fact that in accordance with the guidelines set out in the relevant accounting standard(s), cash equivalents are held in the business for purposes of meeting short term cash commitments. These are not primarily held for investments and other purposes. Moreover, this is very important point to note that for any investment to qualify as cash equivalent this is mandatory that the same should readily be convertible to known amount of cash and must be subject to an insignificant risk of changes in value.
Accordingly, the following items of current assets are left out of calculation in this ratio.
- Stocks in trade – inventories;
- Trade receivables – account receivables;
- Investments – not forming part of cash equivalents;
- Advances & prepayments
So far the current liabilities are concerned, this ratio requires all the current liabilities to be taken without making any distinction with respect to their due date of maturity.
Example of Cash Ratio
The following are the extracts of XYZ Company’s balance sheet as at December 31, 2016.
Inventories $ 14,000
Trade receivables $ 12,000
Investments – for one year $ 20,000
Demand deposits $ 4,000
Cash at bank $ 26,000
Cash in hand $ 9,000
Trade payables $ 16,000
Short term borrowings $ 18,000
Accrued & others $ 6,000
While working out cash ratio, the following assumptions are made:
- Demand deposits as above, have been included in cash equivalents being the most liquid assets ready to liquidate in a period of two months.
- Short term investments have been excluded from cash equivalents because the same are going to mature after 11 months from the date of balance sheet.
This ratio measures the liquidity position of the company in a more strict sense as compared to current ratio. Only cash and cash equivalents are taken to determine the extent of company’s ability to settle its current obligations without selling or liquidating any other current assets. In other words, this ratio explains that how well a company can pay off its current liabilities from most liquid assets i.e. cash and cash equivalents.
Usually ratio 1:1 is considered perfectly suitable. This cash ratio would mean that a company has same amount of current debts as cash and cash equivalents. It can be interpreted in another way that the company would not need to sell or liquidate any other current asset for the settlement of current debts.