What is a Cash Ratio?
The cash ratio compares a company’s most liquid assets to its current obligations. The cash ratio is used to determine if a business can meet its short-term obligations. It also measures whether it has enough liquidity to continue operating. The cash ratio is the most conservative liquidity ratio in comparison to the current ratio and quick ratio. Since it considers only inventory and accounts receivable, it is the most cautious of all the liquidity measures (which is included in the quick ratio). This accounting ratio may be excessively conservative, especially if receivables can be converted into cash quickly.
Types of Cash Equivalents
Cash equivalents are short-term, highly liquid assets that are easily converted and carry a low risk of value fluctuation. The intent behind maintaining cash equivalents is to fund short-term cash obligations. The goal is not driven by having a long term investment in these equivalents. To qualify as a cash equivalent, an investment must be easily convertible into a known amount of cash and have a low risk of value fluctuation. Only investments with a short maturity of ideally three months or less from the date of acquisition are usually considered cash equivalents.
Commercial Paper (CP) is an unsecured money market product issued in the form of a promissory note. It allows highly rated corporate borrowers to borrow from a diversified source or pool. This way the corporates fund their short-term borrowings. Furthermore, it provides the investors with an additional less risky source of investment. CP can be issued for maturities ranging from 7 days to one year from the date of issue. The corporates issue these commercial papers at a discount on face value. This discount represents the market interest rates prevalent at the time of the issue of the commercial paper.
Treasury bills are short term money market instruments with a guarantee of payment at a later date. These bills are issued by the Central Government of India to overcome a shortfall in liquidity and fiscal deficit in the economy. They are issued at a zero interest rate at a discount on the face value and redeemable on maturity. The investors earn returns in the form of a difference between the maturity value and investment value.
Short Term Government Bonds
A government bond is a debt instrument issued by the central and state governments to fund their needs while also regulating the money supply. Bonds are frequently used by governments to raise revenue for infrastructure development and to finance government spending. As a result, the government will issue bonds to the general public, attracting investment. Government bonds are long-term investment vehicles in India. These bonds have a long term, ranging from five to forty years. Short Term Government Bonds include treasury bills, cash management bills, fixed-rate bonds, capital index bonds, inflation indexed bonds, and sovereign gold bonds.
Marketable securities are financial instruments and assets that can be converted into cash immediately and are thus very liquid. These securities are liquid because their maturities are typically one year or less. Moreover, the rates at which they can be traded have even less impact on valuation. Hence, equity shares are not included in the definition of marketable securities.
Explore: Types of Ratio Analysis
Cash Ratio Formula
The Formula for Cash Ratio is:
Cash Ratio = Cash and Cash Equivalent / Current Liabilities
How to Calculate Cash Ratio?
Let us understand the calculation of cash ratio with the help of the following example for 2 financial years.
|Particulars||Financial Year 2021-2022|
|Financial Year 2020-2021|
|Advance Received||Rs 3,20,000||Rs 4,60,000|
|Accounts payable||Rs 4,40,000||Rs 2,80,000|
|Accrued liabilities and other debts||Rs 2,80,000||Rs 2,40,000|
|Cash in Hand||Rs 2,40,000||Rs 1,60,000|
|Current Account Balance With Bank||Rs 2,60,000||Rs 2,40,000|
|Treasury Bills||Rs 1,80,000||Rs 60,000|
|Marketable Securities||Rs 2,80,000||Rs 1,80,000|
|Government Bonds||Rs 1,60,000||Rs 1,40,000|
(Advance Received + Accounts payable + Accrued liabilities and other debts)
(Rs 3,20,000 + Rs 4,40,000 + Rs 2,80,000 +)
(Rs 4,60,000 + Rs 2,80,000 + Rs 2,40,000)
|Cash and Cash Equivalents|
(Cash in Hand + Current Account Balance With Bank + Treasury Bills + Marketable Securities + Government Bonds)Rs 11,20,000
(Rs 2,40,000 + Rs 2,60,000 + Rs 1,80,000 + Rs 2,80,000 + Rs 1,60,000)
(Rs 1,60,000 + Rs 2,40,000 + Rs 60,000 + Rs 1,80,000 + Rs 1,40,000)
(Cash and Cash Equivalents / Current Liabilities)
(Rs 11,20,000 / Rs 10,40,000)
(Rs 7,80,000 / Rs 9,80,000)
|Interpretation||With a cash ratio more than 1.|
the company can pay off all short-term debt while still having cash on hand.
|With a cash ratio of less than 1.|
there are more current obligations than cash and cash equivalents
Analysis of Cash Ratio
When there is a need to make a quick assessment of a company’s liquidity and stability, a cash ratio is an excellent measure. A company may use the cash ratio internally to evaluate its plans. The creditors or lenders may conduct a cash ratio analysis on a company to secure liquidity. When looking for a conservative approach to a company’s finances, the cash ratio is usually the best option. The cash ratio decreases uncertainty by solely assessing short-term assets.
Lower Cash Ratio
There are more current obligations than cash and cash equivalents if a company’s cash ratio is less than one. It suggests there isn’t enough cash on hand to pay off short-term debt. This may not be a negative exposure if the company’s balance sheets are skewed by factors like longer-than-normal credit terms with suppliers, well-managed inventory, and less credit offered to customers.
Higher Cash Ratio
When a company’s cash ratio exceeds one, it means it has more cash and cash equivalents than current obligations. In this case, the company can pay off all short-term debt while still having cash on hand.
No doubt a higher cash ratio appears to be reasonable. However, it might not indicate sound business practices. Moreover, if it is much higher than the industry standards then it is a matter of concern. High cash ratios may indicate that a company is inefficient in its cash management. It could also imply that the company is not realising the potential benefit of short-term investments. Hence, rather than earning interest or return on investment, the company is increasing the bank balance. It could also indicate that a company is concerned about future profitability and is building up a cash cushion to safeguard itself.
Limitations of Using Cash Ratio
If a company intends to demonstrate a high cash ratio to the outside world, it must have a lot of cash on hand at the measurement date, possibly more than is prudent. Another issue is that the ratio only gauges cash balances at a certain point in time, which might change rapidly when receivables and suppliers are paid. As a result, the quick ratio, which includes accounts receivable in the numerator, is a superior measure of liquidity.
In a business, it is an unrealistic expectation that the company will have the capability to fund its current liabilities with cash and cash equivalents. This is because ideally, companies invest their excess cash. Significant amounts of cash on a company’s balance sheet are sometimes viewed as poor asset utilization. This money may be returned to shareholders or employed elsewhere to generate higher returns. While this ratio provides an interesting liquidity perspective, its utility is restricted.
When compared to industry and competitor averages, or when looking at changes in the same company over time, the cash ratio is more informative. However such information is difficult to obtain and apprehend.
A cash ratio of less than one demonstrates a negative perception. It is assumed that due to a less than 1 ratio, the company is facing financial instability. Moreover, this might not be the case at all. The company could be maintaining low cash reserves due to an ongoing expansion project or other similar activities that demand a huge cash outflow.