The Cash Ratio is a commonly used financial formula within the family of Liquidity Ratios . It divides cash holdings and near money by current obligations in order to determine how much of a company’s short-term debt can be covered with cash on hand.
The Quick Ratio Formula:
Quick Ratio = Cash + Near-cash assets / Current Obligations
Near-cash assets: While cash is pretty self-explanatory, “near-cash assets” or “near money” also includes assets that are highly liquid — meaning they can almost immediately be converted to cash. These include savings accounts, certificates of deposit, money market accounts, marketable securities, and Treasury bills.
Current obligations: Also called Current liabilities, these are a company’s short-term financial obligations, due within one calendar year. Current liabilities can include accounts payable, short-term debt, dividends, and taxes owed, among other financial obligations.
What can the Cash Ratio tell me about my business?
If the cash ratio produces a number higher than 1, this indicates that your business is capable of paying off its short-term debt with the cash and near money on hand in case of an emergency.
If it is under 1, then your current obligations cannot be easily paid off without converting other assets (such as inventory or accounts receivable) into cash.
The cash ratio is the most conservative of the liquidity ratios we cover, the other two being the current ratio and the quick ratio. In this circumstance, “conservative,” refers to the fact that this ratio only considers cash and near money, while the other two include a more generous definition of “assets”.
The cash ratio is an indicator of liquidity in a worst-case scenario, where other assets cannot be converted to cash. Though some businesses will keep enough cash on hand to cover expenses several times over, others will run on much thinner margins. Your cash ratio will fluctuate depending on your industry, business model, and priorities.
Your cash ratio can be compared to competitors within the same industry in order to establish a baseline. A low cash ratio may indicate financial vulnerability and an inability to pay obligations. Too high of a cash ratio isn’t ideal either, as keeping too much cash on hand can be a sign that the business is not being smart about reinvestment or leveraging borrowed money.
Because the cash ratio is so conservative, it is rarely used by lenders or analysts to make any sort of significant determinations about a company’s financial health.