What Is Cash Ratio? How To Compute Cash Ratio? YouTube

Cover Current Ratio Explained With Formula and Examples (4467x3304)

Table of Contents

1. What is Cash Ratio?
2. Why is Cash Ratio important?
3. How to Calculate Cash Ratio
4. What is a good Cash Ratio?
5. How can companies improve their Cash Ratio?

What is Cash Ratio?

Cash Ratio is a financial ratio that measures a company's ability to pay off its current liabilities with the cash and cash equivalents it has on hand. Essentially, it shows how much cash a company has compared to its short-term obligations.

The formula to calculate Cash Ratio is:

Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities

Cash and cash equivalents include cash on hand, deposits in checking and savings accounts, and short-term investments that are easily converted to cash. Current liabilities include any debts or obligations that are due within one year.

Why is Cash Ratio important?

Cash Ratio is an important financial metric because it shows a company's ability to meet its short-term obligations. A high Cash Ratio indicates that a company has enough cash on hand to pay off its debt without having to rely on other sources of financing. This gives investors and creditors confidence in the company's financial stability and ability to manage its cash flow.

On the other hand, a low Cash Ratio indicates that a company may struggle to pay off its short-term debt obligations. This could be a red flag for investors and creditors, as it suggests that the company may have to rely on external financing or may be at risk of defaulting on its debt.

How to Calculate Cash Ratio

To calculate Cash Ratio, you'll need to gather the necessary financial information from a company's balance sheet. You'll need to find the cash and cash equivalents and current liabilities.

Let's take a look at an example:

Company XYZ has the following financial information:

• Cash: $50,000
• Short-term investments: $25,000
• Checking account balance: $10,000
• Savings account balance: $5,000
• Accounts payable: $20,000
• Short-term loans: $15,000

To calculate Cash Ratio, we'll need to add up the cash and cash equivalents and divide that by the current liabilities:

Cash Ratio = ($50,000 + $25,000 + $10,000 + $5,000) / ($20,000 + $15,000) = 2.33

This means that Company XYZ has $2.33 in cash and cash equivalents for every dollar of current liabilities.

What is a good Cash Ratio?

There is no universally accepted "good" Cash Ratio, as it can vary by industry and company size. Generally, a Cash Ratio of 1 or higher is considered to be good, as it indicates that a company has enough cash on hand to pay off its short-term debt obligations.

However, some industries may require a higher Cash Ratio due to their capital-intensive nature or seasonal fluctuations in cash flow. For example, a manufacturing company may need a higher Cash Ratio to cover the cost of raw materials and production expenses, while a retail company may have higher cash inflows during the holiday season.

How can companies improve their Cash Ratio?

There are several ways that companies can improve their Cash Ratio:

• Reduce current liabilities: Companies can reduce their current liabilities by paying off their debts or renegotiating payment terms with suppliers. This will increase the Cash Ratio by decreasing the denominator in the formula.
• Increase cash and cash equivalents: Companies can increase their cash and cash equivalents by selling assets, cutting expenses, or increasing revenue. This will increase the numerator in the formula.
• Improve cash management: Companies can improve their cash management by implementing better cash forecasting and budgeting, optimizing their accounts receivable and accounts payable processes, and investing excess cash in short-term investments.

Conclusion

Cash Ratio is an important financial metric that measures a company's ability to pay off its short-term debt obligations with cash and cash equivalents. A high Cash Ratio indicates a company's financial stability and ability to manage its cash flow, while a low Cash Ratio may indicate financial distress. Companies can improve their Cash Ratio by reducing current liabilities, increasing cash and cash equivalents, and improving cash management.