Cash Ratio: Definition, Formula, and Example

What Is the Cash Ratio?

The cash ratio is a measurement of a company's liquidity. It calculates the ratio of a company's total cash and cash equivalents to its current liabilities. The metric evaluates a company's ability to repay its short-term debt with cash or near-cash resources such as easily marketable securities. This information is useful to creditors when they decide how much money, if any, they would be willing to loan to a company.

Cash Ratio Formula

The cash ratio is generally a more conservative look at a company's ability to cover its debts and obligations compared to other liquidity ratios. It sticks strictly to cash or cash-equivalent holdings, leaving other assets such as accounts receivable out of the equation.

The formula for a company's cash ratio is:

Cash Ratio: Cash + Cash Equivalents / Current Liabilities

What Cash Ratio Can Tell You

The cash ratio is most commonly used as a measure of a company's liquidity. This metric shows the company's ability to pay all current liabilities immediately without having to sell or liquidate other assets.

A cash ratio is expressed as a numeral greater or less than one. The company has the same amount of current liabilities as it does cash and cash equivalents to pay off those debts if the result is equal to one when calculating the ratio.

The cash ratio is almost like an indicator of a firm’s value under the worst-case scenario where the company is about to go out of business. It tells creditors and analysts the value of current assets that could quickly be turned into cash and what percentage of the company’s current liabilities these cash and near-cash assets could cover.

The U.S. Small Business Administration advises companies on monitoring healthy levels of liquidity, capacity, and collateral through the use of this and other liquidity ratios, especially when building relationships with lenders. Lenders will analyze financial statements to evaluate the health of the company when companies pursue loans.

Calculations Less Than 1

There are more current liabilities than cash and cash equivalents when a company's cash ratio is less than one. Insufficient cash is on hand to pay off short-term debt. This may not be bad if the company has conditions that skew its balance sheets such as long credit terms with its suppliers, efficiently-managed inventory, and very little credit extended to its customers.

Calculations Greater Than 1

The company has more cash and cash equivalents than current liabilities when its cash ratio is greater than one. It can cover all short-term debt and still have cash remaining in this situation.

A higher cash ratio is generally better but it may also reflect that the company is inefficiently utilizing cash or not maximizing the potential benefit of low-cost loans instead of investing in profitable projects or company growth. A high cash ratio may also suggest that a company is worried about future profitability and is accumulating a protective capital cushion.

Example of the Cash Ratio

Apple, Inc. held $37.1 billion of cash and $26.8 billion of marketable securities at the end of 2021. Apple had $63.9 billion of funds available in total for the immediate payment of short-term debt. Between accounts payable and other current liabilities, Apple was responsible for roughly $123.5 billion of short-term debt.

Short-Term Ratio = $63.9 million / $123.5 billion = Roughly 0.52

Apple's operating structure shows the company leverages debt, takes advantage of favorable credit terms, and prioritizes cash for company growth. The company has nearly twice as many short-term obligations despite having billions of dollars on hand.

Limitations of the Cash Ratio

The cash ratio is seldom used in financial reporting or by analysts in the fundamental analysis of a company. It's not realistic for a company to maintain excessive levels of cash and near-cash assets to cover current liabilities. It's often seen as poor asset utilization for a company to hold large amounts of cash on its balance sheet because this money could be returned to shareholders or used elsewhere to generate higher returns.

The cash ratio is more useful when it's compared with industry averages and competitor averages or when looking at changes in the same company over time. Certain industries tend to operate with higher current liabilities and lower cash reserves.

The cash ratio may be most useful when it's analyzed over time. A company's metric may be low but it may have been directionally improving over the last year. The metric also fails to incorporate seasonality or the timing of large future cash inflows. This may overstate a company in a single good month or understate a company during the offseason.

A cash ratio lower than one does sometimes indicate that a company is at risk of having financial difficulty. However, a low cash ratio may also be an indicator of a company's specific strategy that calls for maintaining low cash reserves, such as because funds are being used for expansion.

The Bottom Line

A company's cash ratio is calculated by dividing its cash and cash equivalents by its short-term liabilities. A company can strive to improve its cash ratio by having more cash on hand in case of short-term liquidation or demand for payments. This includes turning over inventory more quickly, holding less inventory, or not prepaying expenses.

Alternatively, a company can reduce its short-term liabilities. The company can begin paying expenses with cash if credit terms are no longer favorable. The company can also evaluate spending and strive to reduce its overall expenses, thereby reducing payment obligations.