Table of Contents
- 1 What is a Cash Ratio?
- 2 Calculation / Formula
- 3 EXAMPLE
- 4 INTERPRETATION
What is a Cash Ratio?
Cash ratio, also known as absolute cash ratio, is one of the stringent liquidity ratios and it defines the immediate ability of the company to pay off its short-term commitments. Other vital liquidity ratios are current ratio and quick ratio (or acid-test ratio). Cash ratio is useful for creditors in assessing the probability of timely payment of their dues.
Calculation / Formula
The calculation of cash ratio involves cash and cash equivalent current assets and current liabilities. The formula of cash ratio is as follows:
Cash Ratio = Cash and Cash Equivalents / Current Liabilities payable within 12 months or Operating Cycle
Cash & Cash Equivalents
Cash includes only the balances lying as cash in hand and bank accounts. Cash equivalents are those short-term assets which are readily convertible to cash and are highly liquid. For example stocks, bonds, government securities, treasury bills, bank deposits, money market instruments, etc. The primary purpose is to include only those assets whose encashment is readily possible within a very short time say 3 months or so. Here, closing stock, debtors, and miscellaneous expenses are not considered because they are not the cash equivalent.
While calculating the ratio, the value of cash equivalents should be the net realizable value (NRV). NRV is the value or amount which can be realized if sold immediately. NRV is taken to avoid the risk of change in the market value of the investments.
Current Liabilities Repayable within Operating Cycle
Cash ratio intends to find out the capacity of the company to meet its short-term debts using its most liquid items. The short-term debts are debts repayable within 12 months or the operating cycle. Major items being sundry creditors, outstanding expenses, short-term loans & advances, bank overdraft/cash credit, provision for taxation, proposed dividend, unclaimed expenses, etc. The more the cash ratio, the more efficient the company is in paying off its short-term dues.
Let’s assume a balance sheet of a company as on 31.03.2013 as follows:
|Equity share capital||5,00,000||Fixed Assets||5,00,000|
|Reserves & Surplus||1,50,000||Investments||1,00,000|
|Current Liabilities-Sundry Creditors-outstanding Expenses
-Provision for Tax
|Current Assets-Closing Stock-Debtors
-Cash in hand
-Cash at Bank
|Cash Ratio||=||cash in hand+ cash at bank + bank deposit + treasury bills|
|sundry creditors +o/s expenses + provision for tax|
|=||1,20,000 / 80,000|
Here, the cash ratio is 1.5, which signifies that there is excess cash after paying off current liabilities.
The interpretation of cash ratio will vary from business to business. There is no such ideal cash ratio. Following is an indicative understanding of the ratio.
Cash Ratio equals to 1
It means cash and cash equivalents are equal to the short-term liabilities.
Cash Ratio greater than 1
It means more cash in the system than required for payment of short-term liabilities. A creditor of the company will be happy with such ratio as higher as possible because that will reduce the chances of any delay in paying his dues. But, on the other hand, the company would like to keep it low or optimized to suit its requirements because idle cash means unwanted loss of interest cost.
Cash Ratio lower than 1
It means cash in the system is insufficient to pay for short-term liabilities. A creditor of the company will assume more risk while extending credit to the company. In this case, they will rely on the previous track record of the company. Lowest possible cash levels with no delays in creditor’s payments in the company make the management happy because they see the savings in terms of interest cost on idle cash and effective cash management.
Various Other Interpretations of the High Levels of Cash in the Industry
Companies with large cash in the balance sheet indicate that there are limited growth opportunities available to the company otherwise such idle cash could have been used for expansion. From mergers and acquisition point of view, these companies are the potential target for the acquirers. Last but not least, idle cash does not return anything and hence opportunity cost of interest on the idle cash is a direct dent in the profits of the company.1