What is Cash Ratio and Why Does it Matter for Businesses?

Compare Small Business Loans

$

on LendingTree's secure website

{"buttonText":"See Offers","buttonDisclaimer":"on LendingTree's secure website","customEventLabel":"","formID":"us-quote-form--small-business-loan-4405ecf1303901d3","submitURL":"\/small-business\/compare\/value_1","title":"Compare Small Business Loans","style":""}

For creditors, there's nothing like hard cash to allay the fear of not getting paid on time. Creditors consider the cash ratio a significant metric because it signifies how easily a company can meet its short-term obligations: invoices from vendors, salaries due, taxes payable and so on. The cash ratio is a measure of liquidity (the ability to pay short-term debts), much like the current ratio and the quick ratio, and accounts for cash and cash equivalents.

Cash Ratio Defined

The cash ratio shows how well a company can meet its short-term obligations, such as accounts payable or wages payable. The cash ratio, sometimes called the liquidity ratio, is generally defined as:

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

We explain each term in the formula below:

  • Cash: This includes currency, coins, checking accounts, savings accounts, petty cash and undeposited checks. The access to cash must be unrestricted, so items like certificates of deposit (CDs) are classified as cash equivalents rather than cash.
  • Cash Equivalents: Assets that can be quickly converted to a known amount of cash, such as CDs, Treasury bills, savings bonds, corporate commercial paper, bankers' acceptances and other types of money market instruments. They exclude less liquid assets and assets with uncertain value, such as inventory, accounts receivable, stocks, bonds and prepaid expenses.
  • Current Liabilities: Obligations (known as payables) that must be paid within one year, including the interest on long-term debt due in the next 12 months. Common payables include those for taxes, wages, utilities, interest, supplies and so forth.

How to Calculate the Cash Ratio

There are two ways to calculate the cash ratio:

Equation 1:

CR = (Cash + Cash Equivalents) / Current Liabilities

Equation 2:

CR = (Cash + Cash Equivalents) / (Current Liabilities – Accrued Expenses)

The numerator of both equations represents the most liquid assets of the business, a useful metric for bills due in the next few days. The second version of the equation subtracts accrued expenses from current liabilities because the accruals may not be due until later. An accrued expense has been incurred but not yet billed.

For example, if you bought $1,000 in office supplies on credit but don't expect to receive the invoice until next month, you would enter the expense on your books this month and offset against accrued expenses, a current liability account. When you receive the invoice from the office supplies store, you'll reverse the original entry and create the standard one for a payable. In practice, the second version is only used occasionally when unusual precision is required, such as in bankruptcy proceedings.

The following example shows excerpts from the balance sheet of Company X.

ItemAmount
Current Assets
Cash on hand$25,000
Cash in bank$15,000
Cash equivalents$30,000
Inventory$50,000
Accounts receivable$75,000
Noncurrent Assets
Fixed assets$80,000
Goodwill$20,000
Current Liabilities
Accounts payable$90,000
Income tax payable$55,000
Salaries payable$10,000
Accrued expenses$5,000
Noncurrent Liabilities
Bank loan$30,000
Deferred taxes payable$15,000

The numerator for both versions of the cash ratio equation is:

Cash + Cash Equivalents = $25,000 + $15,000 + $30,000 = $70,000

The denominator for Equation 1 is $160,000, whereas its value for Equation 2 is $155,000 after netting out accrued expenses ($160,000 – $5,000).

Solving Equation 1 gives us:

Cash Ratio = $70,000 / $160,000 = 0.4375

Equation 2 gives us:

Cash Ratio = $70,000 / $155,000 = 0.4516

Notice that Equation 2 gives a slightly higher value for the cash ratio. That's because the cash and cash equivalents don't have to be allocated to accrued expenses, leaving more left over to pay other debts.

How to Interpret Cash Ratio

Cash ratio is the strictest of the liquidity ratios because it uses only the most liquid of assets, namely cash and equivalents. A value of 1.0 means a company has exactly enough cash to pay its short-term bills. Values lower than 1.0 indicate that the company doesn't have enough cash and equivalents on hand to immediately pay its bills, while a value greater than 1.0 shows that a company has more than enough cash on hand to pay its current liabilities.

The question then arises: "What is a good cash ratio?" The answer depends on several factors.

  • Industry: Different industries have different norms for cash ratio. For example, some industries operate with low cash reserves. This is often the case with merchandisers because they are constantly using cash to buy inventory. You might see a merchandiser's cash ratio at 0.2 or lower. Other industries, such as construction, might need to keep cash around to pay for wages and materials, so they maintain a cash ratio approaching 1.0.
  • Risk: Business owners with a low tolerance for risk might like to keep cash and equivalents on hand "just in case," whereas risk-tolerant owners might consider extra cash reserves as a sign of inefficient deployment of assets.
  • Growth: A company experiencing very rapid growth might want to keep extra cash and equivalents on hand to pay for swiftly expanding operations.
  • Economic Conditions: If the economic or political environment seems highly uncertain, many companies observe the adage that "cash is king" and keep more money in a liquid form, therefore boosting their cash ratios.
  • Too High: A high cash ratio could mean inefficient use of a company's wealth. Rather than having cash sitting around, a company might want to use it for investments, dividends, stock repurchases and repayment of debt. In addition, some companies depend on access to low-cost loans when cash is short rather than tying money up in low-yielding bank accounts. If you lack a particular reason for maintaining a high cash ratio, you will want to consider redeploying excess cash to where it can do the greatest good.

Business owners can boost their cash ratios by keeping their net profits in cash and equivalents. Another strategy is to reduce liabilities by repaying debt and cutting expenses. Conversely, if their cash ratio is overly high, they can use some of their extra cash for longer-term investments.

Not surprisingly, creditors and lenders like to see a good cash ratio, although most are content with reasonable values for other liquidity metrics like the current and quick ratios. One area where a high cash ratio is a positive is in bankruptcy proceedings, where the cash and equivalents are prized because they are readily available to pay off some debt.

Kenny Zhu

Kenny is a Banking and Mortgage Research Analyst for ValuePenguin and has worked in the financial industry since 2013. Previously, Kenny was a Senior Investment Analyst at PFM Asset Management LLC. He holds a Bachelors of Science from Carnegie Mellon University, where he majored in International Relations & Politics. He is a CFA® charterholder.