We built this cash ratio calculator to help you to calculate a company's cash ratio when analysing its liquidity. Cash ratio is considered to be one of the liquidity ratios and is widely used in company analysis.

This article will help you understand what is cash ratio and how to calculate it. We will also show you some examples to help you understand how to apply the cash ratio equation to real life. Finally, we go into what is a good cash ratio.

What is cash ratio? Cash ratio definition

The cash ratio is one of the most famous liquidity ratios as it measures a company's ability to repay its debts and liabilities using its cash or similar liquid assets.

The cash ratio is popular amongst creditors and is widely used in credit analysis as it measures a company's liquidity based on its most liquid assets - cash and cash equivalents. This is different from other liquidity ratios which take into account other less liquid assets. For instance, the current ratio takes into account current assets which include account receivables. Unlike cash and cash equivalents, a company cannot pay down its debt immediately with account receivables.

Now that you know what cash ratio is, let's look into the cash ratio formula to understand its calculation. We will do that by looking at the cash ratio example below.

How to calculate cash ratio? Cash ratio calculation formula

To understand the cash ratio calculation formula, let's look at a cash ratio example. We will calculate the cash ratio for a hypothetical company - Company Alpha, which reports the following information:

  • Cash balance: $1,200,000;
  • Demand deposit: $3,200,000;
  • Saving account: $500,000;
  • Money market fund: $5,300,000;
  • Treasury bills: $4,200,000; and
  • Current liabilities: $12,000,000.

Now, do not be intimidated by the amount of information displayed. The cash ratio calculation formula only requires 3 steps:

  1. Calculate the cash and cash equivalents

The easiest way to obtain this information is to read it directly from the company's balance sheet. More often than not, the cash and cash equivalents will be the first line of the company's current assets on its balance sheet.

Besides, we can also calculate cash and cash equivalents using the following formula:

cash and cash equivalents = cash balance + demand deposit + saving account + money market fund + treasury bills

The advanced mode of our cash ratio calculator will allow you to find this.

In our example, the cash and cash equivalents = $1,200,000 + $3,200,000 + $500,000 + $5,300,000 + $4,200,000 = $14,400,000.

  1. Determine the current liabilities

The current liabilities can also be found on the company's balance sheet. It is often displayed after the total asset section of the balance sheet.

Company Alpha's current liabilities is $12,000,000.

  1. Calculate the cash ratio with the cash ratio formula

Finally, it's time to calculate the cash ratio. We can complete the calculation by using the following formula:

cash ratio = cash and cash equivalents / current liabilities

Hence, the Company Alpha's cash ratio = $14,400,000 / $12,000,000 = 1.2x.

The purpose of calculating cash ratio

Cash ratio is an excellent way to measure a company's liquidity. Compared to other liquidity ratios, cash ratio tells us a company's ability to pay down its short-term liabilities using only its most liquid asset and without liquidating other assets.

If the cash ratio is larger than 1, it means that a company has the ability to pay down all its short-term liabilities with its cash reserve. If the cash ratio is less than 1, the company can't pay down its current liabilities in full using its cash.

In general, a higher cash ratio is preferred as it signifies a better liquidity position of a company. However, this is not always the case. A cash ratio that is too high can be seen as unfavourable since the cash reserve could also be invested instead to generate more shareholder value. On the other hand, a low cash ratio might be a sign that a company is heavily investing in its future growth.

The bottom line of all this is that, other than just knowing the cash ratio equation, it is vital to compare the cash ratio against a company's peers and the industry benchmark to understand what is a good cash ratio.

Wei Bin Loo
Cash ratio
Cash and cash equivalents
$
Current liabilities
$
Cash ratio
x
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