This article explains the cash ratio in a practical way. After reading you will understand the basics of this powerful financial management tool.
The cash ratio is a calculation formula and liquidity indicator (of the total resources) of an organization. The cash ratio determines how quickly can repay its short term liabilities. A strong cash ratio is useful to creditors for determining how much debt the organization can repay in the short term.
Cash ratio calculation
The formula for calculation the cash ratio is as follows:
|Cash Ratio =||Liquid Assets* / Short-Term Liabilities**|
* = Liquid Assets are resources that are readily available such as cash and money in bank accounts.
** = Short Term Liabilities is the capital that has to be repaid within a short time for example a supplier’s credit, creditors or an overdraft facility.
There are very few organizations that have sufficient liquid assets to cover their short-term liabilities. This does not have to be of any consequence because the company can still be healthy at other levels.
This ratio is seldom used in financial reports or by analysts in the fundamental analysis of a company. It is not realistic for an organization to keep a large amount of liquid assets to continuously cover their current obligations. It could be viewed as poor asset utilization (large amounts of cash on the balance sheet) for the purpose of generating higher returns.
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- Parrino, R., Kidwell, D. S., & Bates, T. W. (2009). Fundamentals of corporate finance. John Wiley & Sons.
- Ross, S. A., Westerfield, R., & Jordan, B. D. (2008). Fundamentals of corporate finance. Tata McGraw-Hill Education.
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