Business can be a financial rollercoaster. One minute you're riding high, the next you're staring down a steep drop of unexpected expenses or missed payments. But by calculating the cash ratio – your financial safety harness, if you will – you can secure yourself against those stomach-churning plunges.
This simple financial metric, which measures your ability to meet short-term obligations using only your most liquid assets (cash and cash equivalents), acts as a financial stress test, revealing just how resilient your business is.
A healthy cash ratio is more than a number on a balance sheet; it's peace of mind. It's the confidence to seize opportunities, knowing you have the financial flexibility to adapt and conquer.
In this article, you’ll learn about the cash ratio, its benefits for businesses, accurate forecasting methods with helpful examples, and the importance of liquidity for businesses.
What is a cash ratio?
A cash ratio is a measurement of a company's liquidity, calculated by comparing its cash or other similar assets with its current liabilities to assess the business's viability to pay back short-term debts.
The cash ratio formula is mainly useful to financiers when attempting to decide how much money they would be willing to provide a business.
Learn more: 6 options for funding your small business.
How to calculate the cash ratio?
The cash ratio formula is a simple calculation to perform, but it's important to get it right to forecast a business's ability to pay back short-term loans.
There are two additional variants of this formula, too - each with unique benefits. The three formulas are as follows:
- Cash ratio: (Cash + Cash Equivalents) / Current Liabilities
- Quick ratio: Current Assets - Inventory / Current Liabilities
- Current ratio: Current Assets / Current Liabilities
Cash ratio example
When looking at a produce wholesaler, for example, its cash ratio would consider available cash (in this case, $3,000), plus cash equivalents, like assets that can be sold, or money owed to them ($3,000).
First, we add those two totals together ($6,000) and then calculate the business's current liabilities owed, also known as debts ($3,000). The cash ratio of the wholesaler would be 6000:3000, or, to make it easier, 2:1. This would also be displayed as '2'.
Formula: (Cash + Cash Equivalents) / Current Liabilities
In our example:
- The produce wholesaler has $3,000 in cash
- They also have $3,000 in cash equivalents
- This totals to $6,000 in highly liquid assets
- Their current liabilities (short-term debts) are $3,000
- Calculation: ($3,000 + $3,000) / $3,000 = 2:1 or simply 2
Interpretation: A cash ratio of 2 indicates that the wholesaler could pay off all its current liabilities twice over with its readily available cash and cash equivalents. This means strong short-term liquidity.
Cash vs. quick vs. current ratio
A cash ratio can be further refined into two separate categories - the 'quick' ratio or the 'current' ratio.
A quick ratio excludes the company accounts and is a more conservative and stringent projection of a company's ability to pay back short-term loans or debt financing. It only includes company assets that can be liquidated in less than 90 days for a quicker payout. For a company with a strong stock inventory, it's natural for a quick ratio to be lower than average.
For the calculation, a 'quick ratio' would be similar, but we take away any inventory from current liabilities. In the case of this business, $2,000 of those equivalent assets are inventory.
So combining both available capital and assets, the total instead would be $4,000 (not $6,000). This would make the quick ratio 4000:3000, or more simply 4:3, or accurately '1.3'.
Formula: (Current Assets - Inventory) / Current Liabilities
In our example:
- We start with $6,000 in cash and cash equivalents
- $2,000 of the cash equivalents are inventory, which we subtract
- This leaves us with $4,000 in quick assets
- Current liabilities remain at $3,000
- Calculation: ($6,000 - $2,000) / $3,000 = 4:3 or approximately 1.33
Interpretation: A quick ratio of 1.33 suggests that the wholesaler can cover its short-term obligations even after excluding inventory. While still healthy, it’s lower than the cash ratio, indicating a degree of reliance on inventory for liquidity
The current ratio divides current assets by current liabilities, giving no projections about potential future assets and liabilities. It provides a company with an idea of its cash ratio in its present state and includes accounts like inventory and cash receivable. For companies with a strong stock inventory, the current ratio will be naturally higher.
The 'current ratio' only considers current assets and current liabilities. Unfortunately, $1,000 of the current assets cannot be liquidated before 90 days. This leaves the current assets at $5,000. So, the ratio would be 5000:3000, '5:3', or more accurately '1.6'.
Formula: Current Assets / Current Liabilities
In our example:
- Initially, the wholesaler has $6,000 in current assets (cash and equivalents)
- However, $1,000 of these assets are not readily convertible to cash within 90 days, so we deduct them
- This leaves us with $5,000 in adjusted current assets
- Current liabilities remain at $3,000
- Calculation: $5,000 / $3,000 = 5:3 or approximately 1.67
Interpretation: A current ratio of 1.67 indicates that the wholesaler has £1.67 in current assets for every $1 in current liabilities. This ratio, while still above 1 (which is generally considered healthy), is the lowest of the three, highlighting the importance of considering the liquidity of all current assets.
How to interpret cash ratio
A cash ratio of 1 or higher means a company has enough readily available cash to cover all its short-term debts, making it financially stable in the short term. A ratio above 1 is ideal, while a ratio below 0.5 raises red flags, indicating potential difficulty in covering immediate financial obligations.
Here's a more detailed breakdown of cash ratio interpretation:
A cash ratio of 1 or higher
Considered a healthy sign. It means you have at least $1 in cash or cash equivalents for every $1 of current liabilities. You're in a great position to cover your short-term debts and even handle unexpected expenses without breaking a sweat. Lenders and investors love to see this.
A cash ratio between 0.5 and 1
It depends. This gray area requires a closer look at your specific industry and business model. Some industries naturally operate with lower cash ratios, and a ratio in this range might not be a cause for immediate concern. However, it could also signal potential liquidity issues.
A cash ratio below 0.5
This is a red flag. It means your short-term liabilities are more than double your readily available cash. You might struggle to pay your bills on time, and lenders will probably be hesitant to offer financing. It's time to take a hard look at your finances.
Limitations of using cash ratios
Despite how useful cash ratios can be for financiers, they do have their limitations.
Financial reporting or analysts rarely use the formula to assess a company’s financial metrics for its overall viability. A business may provide more to the industry than what it possesses in assets.
It’s both unrealistic and risky for a company to maintain excessive levels of liquid capital and assets to be used on short-term loans.
Likewise, a cash ratio analysis doesn't consider the size of a business or take into consideration uniform accounting. Both are necessary for accurate overall business analysis.
The importance of liquidity for businesses
The reason the cash ratio formula is useful for businesses is down to the value of liquidity. Availability of cash and asset liquidity is crucial for both importers and exporters, which require rapid access to cash to meet financial obligations, such as paying manufacturers or logistics partners.
Because of popular deferred payment terms in the import and export industries, many companies may find themselves in need of liquid capital to cover everyday business costs.
Similarly, industries like eCommerce and SaaS face unique challenges – security, compliance, and volatile demand – making liquidity crucial for weathering unexpected disruptions.
The formula for the cash ratio allows businesses to manage their liquidity routinely and react at the first signs of vulnerability to avoid missing payments or accruing bad debt.
Read more: 5 tips for securing the capital you need to scale your business.
Access immediate liquid capital with Stenn
A healthy cash ratio is essential, no doubt. It shows the world you can handle your short-term commitments. But what about seizing those big opportunities, the ones that demand a surge of capital?
That's where Stenn steps in, providing alternative financing options designed to keep your business moving.
We offer two powerful financing options:
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Cash ratio: Frequently Asked Questions (FAQs)
What is a good cash ratio?
While no precise figure defines an ideal cash ratio, businesses generally favor a ratio between 0.5 and 1. This range indicates the business can likely pay its short-term debts and free up liquid capital.
If the cash ratio falls below 0.5, lenders are unlikely to take a risk on the business. Lenders typically avoid offering finance to businesses that risk defaulting on repayments. A ratio between 0.5 and 1 generally strengthens a business's qualifications for funding.
How can a company improve its cash ratio?
Improving the current cash ratio of a business should be a primary objective if they are looking to secure a short-term loan grant. It can be as simple as paying off current liabilities, while current assets need to be increased. This strategy boosts available liquid capital relative to short-term debts, making the business more attractive to finance providers.
Is a high or low cash ratio better?
A higher cash ratio means that a company has more liquid capital available and lower short-term liabilities in need of payment, while a lower cash ratio means that there is a higher amount of liabilities and less cash on hand as an asset. So a higher cash ratio is more desirable.
What causes a low cash ratio?
A cash ratio reflects a business's ability to pay off short-term debts. A low cash ratio means that the amount of short-term liabilities a business has is either similar to or higher than the number of assets it has to pay off those liabilities. So the business is less likely to be able to pay off short-term loans.
What is a net cash ratio?
A net cash ratio is another formula capable of estimating a business's ability to pay back short-term loans. The formula for a net cash ratio is net cash minus liabilities. It's also a helpful formula for businesses in determining how much cash will be left after paying off all transactions.
Is a cash ratio a percentage?
A cash ratio is an easy-to-understand representation of how well a company can pay back short-term debts and assess its viability for further loans by comparing assets and liabilities. While the cash ratio is displayed as a ratio, and not a percentage, it's relatively similar in how it converts a complex idea into an intuitive and accessible figure.
What does a cash ratio of 0.2 mean?
If a cash ratio is 0.2, it means that a company likely has more current liabilities than it does cash or cash assets to pay them off. This situation poses a significant problem for finance providers, who are less likely to offer funding to a company burdened with high current liabilities.
However, businesses with high stock are likely to have a lower-than-average ratio, so many finance providers do take into account this wider context when deciding on whether or not to offer a company funding.
