What is the Cash Ratio, Cash Ratio Definition, and Cash Ratio Formula?
Different Ways of Establishing Liquidity Ratios Produce Different Results
The cash ratio is one of three common ways of evaluating a company's liquidity -- its ability to pay off its short-term debt. All three of these related methods calculate in some way the ratio of the company's short-term assets to its short-term liabilities. Here, for comparison purposes, are the formulas for all three:
Three Liquidity Ratios
Cash ratio = (Cash + Marketable Securities)/Current Liabilities
Quick ratio = (Cash + Marketable Securities + Receivables)/Current liabilities
Current ratio = (Cash + Marketable Securities + Receivables + Inventory)/Current Liabilities
All three have the same denominator, "current liabilities" and all three include "cash+marketable securities" in the numerator. The differences between them are that the cash ratio, the most stringent and conservative of the three, allows only the most liquid of assets -- cash and marketable securities -- as offsetting assets against liabilities, whereas both the current ratio and the quick ratio allow other assets to count against liabilities as well.
The Cash Ratio vs. the Quick Ratio
In addition to assets that are either already cash or capable of being turned into cash in a day or two, the quick ratio also allows receivables to count among its short-term assets. The significance of adding receivables to qualifying short-term assets is to some extent dependent on the particular circumstances of the business involved. A well-established business may regularly collect its receivables in a short period of time -- ten days, for instance --from financially stable longstanding clients.
This history of the prompt collection of receivables means that there is little risk -- some risk, certainly, but not much --in adding to the short-term assets side of the equation an asset that is not actually within the company's possession. The reasonable assumption is that it soon will be.
Nevertheless, economy-wide financial crises can take shape quickly, as they did most notably in the 1929 stock market crash that heralded a prolonged and uniquely severe recession. In such an admittedly rare and extreme circumstance, there could be a meaningful difference between the most conservative cash ratio and the somewhat less stringent quick ratio. In fact, this difference -- the inclusion of receivables among short-term assets -- became an issue during the financial meltdown of 2007-8.
The failure of some large corporations to make promised payments to others once the crisis got underway contributed to the collapse of the country's oldest and widely revered brokerages and to the near collapse of many businesses, notably in the auto industry, which survived only because the U.S. government bailed them out when they threatened to fail.
The Cash Ratio vs. the Current Ratio
The current ratio adds to the three acceptable receivables in the quick ratio -- cash, marketable securities, and receivables -- a fourth: inventory.
Again, the significance of this depends on the direction of both the general economy, the overall health of the company's business and, importantly, the particular business the company is in. Inventory, needless to say, consists of assets that have not yet been sold. Why have they not? If the inventory represents a predictable flow of goods from suppliers through the company to its customers -- think of a restaurant's food inventory -- then the added risk may not be significant. If the inventory consists of goods in an unpredictable industry -- the fashion industry, for instance -- it may be unwise to count as assets goods that may be sold quickly, sold slowly, sold slowly at discounts or perhaps never sold at all.
How Useful Is the Cash Ratio?
If a company was tipping into insolvency, the application of the cash ratio, which assumes nothing about the collectibility of company receivables or of the company's ability to move inventory, might be the most realistic of the three liquidity ratios. For this reason, lenders sometimes use the cash ratio to understand what the worst case might be.
In general, however, most analysts don't use the cash ratio. Not only does it presume a degree of risk that is fairly uncommon, it also gives a value to cash and short-term securities that overestimates their utility in a well-run company. Until you do something with cash, it has little ability to generate a reasonable return. In some economic environments, short-term marketable securities don't even keep up with the real loss in value caused by inflation. A company with too much cash and heavily-weighted in short-term securities is unlikely to be highly profitable.