What Is the Cash Ratio and How Is It Used?

Different liquidity ratios produce different results


Tetra Images/Getty Images

The cash ratio is one of three common ways to evaluate 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:

  • 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 current liabilities as the denominator and all three include cash and 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. Both the current ratio and the quick ratio allow other assets to count against liabilities.

Cash Ratio vs. Quick Ratio

In addition to assets that are 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 as 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—10 days, for instance—from financially stable longstanding clients. This history of the prompt collection of receivables means there is a limited risk in adding them to the short-term assets side of the equation even though they are not actually within the company's possession. The reasonable assumption is that they soon will be.

Nevertheless, economy-wide financial crises can take shape quickly, as one 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 2007–08. 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 most widely revered brokerages and to the near collapse of many businesses. Most notable were businesses in the auto industry, which survived only because the U.S. government bailed them out when they threatened to fail.

Cash Ratio vs. 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 the particular business the company is in. Inventory 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—a restaurant's food inventory, for example—then the added risk may not be significant. If the inventory consists of goods in an unpredictable industry—fashion, 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 is 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, but it also gives 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.