The cash ratio, also known as the cash-asset ratio, is a measure of liquidity or a company's ability to meet short-term debts. It's also known as the cash conversion cycle.
When you own a business, monitoring your cash ratio is a significant financial metric that can help you identify potential risks and make informed decisions about managing your cash flow.
You might wonder why reading about cash ratios is relevant if you are not an accountant. The truth is that few businesses can succeed without keeping track of their finances regularly.
Many new entrepreneurs fail because they don't understand the importance of always watching their balance sheet. If this sounds like something that might apply to you, keep reading for more information on understanding cash ratio, what it is, and why you should care!
What is the cash ratio?
The cash ratio measures the amount of cash you have versus the amount of cash you expect to owe soon. Put another way, the cash ratio shows how long you can meet your obligations with the amount of cash you currently have.
For example, if you have $100,000 in the bank and you owe $300,000 in the next 30 days, your cash ratio is 0.33, meaning you need more cash to pay your obligations before the deadline.
Cash ratio analysis measures liquidity, or the ability of a firm to meet short-term obligations with cash on hand. It can be calculated by dividing the amount of cash in the company's bank accounts by the firm's short-term liabilities.
Why is understanding the cash ratio important?
The cash ratio is an important financial metric that can help you identify potential risks and make informed decisions about managing your cash flow best.
If you have a low cash ratio, you may have trouble paying your short-term obligations, including your credit card bills, payroll, utilities, taxes, and other expenses. You'll likely have to take on debt or sell off some of your business assets to avoid getting into trouble.
On the other hand, a high cash ratio means you may not be taking advantage of investment opportunities. This can hinder the growth of your business.
Your cash flow and cash ratio will fluctuate throughout the year, so it's important to look at trends rather than individual figures. That way, you can identify and address issues before they become significant problems.
Cash ratio vs. current ratio
The cash ratio is similar to the current ratio, which evaluates a company's liquidity and measures how long it would take to become insolvent if no more cash was coming in. The current ratio compares the number of current assets against current liabilities.
The main difference between the two liquidity ratios is the inclusion of cash in the cash ratio. Both ratios and other liquidity ratios are essential financial metrics that can help you identify potential risks and make informed decisions about managing your cash flow best.
How to calculate the cash ratio
To calculate the cash ratio, divide the amount of cash into your bank accounts by the number of your short-term liabilities. A company's short-term liabilities include accounts payable, short-term loans, and other obligations that must be repaid within one year.
If you use a business management platform or an online cash ratio calculator, it should calculate the cash ratio for you.
What is a good cash ratio?
A good cash ratio depends on the type of business you're running. A healthy cash ratio may be different for manufacturers than for retail stores.
However, a general rule is that you want your company's cash ratio to be greater than or equal to the number of your short-term liabilities. Simply put, a healthy liquidity position or ratio should be between 0.5 and 1.
Cash ratio formula example
Let's say you own a printing company, have $45,000 in the bank, $25,000 in accruals, and an account payable of $50,000. Your cash ratio is then calculated using the below formula:
($45,000 ) / ($25,000 + $50,000)
Cash ratio = $0.6
With a cash ratio of 0.6, it means that your company can comfortably pay off 60% of current liabilities.
When should you be concerned about your cash ratio?
You should be concerned if your cash ratio is below the number of your short-term liabilities. Ideally, you need a higher cash ratio than your short-term liabilities, but you may have trouble making payments on time if you're too far below the amount you owe.
If your cash ratio is dangerously low, you should consider ways to increase it. You may have to take on additional debt or sell off liquid assets to get the money you need.
What are the limitations of the cash ratio?
As with any ratio, the cash ratio is not a perfect liquidity measurement. It doesn't take into account liquid assets like inventory or property, only cash. It also doesn't account for other factors like the amount of debt you have.
Furthermore, the cash ratio can vary depending on your industry. For example, the printing company example above should have enough cash to make it through one month, but a retail store may need more cash to last longer.
Ways to improve your cash ratio
There are several things you can do to improve your cash ratio. First, ensure you're taking advantage of every opportunity to increase your cash flow. If you're using accounting software or a business management platform, ensure it's set up to help you track your cash flow.
You should also make sure all your bills are paid on time, including payroll and debt obligations. It's also important to be selective about the projects you take on.
For example, you may want to pass up on a big contract if you aren't sure you can complete it within the allotted time and spend the money you would have spent on it wisely.
The cash ratio is a critical metric for any business owner to track. It shows your company's time to generate new cash flow to pay short-term liabilities. The ratio can be affected by many factors, including your business's financial health, industry, and cash on hand.
Remember that by monitoring your financial ratios and taking steps to improve them when necessary, you can reduce the risk of cash flow problems in your business, therefore, impressive financial reporting.