Liquidity is a ratio that indicates a company’s ability to meet its short-term obligations. To measure liquidity, you can use several ratio calculations, one of which is the ratio of cash. This ratio is an evolution of the quick ratio and serves as a determinant of the extent to which a company’s cash is able to pay the current or short-term debt.
Table of Contents
- Definition of Cash Ratio
- Advantages of Using the Ratio
- Calculation of the ratio
- What Cash Ratio Says About Your Business Status
- Factors That Affect the Cash Ratio
- How to Optimize Cash Ratio
- Cash Ratio Analysis
- Conclusion
Definition of Cash Ratio
The cash ratio is a measurement of a company’s liquidity, specifically the ratio of a company’s total cash and cash equivalents to its current liabilities. On the other hand, to find out whether a company is liquid or not can be determined by comparing balance sheet components, such as total current assets and total current assets.
Advantages of Using the Ratio
Calculating ratio of a company’s cash has two main advantages. The ratio can be use in order to determine the level of liquidity security and overcome various liquidity problems of a company. Knowing the value of the current ratio helps management take strategic steps. This step will be helpful as a solution to save your company’s financial status in the event of a problem. Therefore, the management of a company must maintain the value of its ratio periodically within a certain period so that the company is in good financial condition and can carry out all operational activities smoothly.
Calculation of the ratio
To calculate the ratio in this case you can use the following formula.
Cash ratio = (cash + cash equivalents) / current liabilities
In this calculation, cash becomes a payment method for transactions. Meanwhile, cash equivalents are highly liquid and short-term investment products that can be converted into a fixed amount of cash in a short period without worrying about the risk of fluctuations in value. Current liabilities are the debt that a company must pay off immediately within a year or business cycle.
What Cash Ratio Says About Your Business Status
The ratios in this form is the tightest liquidity ratio because it uses only the most liquid assets, namely cash equivalents. If the value is 1.0, the company has enough money to pay the short-term debt. Whereas if the value <1.0, the company does not have enough cash or cash equivalents to pay its obligations. Then if the value >1.0, it means that the company has enough cash.Â
Factors That Affect the Cash Ratio
In addition to nominal, several factors affect the cash ratio of a company. These factors are industry, economic conditions, growth, high ratio number, and risk. Here we summarize the explanation of these five factors.
Industry
Different industries have different ratios for the level of cash as their standards. If some sectors have low cash reserves, it may be because those industries often use cash to buy certain assets or assets. Therefore, the value of its cash ratio will be less than 1.0. So that companies in the industry must be able to store cash so that later they can pay all their obligations to achieve an equivalent cash flow value of 1.0.
Economic Conditions
Economic stability is also one factor that affects cash flow in a country. This is because economic conditions have a direct and significant impact on the smooth business of the company. If a country’s economic or political situation becomes unclear and directionless, many companies will spend money to increase their cash ratios.
Growth
Fast-growing businesses are likely to save most of their cash to meet their growing operational needs.
Too High Ratio Number
If the level is too high, it means that the utilization of the company’s assets is not carried out efficiently. Instead of just saving cash, it’s good to allow the company to use the funds to invest it. This investment will provide passive benefits for the company. So the company can take advantage of the high cash and make a profit again.
Risk
Business-owners with a low tolerance for risk are more likely to keep all their money just in case. But on the other hand, high-risk tolerant business owners are more likely to use excess cash to buy other inefficient assets.
Read more: Gross Margin: Definition, Formulas, and Examples
How to Optimize Cash Ratio
As a businessman, you can increase your cash ratio by keeping your net income in cash or cash equivalents. Another option is to reduce payment obligations or reduce operating costs. Conversely, if your company’s cash is too high, you can spend that cash on long-term investments. So do not be surprised if a lender wants to know about the liquidity ratio of a company. Some of them are satisfied with the fair ratio by using other liquidity indicators such as the current and quick ratios.
Cash Ratio Analysis
Investors and creditors can use this to determine how the company’s financial condition is. Therefore, in the short term, these data can be useful as good indicators rather than other liquidity indicators. Intuitively, a high level means the company has enough time to pay its debts. There is no definite value regarding the minimum level of the data that is a requirement for the company in practice. But in general, investors and creditors receive a ratio between 0.5 and 1.0.
This metric can provide the most conservative guide to a company’s liquid money value since the cash ratio only adds cash from assets and cash equivalents to the equation. However, it is essential to remember that companies usually have little to do with assets in cash or cash equivalents. This is because the money that has not moved is not a good investment and does not profit.
Conclusion
The cash ratio compares the total asset and its equivalents of a company with its current liabilities. Investors and creditors use this ratio to determine the company’s financial condition and provide funds. To calculate the the ratios with an automatic system, you can use the best accounting system from HashMicro. Not only cash ratios, but this system can also help you to automate cash flow management, financial statement-making, bank reconciliation, adjustment journals, invoicing, and others.
