A company’s ability to pay off its current obligations with cash equivalents or cash only is determined with the help of the cash ratio, also known as cash coverage ratio. Naturally, this type of ratio is more restrictive than the quick or current ratio, because the company can use no other assets to pay off its current debt.
Many creditors take a look at the cash ratio, as they want to see if a company is able to maintain a sufficient balance of cash in order to pay its debts when they are due.
Moreover, you might see a smile on a creditor’s face if your company is able to pay its obligations with cash only because the inventory and accounts receivable are not actually guaranteed to be available when it comes to debt servicing.
Why is that? Because receivables can take more than a couple of weeks to collect and inventory months or even years to sell – while cash is always present and available for the creditors.
The Basics of Cash Ratio
When it comes to calculating a business’ cash ratio, this is done quite easily, as it only requires one simple formula. Basically, you take all the cash and cash equivalents and divide them by the total current liabilities of your company.
While some companies do list their cash and cash equivalents separately, on a different sheet, most of them list these together on the balance sheet of the company. Also, you don’t have to think of cash equivalents as actual cash.
These are part of the company’s investments that can be converted into cash in a time period of 90 days. Still, GAAP considers them as being equivalent to cash – hence the name – because there’s not a long process to them becoming actual cash.
Basically, the cash ratio shows if your company is able to pay off all of its obligations by using only cash and cash equivalents. There are three states this ratio can be found in.
A ratio that is equal to 1 means that a company has available an amount of cash and cash equivalents that’s equal to its current debt – meaning that the company will run out of them after paying the debt.
On the other hand, if your company has a cash ratio of above 1, this means that it will have cash and cash equivalents left after paying off all of its obligations. Naturally, this is sought by creditors, as the remaining amount of cash is seen as guaranteed and available to them.
And, of course, a ratio of below 1 means that a company doesn’t have enough cash and cash equivalents in order to pay off its obligations – which raises question marks for the investors, as the risk of the company’s loans being unpaid increases.
This type of ratio is also a liquidity ratio – and, as most of these, it implies that a higher cash ratio is safer for a company to have. This is because it can fund its debt easier, without taking any unpleasant risks.