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Lesson 7: Liquidity Ratios, Cash Ratio

Cash Ratio, Liquidity ratios, Fundamental analysis

Cash Ratio, Liquidity ratios, Fundamental analysisIn the previous articles, we have seen the Current Ratio and the Quick Ratio. Today we see the third and last Liquidity Ratio of this course, the Cash Ratio. The Cash Ratio goes a step further and examines the ability of the company to settle short-term liabilities using only cash and cash equivalents such as marketable securities. In other words, the cash ratio indicates the extent to which current liabilities can be paid through very liquid assets.

The Cash Ratio is the most conservative measure of solvency; it is used if neither accounts receivables nor inventories are liquid. It is calculated as simply cash and short-term marketable securities divided by current liabilities, as showed below.

Cash Ratio, Liquidity ratios, Fundamental analysis

 

Cash and short-term marketable securities represent the most liquid assets of a firm. Short-term marketable securities include short-term highly liquid assets such as publicly traded stocks, bonds and options held for less than one year. During normal market conditions, these securities can easily be liquidated on an exchange.

Although this ratio is generally considered the most conservative and very reliable, it is possible that even short-term marketable securities can experience a significant drop in prices during market crises.

 

Example

A company has cash in the amount of $ 45,000, cash equivalents in the amount of $ 10,000 and current liabilities in the amount of $80,000. This gives a cash ratio of 0.69. 

Cash Ratio, Liquidity ratios, Fundamental analysis

 

The example above means that the company can pay off 69% of its current liabilities without generating additional cash. This number can be compared to industry averages or other companies to compare liquidity. 

A cash ratio of 1.00 and above means that the business will be able to pay all its current liabilities in the immediate short term. Therefore, creditors usually prefer high cash ratio. But businesses usually do not plan to keep their cash and cash equivalent at level with their current liabilities because they can use a portion of idle cash to generate profits. This means that a normal value of cash ratio is somewhere below 1.00. If the ratio is relatively lower than one, it represents that the company's day-to-day cash management is poor.

With the next article, we will start to see the Solvency ratios.

 

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