Cash ratio measure the liquidity of the firm and considers only the Cash and Cash Equivalents (these are the most liquid assets within the Current Assets). If the company has a higher cash ratio, it is more likely to be able to pay its short-term liabilities.
If we look at the above graph, we note that Starbucks has the highest cash ratio (0.468x in FY2016) as compared Colgate and Procter & Gamble. But what does it mean by cash ratio? Does it matter if this ratio of a company is more than 1? We will find out in this article.
In this article, we look at the nuts and bolts of cash ratio –
- What is Cash Ratio?
- Cash Ratio Formula
- Interpretation of Cash Ratio
- Cash Ratio Example
- Cash Ratio Calculation – Nestle Example
- Cash Ratio Calculation – Colgate Example
- Limitations of Cash Ratio
What is Cash Ratio?
The cash ratio is used to measure the liquidity of the firm and gives us a quantitative relationship between cash & cash equivalent with the current liabilities of the company.
The question remains what is a good measure of cash ratio? Should it be more than 1 or less than 1? If the cash ratio is more than 1, would it indicate that there is inefficiency in utilizing the cash to earn more profits or the market is saturating? If the cash ratio is less than 1, would it indicate that the firm has utilized the cash efficiently or they have not made enough sales to have more cash?
Cash Ratio Formula
Cash ratio formula is as simple as it can be. Just divide cash & cash equivalents by current liabilities and you would have your cash ratio or cash coverage ratio.
Cash Ratio Formula = Cash + Cash Equivalents / Total Current Liabilities
Most of the firms show cash & cash equivalent together in the balance sheet. But few firms show the cash and the cash equivalent separately.
But what cash equivalent really means?
According to GAAP, cash equivalents are investments and other assets which can be converted into cash within 90 days or less. Thus, they get included in the cash ratio.
Current Liabilities are liabilities which are due in the next 12 months or less.
Let’s have a look at the cash & cash equivalents and current liabilities that any firm considers to include in their balance sheet.
Cash & Cash Equivalent: Under Cash, the firms include coins & paper money, undeposited receipts, checking accounts and money order. And under cash equivalent, the organizations take into account money market mutual funds, treasury securities, preferred stocks which have maturity of 90 days or less, bank certificates of deposits and commercial paper.
Current liabilities: Under current liabilities, the firms would include accounts payable, sales taxes payable, income taxes payable, interest payable, bank overdrafts, payroll taxes payable, customer deposits in advance, accrued expenses, short-term loans, current maturities of long-term debt etc.
Interpretation of Cash Ratio
- Let’s say, that the Cash & Cash Equivalent > Current Liabilities; that means the organization has more cash (more than 1 in terms of ratio) than they need to pay off the current liabilities. It’s not always a good situation to be in as it denotes that the firm has not utilized assets to its fullest extent
- If Cash & Cash Equivalent = Current Liabilities; that means the firm has enough cash to pay off the current liabilities.
- If Cash & Cash Equivalent < Current Liabilities; then this is the right situation to be in, in terms of the firm’s perspective. Because this means the firm has utilized its assets well to earn profits.
Even if it’s a useful ratio as it strips away all the uncertainties (receivables, inventories etc. to turn into cash to pay off current liabilities) from current assets and focuses on only cash & cash equivalent, most of the financial analysts don’t use cash ratio to come to the final conclusion about the firm’s liquidity position.
Cash Ratio Example
Let’s take an example to illustrate this. In the example below, our primary concern would be to see the liquidity position of the firm from two perspectives. First, we will look at which company is in a better situation to pay off short-term debt and second, we will look at which company has better utilized its short-term assets.
|X (in US $)||Y (in US $)|
|Current Taxes Payable||5000||6000|
|Current Long-term Liabilities||11000||9000|
Now from the above example, we will be able to make some conclusions.
First which company is in a better position to pay off short-term debt for sure (not having any uncertainty)? It’s surely Company X because the cash & cash equivalent of the Company X is much more than Company Y compared to their respective current liabilities. And if we look at the cash ratio of both the companies, we would see that the cash ratio of Company X is 0.55 whereas the cash ratio of Company Y is just 0.19.
If we include current ratio to the perspective (current ratio = current assets / current liabilities), Company Y is in a better position to pay off short-term debt (if we consider that account receivables and inventories could be turned into cash within a short period of time) as its current ratio is 0.81.
Even if Company X has more cash, they have lesser accounts receivables & inventories. From one perspective it is a good position to be in as nothing is locked up and the major part has been liquidated. But at the same time, more cash ratio and less current ratio means (compared to Company Y); Company X could have better utilized the cash lying for asset generation. From this perspective, Company Y has better utilized their cash.
Cash Ratio Calculation – Nestle Example
Now you may have understood the meaning of cash ratio. In this section, we will take an example from the industry so that you can understand how this ratio works.
Here we will take into account the raw data and will calculate this ratio for two consecutive years.
First ,we will take into account the balance sheet data of Nestle.
source: Nestle Annual Report
If you look at the balance sheet, you would see that there are two sets of information are important to us in terms of determining the cash ratio.
The first is the two year data of cash & cash equivalent (see the highlighted yellow in the balance sheet above) and the second data which is useful to us is the total current liabilities for the year 2014 and 2015.
Now, we would determine the this ratio by using the simple formula we have mentioned above.
In 2014, Nestlé’s cash ratio was = (7448/32895) = 0.23.
In 2015, Nestlé’s cash ratio was = (4884/33321) = 0.15.
If we compare the cash ratios of these two years, we would see that in 2015, the ratio is lesser compared to 2014. The reason may be better utilization of cash in the generation of profits.
On the other hand, we note that in 2014, Nestle had more cash to pay off short-term debt than it had in 2015.
Let us now compare how Nestle’s Cash Ratio is compared to its competitors – Hersheys and Danone.
- We note that Nestle’s ratio has been fairly stable ranging between 0.14x – 0.25x over the past 10 years
- Danone’s ratio is the lowest among its competitors at 0.056x
- Hershey’s ratio has been variable in the past 10 years. Cash ratio was between 0.45-0.80x between 2011 – 2015. However, most recentely, Hershey’s cash ratio has dipped to around 0.156x
Cash Ratio – Colgate Example
Let us now take another example of Colgate
Colgate has been maintaining a healthy cash ratio of 0.1x to 0.28x in the past 10 years. With this higher cash ratio, the company is in a better position to payoff its current liabilities.
Below is a quick comparison of Cash Ratio of Colgate’s vs P&G vs Unilever
- Colgate’s ratio as compared to its peers seems to be much superior.
- Unilever’s Ratio has been declining in the past 5-6 years.
- P&G ratio has steadily improved over the past 3-4 years period.
Limitations of Cash Ratio
From the above discussion, it’s clear that cash ratio could be one of the best measuring grids of liquidity for a firm. But there are few limitations of cash ratio which may become the reason of its infamous nature.
- First of all, most companies think that the usefulness of cash ratio is limited. Even for a company which has portrayed lower cash ratio may portray much higher current and quick ratio at the end of the year.
- In some countries, cash ratio of less than 0.2 is healthy.
- As cash ratio portray two perspectives, it is difficult to understand which perspective to look at. If the cash ratio of a company is lesser than 1, what would you understand? Has it utilized its cash well? Or it has more capacity to pay off short term debt? That’s the reason, in most of the financial analyses, cash ratio is used along with other ratios like Quick Ratio and Current Ratio
Having talked about the limitations, cash ratio could be the less useful than other liquidity ratios. But if you still want to check, how much cash is lying around in your company, it’s good to use this guide to find out cash ratio on your own.