What is cash ratio or cash Coverage ratio (CCR)
Cash Ratio or Cash Coverage Ratio: It is used to measure the liquidity of the company and gives us a quantitative relationship between cash & cash equivalent with ability to pay off the current liabilities of the company.
This ratio is much more restrictive than the current ratio or quick ratio because no other current assets can be used to pay off current debt but only cash
The question remains what is a good measure of cash coverage 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?
Read| Quick Ratio
Advantage of Cash Ratio
- Provides an easy cash to pay its current liabilities.
- Measures of a company’s liquidity
- It is more pure liquid than quick and current ratio.
- Represents the standing position of the company.
- Indicates the capability of strong and need not to borrow from others.
Disadvantage of Cash Ratio
- First of all, most companies think that the usefulness of cash coverage 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.
- It does not provide a clear figure that in which company higher cash is better or in which company lower cash.
- Unable to give assumption of the use of the cash without referring the quick and current ratio.
- In some countries, cash coverage ratio of less than 0.2 is healthy.
- As cash coverage ratio depict two perspectives, it is difficult to understand which perspective to look at. If the cash coverage 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 coverage ratio is used along with other ratios like Quick Ratio and Current Ratio as well.
Formula of Cash Ratio
cash-ratio Cash or Cash equivalents are investments and other assets which can be converted into cash within 90 days or less.
Analysis and Interpretation of Cash Ratio
Here we are look at three conditions of the cash ratio which are as follows:
- Cash & Cash Equivalent > Current Liabilities i.e. cash ratio > 1
- Cash & Cash Equivalent = Current Liabilities i.e. cash ratio = 1
- Cash & Cash Equivalent < Current Liabilities i.e. cash ratio < 1
Let’s say, in the first condition when Cash & Cash Equivalent > Current Liabilities; that means the company 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
Let’s say, in the second condition when Cash & Cash Equivalent = Current Liabilities; that means the firm has enough cash ( equal to 1 in terms of ratio) to pay off the current liabilities.
Let’s say, in the third condition when Cash & Cash Equivalent < Current Liabilities; that means this is the right situation to be in (less than 1 in terms of cash ratio), in terms of the firm’s perspective. Because this means the company has utilized its assets well to earn profits but too short in cash is also not good in the case if any liquid crisis, that why, most of the financial analysts don’t use cash ratio to come to the final conclusion about the company’s liquidity position.
Let’s take an example suppose City Palace is a restaurant that is looking to remodel its dining room. City Palace is asking its bank for a loan of $100,000. City’s balance sheet lists these items:
- Cash: $10,000
- Cash Equivalents: $2,000
- Accounts Payable: $5,000
- Current Taxes Payable: $1,000
- Current Long-term Liabilities: $10,000
City’s cash ratio is calculated like this:
Total Current Liabilities = Accounts Payable + Current Taxes Payable + Current Long-term Liabilities
= $5000 + $1000 + $10000
Cash Ratio Formula = Cash + Cash Equivalents / Total Current Liabilities
= $10000 + $2000/ $16000
As we can see, City’s ratio is 0.75. This means that City Palace only has enough cash and equivalents to pay off 75 percent of her current liabilities. This is a moderately high ratio which means City Palace maintains a relatively high cash balance during the financial year.
Clearly, City’s bank would look at other ratios before accepting its loan application, but based on this coverage ratio, City Palace would most likely be accepted by its bank to grant the loan because overall situation of the company is favorable.