Definition: The Cash Ratio shows how quickly the firm can pay off its liabilities relative to Cash, bank balances, marketable securities since these are considered as the most liquid component of the current assets. Simply, this ratio measures the ability of a firm to meet its current obligations with the cash or cash equivalents.
It is the most stringent liquidity ratio and is considered as an important decision factor for the creditors regarding how much amount is to be lent to the asking firm. The high value of cash ratio shows sufficient cash balance with the firm and is capable of paying the current debts. The formula for calculating the Cash Ratio is:
Cash Ratio = (Cash and Bank Balances+ Current Investments) / Current Liabilities
A Higher value of ratio results in more lending from the creditors due to a safety of returns.
Example: Suppose a firm’s cash balance is Rs 50,000, cash equivalents worth Rs 15,000 and the current liabilities comprising of bills payable, current long term liabilities and current taxes amounting to Rs 7,000, 10,000 and 3,000 respectively. Then the Cash ratio will be:
= 75,000/20,000 = 3.75 : 1
cash = 50,000+15,000 =75,000
Current liabilities= 7,000+10,000+3,000 = 20,000