If you are at least slightly interested in financial analysis, you have surely heard the term cash ratio. Do you know what lies beneath it? In the following article, you will learn what this term means, how the cash ratio is calculated, what range its values should fall within, and what good it will do you.
Cash ratio recommended value
Liquidity is an important concept in financial analysis. But watch out! There are two main types, which are not very related. Firstly, there is liquidity in general. This expresses the ability to quickly turn an investment into cash. The higher these values are, the lower the return on the investment. And then there is business liquidity. This expresses its ability to pay liabilities on time. You can measure current, quick or cash liquidity.
Using the cash ratio, you measure the ability of a business to immediately pay short-term liabilities. However, it must not be too large or too small. If it reaches too low values, you might think that you will have a problem paying off liabilities. Yes, that is right. You can thus get into debt, and the whole situation might unfortunately lead you all the way to bankruptcy.
However, if the cash ratio reaches too high values, it means that you are probably using your own capital too much for financing. Experts describe this as inefficient. External capital is cheaper after all. Because the interest that you pay, for example, on a bank loan, meaning external capital, is tax-deductible, you can state it as your expense and thus reduce not only the tax base, but also your tax liability. You could not do that with your own capital.
INTERESTING FACT: Many banks and financial institutions had problems with the cash ratio during the global financial crisis in 2008. At that time, trust between banks and investors declined, and institutions found that they had a problem converting their assets into cash. This required interventions by central banks and governments. They tried to ensure sufficient liquidity and prevent collapse.
Cash ratio formula
Within what range should the values of the cash ratio therefore move? Czech sources state an interval of 0.3 to 0.5. Foreign ones are more conservative and recommend a range from 0.5 to 1. And how to find out the specific value of the cash ratio that your business achieves? Focus on financial assets. And divide them by short-term liabilities.
You can calculate financial assets as the sum of cash and cash equivalents. These are funds that are very close to cash in their character, risk and liquidity. They are quickly convertible into cash, and holding them therefore does not represent high risk for you. Specifically, financial assets include:
- Current account
- Cash desk
- Money in transit
- Treasury bills
- Marketable securities with a maturity of up to 1 year
- Money market funds
And short-term liabilities? These are those that you expect to pay within 12 months from the balance sheet date. Their main task, along with your own financial sources, is to finance the day-to-day operations of the business. Examples include:
- Short-term bank loans
- Payables to suppliers
- Payables to employees
- Tax liabilities
- Received advances
- Accruals and deferrals
In conclusion, try to realise what advantages you will gain if you try to move within the recommended interval of cash ratio values. On the one hand, you will ensure the smooth operation of the business. Thanks to it, you will be able to pay supplier invoices on time. Or employee wages. Or bank loans. And furthermore, if you pay attention to the recommended range, you will react better to various newly emerging opportunities. So, what do you say? Will you give the cash ratio a try?