A cash ratio is a financial parameter that determines a company’s ability to pay off its short-term liabilities with cash and cash equivalents alone. It is an indicator of a company’s liquidity position and is calculated by dividing the total cash and cash equivalents by the total current liabilities. A cash ratio of more than 1 implies that the company has enough cash and cash equivalents to pay off its immediate obligations, hence signifying stable financial health.
1. How is the cash ratio calculated?
The cash ratio is calculated by dividing the total of cash and cash equivalents by the total current liabilities of the company. It shows the company’s ability to instantly repay its short-term debts, considering it doesn’t receive any more cash inflow.
2. What is the difference between the cash ratio and current ratio?
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Both cash ratio and current ratio evaluate a company’s short-term liquidity. However, the cash ratio is stricter as it includes only cash and cash equivalents in its numerator. The current ratio, on the other hand, includes all current assets, hence providing a broader view of the company’s liquidity position.
3. What does a cash ratio of less than 1 mean?
A cash ratio of less than 1 means the company does not have enough cash to cover its short-term liabilities. This can be a warning signal for potential financial distress, but it can also occur in industries with fast inventory turnover.
4. What does a high cash ratio indicate?
A high cash ratio suggests that a company is in a better position to pay off its short-term obligations. However, it could also mean that the company is not investing its assets efficiently to generate profits.
5. Should a company always aim for a high cash ratio?
No, a company should not always aim for a high cash ratio. While it implies better liquidity, it could also indicate underutilization of cash resources. The optimal cash ratio varies with industry standards and the company’s growth stage. A start-up might keep a higher cash ratio for unexpected costs, while an established firm might opt for a lower ratio to better utilize its assets for growth.