There are three standard methods via which you can calculate the liquidity of a company, which refers to the ability to pay down short-term debt. One of these is the cash ratio, also known as the cash flow ratio, and this is a brief explanation of how the cash ratio works and how it compares with the other two standard methods.
How to calculate the cash ratio
In simple terms the cash ratio compares the liquid assets of a business – including cash – to the current liabilities, in a way that paints a picture of the ability to pay off short-term debt. The cash ratio is particularly useful if there is a fear that the business is edging toward insolubility, as it presents a picture of the worst case scenario if the business was compelled to clear all short-term debts immediately.
The actual calculation of the cash ratio involves working out the valuation of the cash being carried by the business and any marketable securities, and then dividing that figure by the figure for current liabilities. If the cash ratio generated using this calculation is higher than 1 then the business is in the position of being able to meet its debts and still have some cash remaining.
A practical example of cash ratio
If your business has $200,000 in cash and marketable securities and $150,000 in liabilities then the cash ratio produced is 1.33. In this scenario, the company could pay off all of its debts and still have funds left over.
If, on the other hand, a company has $3 million in cash and marketable securities and $3.5 million in liabilities then the cash ratio is less than 1, at 0.85. This means the business would not be able to cover all the liabilities it is carrying using the cash and marketable securities it has. A cash ratio is more illustrative than it is practical because it is unlikely that a business would suddenly have to pay all liabilities at once. What a cash ratio of less than one indicates, however, is that the business may not be on the soundest financial footing.
Alternatives to the cash ratio
Of the three methods of calculating the liquidity of a business, the cash ratio is likely to produce the most negative result as it takes a very conservative view of the value of the business by using only cash and liquid assets. The alternatives are the quick ratio and the current ratio, and they work as follows:
The quick ratio equals the cash, plus marketable securities, plus receivables, all divided by the current liabilities
The current ratio equals the cash, plus marketable securities, plus receivables, plus inventory, all divided by current liabilities
By including receivables, as well as assets that can be liquidised in a day or two, the quick ratio adds receivables to the short-term assets. This is appropriate if this business has a track record of receiving prompt payments from financially stable customers, and can rely on a specific amount to come in over a period such as the next 10 days.
The current ratio adds inventory to the formula, which is a low risk calculation if this business has a steady, reliable and predictable flow of goods from suppliers, through the business and on to customers. Businesses in less predictable sectors – with the chance that stock may sit unsold for longer periods of time – probably shouldn’t include inventory if they want to arrive at an accurate figure.
We can help
The cash ratio can provide a snapshot of the stability of a business, and that stability can be enhanced by processing payments promptly and simply. Partnering with a payment platform like GoCardless makes it simple to ensure that cash keeps flowing into your business, and this includes the more complex aspects such as dealing with ad hoc payments or recurring payments.