The cash ratio compares a company's most liquid assets to its current liabilities. The ratio is used to determine whether a business can meet its short-term obligations - in effect, whether it has sufficient liquidity to stay in business. It is the most conservative of all the liquidity measurements, since it excludes inventory (which is included in the current ratio) and accounts receivable (which is included in the quick ratio). This ratio may be too conservative, especially if receivables are readily convertible into cash within a short period of time.
The formula for the cash ratio is to add together cash and cash equivalents, and divide by current liabilities. A variation that may be slightly more accurate is to exclude accrued expenses from the current liabilities in the denominator of the equation, since it may not be necessary to pay for these items in the near term. The calculation is:
(Cash + Cash equivalents) ÷ Current liabilities = Cash ratio
For example, ABC Company has $100,000 of cash and $400,000 of cash equivalents on its balance sheet at the end of May. On that date, its current liabilities are $1,000,000. Its cash ratio is:
($100,000 Cash + $400,000 Cash equivalents) ÷ $1,000,000 Current liabilities
= 0.5:1 Cash ratio
If a company wants to show a high cash ratio to the outside world, it must keep a large amount of cash on hand as of the measurement date, probably more than is prudent. Another concern is that the ratio only measures cash balances as of a specific point in time, which may vary quickly, as receivables are collected and suppliers are paid. Consequently, a better measure of liquidity is the quick ratio, which includes accounts receivable in the numerator of the ratio.
The cash ratio is also known as the liquidity ratio.