The doomsday ratio is the most conservative measure of the ability of a business to pay its short-term obligations. The name is derived from the assumption that, if a business were on the verge of bankruptcy, could it still pay its bills right now? The ratio is not actually used for that purpose, but rather to determine the adequacy of the amount of cash on hand. The ratio is especially useful when tracked on a trend line, to see if the amount of cash buffer is decreasing over time, indicating a possible liquidity crisis in the near future.
The calculation of the doomsday ratio is to aggregate cash and cash equivalents (items immediately convertible into cash) and divide by the total amount of current liabilities. The formula is:
(Cash + Cash equivalents) ÷ Current liabilities
A business that uses this measurement will likely adopt the most conservative cash management practices, in order to bolster the amount of cash on hand at all times. A more tightly-managed treasury function with good cash forecasting capabilities is more likely to invest excess cash in instruments that cannot be so readily converted into cash, resulting in a lower doomsday ratio.
An issue with this ratio is that cash and liability balances can vary considerably within a single reporting period, so it can make sense to use average balances for both the numerator and denominator for the measurement period. Also, the ratio does not account for assets that are about to convert into cash, or incipient liabilities; in other words, the ratio is based on the immediate situation, not a projection of cash balances and liabilities even a day or two in the future.
The doomsday ratio is also known as the cash ratio.