Q:What is the cash ratio?
A:The cash ratio helps determine a company’s ability to pay its short-term liabilities with its most liquid assets that consist of cash and cash equivalents.
I think most readers are clear on the definition of cash. However, cash equivalents probably needs some explaining. These are current assets that can quickly be converted into a known amount of cash with little risk of a value change. Cash equivalents may include assets such as short-term government bonds, treasury bills, marketable securities, and money market accounts as examples.
The cash ratio is calculated as follows:
Cash Ratio = (Cash + Cash Equivalents) ÷ Total Current Liabilities
As a real life example of how to calculate the cash ratio, we will use the following annual data from McDonald’s balance sheet for 2014 to 2016.
|Cash & Cash Equivalents||1,223,400,000||7,685,500,000||2,077,900,000|
|Total Current Liabilities||3,468,300,000||2,950,400,000||2,747,900,000|
Using the above financial data, we can calculate the cash ratio for McDonald’s as follows:
2014: 1,223,400,000 ÷ 3,468,300,000 = .35
2015: 7,685,500,000 ÷ 2,950,400,000 = 2.60
2016: 2,077,900,000 ÷ 2,747,900,000 = .76
Keep in mind that the cash ratio is the most conservative of the liquidity ratios. Other liquidity ratios include the current ratio and the acid test (quick) ratio, which include additional current assets in their calculations. You can use these ratios based on how conservative you want to be in your measurement of liquidity. The current ratio is the broadest measurement of liquidity, followed by the acid test ratio, and then the cash ratio.