What it means
Liquidity ratios form a ladder. The current ratio includes all current assets.
The quick ratio removes inventory and prepayments. The cash ratio removes receivables as well, leaving only cash, bank balances and investments that can be converted to cash within days, such as treasury bills and money market funds.
Each step asks a harder question, and the cash ratio asks the hardest: with no help from customers or from selling anything, how much of what we owe could we pay right now? For most businesses the answer is a fraction, and that is fine.
A distributor with a cash ratio of 0.2 pays its suppliers from the cash its customers pay it, week by week; it does not need a bank balance equal to five months of payables. Lenders and analysts read the cash ratio alongside the other two and alongside cash flow.
A low cash ratio in a business with strong, predictable operating cash flow and undrawn credit facilities is normal. A low cash ratio in a business with erratic cash flow, a large debt maturity approaching and no committed facilities is dangerous.
The ratio also matters in negotiations. A company with a high cash ratio can demand early-payment discounts from suppliers, ride out a dispute with a customer or a delay in a contract, and refuse unattractive financing.
A company with a low one is a price-taker. Technology companies and some conglomerates hold cash ratios well above 1.0 for exactly that reason, and also to fund acquisitions without asking anyone's permission, though shareholders sometimes argue the surplus should be returned to them.
What counts as cash requires care. Bank balances in a subsidiary that cannot remit them, deposits pledged as security, and investments that would take weeks to sell or that carry a penalty on early withdrawal are not equivalent to cash in hand and should be excluded or noted.
In practice
Real-world examples.
Example
A large technology company holds cash and marketable securities equal to 2.5 times its current liabilities, a cash ratio that lets it make acquisitions and weather any downturn without borrowing.
Example
A restaurant chain runs a cash ratio of 0.15, paying suppliers weekly from daily takings, and its lenders consider that normal for the industry.
Example
A manufacturer's cash ratio falls from 0.4 to 0.05 after a large customer delays payment, and its bank asks for weekly cash forecasts until the position recovers.
Think of it
“The cash ratio is like checking if you have enough cash in your wallet right now to pay immediate bills, ignoring everything else.
Formula
Calculation
Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities
Cash equivalents are short-term, highly liquid investments readily convertible to known amounts of cash, generally with maturities of three months or less at acquisition.
Worked example. An electronics distributor's balance sheet at year end:
- Cash at bank: $420,000
- Money market fund: $180,000
- 90-day term deposit: $200,000
- Accounts receivable: $2,100,000
- Inventory: $1,900,000
- Current liabilities: $3,200,000
Cash and equivalents = $420,000 + $180,000 + $200,000 = $800,000
Cash ratio = $800,000 / $3,200,000 = 0.25
For comparison, quick ratio = ($800,000 + $2,100,000) / $3,200,000 = 0.91 and current ratio = ($800,000 + $2,100,000 + $1,900,000) / $3,200,000 = 1.50.
The distributor could pay a quarter of its current liabilities from cash today. Whether that is enough depends on its cash conversion: if receivables of $2,100,000 turn into cash within 45 days on average, and payables of $2,000,000 fall due over a similar period, the position is comfortable. If its largest customer, owing $700,000, were to fail, the cash ratio would not change, but the quick ratio would fall to 0.69 and the company would be relying on its $800,000 of cash and its overdraft facility to bridge the gap.
Stress test: current liabilities include a $900,000 loan instalment due in four months. Cash of $800,000 does not cover it; the company needs $100,000 of net collections over the period or a refinancing. Knowing that four months in advance is the point of the calculation.Case study
Seen in the real world.
A regional airline operated with a cash ratio of about 0.3, typical for the industry, relying on advance ticket sales to fund operations. When a volcanic ash cloud grounded flights for nine days, ticket sales stopped, refunds surged, and the airline's cash fell to a ratio of 0.08 within two weeks against current liabilities that included fuel, airport charges and refund obligations. It survived only because it had a committed but undrawn revolving credit facility of $40 million, arranged two years earlier when the chief financial officer had argued that an airline's cash ratio should be read together with committed liquidity.
A competitor with a similar cash ratio but no committed facility entered administration in the same month. The airline's board subsequently adopted a liquidity policy requiring cash plus committed undrawn facilities to cover at least 60 days of fixed costs and refund exposure, and reports the combined figure alongside the cash ratio every month.
Watch out
Common mistakes.
- Treating a low cash ratio as a problem in itself. Most businesses run below 0.5, and holding more cash has a cost.
- Counting restricted cash, pledged deposits or trapped overseas balances as cash. Only freely available funds belong in the numerator.
- Ignoring committed credit facilities. A company with a low cash ratio and a large undrawn facility is more liquid than the ratio suggests.
Questions
People also ask.
What is a good cash ratio?
Between 0.2 and 0.5 is common for healthy operating businesses. Above 1.0 is unusual and often reflects a deliberate war chest; below 0.1 deserves a close look at cash flow and facilities.
How is the cash ratio different from the quick ratio?
The quick ratio includes receivables; the cash ratio does not. The cash ratio therefore ignores the possibility that customers will pay.
Should cash equivalents include short-term investments?
Only those convertible to cash within about three months without significant loss. Longer-dated or illiquid investments are excluded.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%