BAJAJ BROKING
March 12, 2025
1 mins read
Ratio analysis is one of the most important techniques of financial analysis, and widely used by businesses and their stakeholders to assess the financial strength of the organisation. Various types of financial ratios can be computed using pivotal financial metrics from the profit and loss account, balance sheet, and cash flow statement of an entity. These include liquidity ratios, efficiency ratios, profitability ratios, and solvency ratios.
Liquidity ratios are computed to gauge the ability of an organisation to honour its short-term obligations. Current ratio, quick ratio, and cash ratio are the most prominent liquidity ratios. In this article, we shall discuss what is cash ratio, how it is calculated and interpreted, the significance it holds in financial analysis, and the limitations that restrict its scope.
Cash ratio is a liquidity ratio which is utilised to ascertain a business’s capacity to honour its short-term liabilities, that is, current liabilities. While current ratio takes into account all the current assets of an entity, cash ratio is computed using only cash and cash equivalents as current assets. Therefore, the cash ratio paints a clear picture of a company's liquidity. The formula for the calculation of cash ratio is as follows:
Cash Ratio = Cash and cash equivalents / Current Liabilities
In order to arrive at a company's cash ratio, the following components are used to compute cash and cash equivalents and current liabilities.
Cash and cash equivalents (cash and current assets easily convertible to cash):
Current Liabilities (obligations to be honoured within a year):
It is worth noting here that accounts receivable, inventory, and other current assets are not included in the calculation of cash ratio since these assets may not be easily liquidated under all possible circumstances.
As stated earlier, cash ratio can be computed by dividing an organisation’s cash and cash equivalents by its current liabilities. Let us understand how to calculate the cash ratio using an example.
Let's say company A has the following current assets and current liabilities
Current assets:
Current liabilities:
Cash ratio for company A shall be calculated as follows
Cash Ratio = Cash and cash equivalents/ current liabilities
The cash and cash equivalents for company A amount to ₹7,00,000 and the total current liabilities are ₹5,00,000. Therefore, the cash ratio is 7/5 or 1.4. Neither inventory nor accounts receivable have been used to compute cash and its equivalents.
Now that we have discussed what the cash ratio is and how it is calculated, let us delve into the interpretation of this ratio by the internal and external stakeholders of an organisation. Cash ratio is determined using only cash and its equivalents, thereby shedding light on a company's actual liquidity position. Therefore, a high cash ratio is a marker of high liquidity and a substantial capacity to repay short-term liabilities. The caveat in such a scenario is that the company has substantial idle cash which could be deployed in a productive avenue instead. Hence an extremely high cash ratio is also considered unsuitable for an entity.
A low cash ratio, on the other hand, represents low liquidity and a potential for failure in honouring short-term obligations such as outstanding tax, interest payable, and creditors. In the example cited above, company A has a cash ratio of 1.4 which signifies its capacity to repay its short-term liabilities 1.4 times over without the liquidation of inventory or accounts receivable. It is worth noting here that the cash ratio for a company with high reserves of cash is likely to be different to the corresponding ratio for a company with low cash reserves (or high requirement of cash in operations). Therefore, there is no ideal cash ratio that applies to organisations across industries. This is one of the prominent limitations of the cash ratio and the main reason why it cannot be used to compare companies, particularly across sectors.
Since cash ratio depicts the actual liquidity position of an organisation, it is a widely used tool for financial analysis. For internal and external stakeholders alike, cash ratio can be used as the barometer for a company's short-term liquidity. A high cash ratio can help a company secure short-term credit (if required) with relative ease. From lenders’ perspective, such a company is a good potential borrower.
Secondly, cash ratio can be used to compare a company's financial strength across periods. For instance, the cash ratio for the present year may be compared to the corresponding ratio for previous years. This analysis can help a company in the efficient management of cash and ensure optimal liquidity. Thirdly, cash ratios of different organisations (ideally in the same industry) can be compared to gauge which organisation has better liquidity and cash management. Lenders and investors can deploy such an analysis to choose between organisations (to lend to and invest in, respectively).
Not only is the cash ratio of an organisation an indicator of its liquidity and financial strength, but it also represents its creditworthiness (particularly in the short term). Furthermore, it is an effective tool to aid strategic planning and cash flow management for an organisation.
Additional read: Quick Ratio
Cash ratio has significant application in financial analysis and informed decision making for a business and its stakeholders. However, there are several other liquidity ratios that can also be used to assess the overall liquidity of an organisation (not just cash and its equivalents based liquidity). Let us compare cash ratio with two other prominent liquidity ratios, namely, current ratio and quick ratio.
Cash ratio |
Current ratio |
Quick ratio | |
Metric of comparison | |||
Meaning | Cash ratio is a liquidity ratio that signifies a company's ability to repay its short-term liabilities using only cash and cash equivalents. | Current ratio is a liquidity ratio that depicts an organisation's ability to honour its current liabilities using all current assets at its disposal. | Quick ratio is a liquidity ratio that reflects an organisation's ability to repay its short-term obligations using cash and marketable securities. |
Formula | Cash and cash equivalents/ current liabilities | Current assets/ current liabilities | Current assets (except inventory and prepaid expenses) / current liabilities |
Scope | Extremely limited because only cash and cash equivalents are considered to assess liquidity | High because all the current assets are included in the computation of liquidity | Lower scope than current ratio but higher than that for cash ratio |
Degree of conservatism | Most conservative of the three ratios | Least conservative of the three ratios | More conservative than current ratio but less conservative than cash ratio |
Ideal ratio | Depends on the industry | 2:1 | 1:1 |
As is the case with most financial tools, the cash ratio has several limitations. Let us discuss the key limitations of the cash ratio.
Additional read: Current ratio vs quick ratio
Real-world Examples of Cash Ratio Application
Cash ratio is an important financial tool that can be used to analyse the absolute liquidity of an organisation (without the need to liquidate inventory or accounts receivable); this is why it is also termed as Absolute Liquidity Ratio. This ratio holds value for the internal stakeholders as well as the external stakeholders (particularly lenders and potential shareholders) of an organisation.
While it is important for a company to have sufficient liquidity to honour its short-term liabilities, it is also critical not to keep excessive amounts of cash and cash equivalents unutilised. Therefore, companies must walk a fine line while maintaining a cash ratio that is in line with their cash flow management, current liabilities repayment schedule, and industry requirements.
Do you have a trading account app or demat account app?
You can open an account with Bajaj Broking in minutes.
Download the Bajaj Broking app now from Play Store or App Store.
Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.
This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
For All Disclaimers Click Here: https://www.bajajbroking.in/disclaimer
Share this article: 
No result found
Cash ratio is a financial ratio that is calculated to ascertain the liquidity of a business. The formula for calculating cash ratio is as follows:
Cash Ratio = Cash and cash equivalents/ current liabilities
Cash ratio depicts the ability of a company to honour its short-term liabilities without needing to liquidate inventory and accounts receivable. Therefore, it can be used by creditors to gauge a company's creditworthiness and repayment capacity. Investors can use cash ratio to determine the financial strength of a company and its standing as a potential investment.
Cash ratio takes into account only cash and cash equivalents while calculating current assets. Current ratio, on the other hand, considers all current assets while quick ratio considers all current assets except inventory. Of the three, cash ratio reflects the real short-term liquidity of a company (without the need to liquidate inventory and accounts receivable).
No consideration for accounts receivable
Non inclusion of marketable securities
No consideration for cash generated from operations
Not ideal as a tool for comparison across industries
Yes, a high cash ratio can be a reflection of inefficient utilisation of cash and its equivalents. Such a situation indicates a high opportunity cost for the company as the unused cash can be channelised towards various productive avenues.
Level up your stock market experience: Download the Bajaj Broking App for effortless investing and trading
TRENDING CALCULATORS AND STOCKS ON BAJAJ BROKING
POPULAR STOCKS: Tata Motors Share Price Infosys Share Price IRFC Share Price SBI Card Share Price Cipla Share Price NBCC Share Price IDFC First Bank Share Price IRCTC Share Price PNB Share Price Zomato Share Price Vodafone Idea Share Price Axis Bank Share Price JSW Steel Share Price Bandhan Bank Share Price SBI Share Price Tata Steel Share Price ONGC Share Price Ashok Leyland Share Price Paytm Share Price Subex Share Price DLF Share Price Reliance Share Price HDFC Bank Share Price Suzlon Share Price IOC Share Price HUL Share Price Asian Paints Share Price Bank Of Baroda Share Price ITC Share Price TCS Share Price HFCL Share Price Icici Bank Share Price Tata Chemicals Share Price CDSI Share Price MRF Share Price Tata Power Share Price Adani Green share price BPCL Share Price Vedanta Share Price Dmart Share Price Hindalco Share Price LIC Share Price SAIL Share Price Adani Port Share Price IEX Share Price Nalco Share Price L&T Share Price Adani Power Share Price BHEL Share Price Bajaj Finance Share Price Canara Bank Share Price Indusind Bank Share Price Gail Share Price Yes Bank Share Price Wipro Share Price Happiest Minds Share Price Coal India Share Price Maruti Share Price Reliance Power Share Price
INDIAN INDICES: Nifty 50 Share Price SENSEX Share Price Nifty Next 50 Share Price BSE100 Share Price Nifty Bank Share Price LRGCAP Share Price Nifty 100 Share Price MIDCAP Share Price Nifty 200 Share Price SMLCAP Share Price Nifty 500 Share Price BSE500 Share Price Nifty Midcap 50 Share Price ALLCAP Share Price NIFTY SMLCAP 50 Share Price BSE200 Share Price India VIX Share Price BSEIPO Share Price
