Advantages and Disadvantages of Cash Ratio

Cash ratio is the financial ratio that measures company’s ability to settle the current liabilities by using the cash and cash equivalent. It is similar to current ratio, quick ratio and other liquidity ratio but it uses only the cash and cash equivalent.

This ratio measures the company’s cash with the short-term debt if there is any risk which causes by the ability to pay the upcoming liabilities. It is similar to the current ratio, quick ratio, and others, but it focuses only on the cash available. It excludes other current assets even they are easily converted to cash. It aims to access the company’s real liquidity position.

Cash Ratio Formula

\[Cash\ Ratio = {Cash\ \&\ Cash\ Equivalent \over Current\ Liabilities}\]

Advantages of Cash Ratio

• More meaningful than other liquidity ratios: if we compare this ratio to other ratios such as current ratio, quick ratio, we can see that cash ratio is more reliable as it uses only cash rather than current assets. Some currents assets are not easily converted into cash, for example, inventory and accounts receivable.
• Access company ultimate liquidity position: This ratio using only the cash balance to measure company financial health. It is the ultimate liquidation position of the company as it depends only on available cash. Whatever happens to the company, it has almost no impact on this ratio.
• Ignore noncash current assets: This ratio has eliminated the risk which current assets does not convert to cash fast enough to settle the current liabilities. It excludes those items from the calculation.

Disadvantages of Cash Ratio

• Encourage company to keep cash on hand: It may encourage management to keep high cash on hand to maintain a good ratio. The company may miss the opportunity in making investments by keeping a high cash balance. It will impact the long-term company’s profitability.
• No clear guideline: Higher ratio means better, it shows that the company has strong financial health. However, it is not clear which is the good ratio. What is a ratio that each company should maintain?
• Ignore salable current assets such as inventory and marketable security: The ratio ignores some current assets that are easily converted to cash such as marketable security and receivable. The company liquidation position is better than this ratio.