What should cash ratio be

They want to see if a company maintains adequate cash balances to pay off all of their current debts as they come due. Creditors also like the fact that inventory and accounts receivable are left out of the equation because both of these accounts are not guaranteed to be available for debt servicing. Inventory could take months or years to sell and receivables could take weeks to collect. Cash is guaranteed to be available for creditors. The cash coverage ratio is calculated by adding cash and cash equivalents and dividing by the total current liabilities of a company.

Most companies list cash and cash equivalents together on their balance sheet, but some companies list them separately. Cash equivalents are investments and other assets that can be converted into cash within 90 days. These assets are so close to cash that GAAP considers them an equivalent. Accounts receivable, inventory, prepaid assets, and certain investments are not included in the cash ratio, as they are with other liquidity measurements.

The rationale is that these items may require time and effort to find a buyer in the market. In addition, the amount of money received from the sale of any of these assets may be indeterminable. The cash ratio is most commonly used as a measure of a company's liquidity. If the company is forced to pay all current liabilities immediately, this metric shows the company's ability to do so without having to sell or liquidate other assets. A cash ratio is expressed as a numeral, greater or less than 1.

Upon calculating the ratio, if the result is equal to 1, the company has exactly the same amount of current liabilities as it does cash and cash equivalents to pay off those debts. If a company's cash ratio is less than 1, there are more current liabilities than cash and cash equivalents.

It means insufficient cash on hand exists to pay off short-term debt. This may not be bad news if the company has conditions that skew its balance sheets , such as lengthier-than-normal credit terms with its suppliers, efficiently-managed inventory, and very little credit extended to its customers.

If a company's cash ratio is greater than 1, the company has more cash and cash equivalents than current liabilities. In this situation, the company has the ability to cover all short-term debt and still have cash remaining. While that sounds responsible, a higher cash ratio does not necessarily reflect a company's strong performance, especially if it is significantly greater than the industry norm. High cash ratios may indicate that a company is inefficient in the utilization of cash or not maximizing the potential benefit of low-cost loans: Instead of investing in profitable projects, it's letting money stagnate in a bank account.

It may also suggest that a company is worried about future profitability and is accumulating a protective capital cushion. The cash ratio is seldom used in financial reporting or by analysts in the fundamental analysis of a company. It is not realistic for a company to maintain excessive levels of cash and near-cash assets to cover current liabilities.

It is often seen as poor asset utilization for a company to hold large amounts of cash on its balance sheet, as this money could be returned to shareholders or used elsewhere to generate higher returns. While providing an interesting liquidity perspective, the usefulness of this ratio is limited. The cash ratio is more useful when it is compared with industry averages and competitor averages, or when looking at changes in the same company over time. A cash ratio lower than 1 does sometimes indicate that a company is at risk of having financial difficulty.

However, a low cash ratio may also be an indicator of a company's specific strategy that calls for maintaining low cash reserves—because funds are being used for expansion, for example. Certain industries tend to operate with higher current liabilities and lower cash reserves , so cash ratios across industries may not be indicative of trouble.

Financial Ratios. Business Essentials. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page. This is one of the most liquid forms of money. It differs from a normal bank savings account since it allows multiple deposits and withdrawal in a particular period.

And under cash equivalent, the organizations take into account money market mutual funds, treasury securities, preferred stocks which have a maturity of 90 days or less, bank certificates of deposits, and commercial paper. Current liabilities: Under current liabilities, the firms would include accounts payable Accounts Payable Accounts payable is the amount due by a business to its suppliers or vendors for the purchase of products or services. It is categorized as current liabilities on the balance sheet and must be satisfied within an accounting period.

In the example below, our primary concern would be to see the liquidity position of the firm from two perspectives. First, we will look at which company is in a better situation to pay off short-term debt, and second, we will look at which company has better utilized its short-term assets. First, which company is in a better position to pay off short-term debt for sure not having any uncertainty? And if we look at the ratio of both the companies, we would see that the ratio of Company X is 0.

Even if Company X has more cash, they have lesser accounts receivables Accounts Receivables Accounts receivables refer to the amount due on the customers for the credit sales of the products or services made by the company to them. It appears as a current asset in the corporate balance sheet. From one perspective, it is a good position to be in as nothing is locked up, and the major part has been liquidated.

But at the same time, more the cash ratio and less current ratio means compared to Company Y ; Company X could have better utilized the cash lying for asset generation. From this perspective, Company Y has better utilized its cash.

In this section, we will take an example from the industry so that you can understand how this ratio works.