What is a cash asset ratio?
A company’s current asset ratio is the present value of its marketable securities and cash, and we divide that by its current liabilities. Other people refer to it as simply the cash ratio, and it is a comparison between the amount of the most liquid assets and the amount of short-term liabilities. Using this, we can measure a company’s liquidity. And when we say liquidity, we refer to its ability to pay its short-term liabilities.
Here is a formula that we can use to calculate the cash asset ratio:
Cash asset ratio = (Cash+ Cash Equivalents)/ Current liabilities
Cash and cash equivalents
We are all well aware of what cash is. But are we aware of cash equivalents? These are assets we can quickly convert to cash. For example, we have treasury bills, certificates of deposits, commercial paper, and different money market instruments. Cash equivalents are also highly liquid like cash because they have high credit quality.
What can I get out of the cash asset ratio?
The cash asset ratio tells us a lot about a company’s financial liquidity. Hence, it tells us a company’s capability to cover its short-term obligations. The calculation is very conservative because it only consists of cash and other cash equivalents. It does not consider any other assets to know the liquidity of a company. And when we say short-term obligations, we might be referring to accounts payable and short-term debts. We pay for these using the most liquid assets in the cash asset ratio.
Let us say that the cash asset ratio is 1 and above. It means that the company’s financial health is doing quite well. It can quickly pay its short-term obligations using liquid assets. On the other hand, if it is below 1, the company might be experiencing some financial problems. And we are stressing the word “might” here because it is not always the case. More than one data point must be assessed before judging a company’s financial health.
Is there such thing as a company that has too much cash?
Many companies prefer not to stockpile cash and cash equivalents because they would instead use those for expansion or investment. Does it make sense that a company has too much cash? Believe it or not, there is such a thing. Others do not agree on stockpiling cash on the balance sheet because it shows poor cash management when they could have used it to generate more money.
Setting cash asset ratio apart from the current ratio
The cash asset ratio refers to a liquidity ratio that is the same as another liquidity ratio. On the other hand, the current ratio considers every existing asset on top of cash and marketable securities like inventories. The current ratio does not exclude any current assets, even those that are not highly liquid are considered. Hence, it might be less precise than the cash asset ratio. So, if you want to know how liquid one firm is, the cash asset ratio might be a better choice to use.