Cash ratio: find out if your company is solvent

The cash ratio is one of the financial indicators that provide insight into a company's financial situation.

Whether you are an SME or a larger company, this ratio is necessary to assess your solvency capacity.

Read on if you want to know in detail what the cash flow ratio is, what it is used for and how to interpret it.

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What is the cash ratio?

The cash ratio is an effective indicator that allows us to know and measure a company's ability to pay its short-term debts. In other words, this ratio provides information on the liquid cash of a company, available in a period of less than one year.

☝️ It is essential to find out the liquidity of a company in order to know its financial health.

💡 The cash ratio is also known as the acid test .

What is the cash ratio used for?

Apart from the solvency capacity of the company, the cash ratio is useful for:

• To know the financial evolution of the company,
• to monitor the company's accounts,
• detect future payment problems,
• plan the accounting activity.

Cash and solvency ratios

At this point, it is pertinent to make a small clarification so as not to confuse the cash ratio with the solvency ratio.

Although both measure the company's ability to pay its debts, the information they convey is different:

• On the one hand, the cash ratio focuses exclusively on the liquid cash that the company may have in the short term, which will be used to pay debts.
  
  
• The solvency ratio, on the other hand, does not distinguish between time periods or assets (liquid or not), but compares assets with liabilities to show the overall solvency of the entity.

How is the cash ratio calculated?

Cash ratio formula

🔵 The cash ratio is calculated from the following formula:

Let us look in more detail at what these concepts refer to:

• Available = Liquidity of the company.
• Realisable = Assets and rights that can be converted into cash in the short term.
• Current liabilities = Short-term debts and obligations.

☝️ All these values can be found in the balance sheet (also called balance sheet) of the company.

💡 Both cash and cash equivalents are part of current assets.

Cash ratio interpretation and optimal values

The optimal value of the cash ratio is 1.

For this to be the case, the amount of current assets (cash plus cash equivalents) must be equal to the amount of current liabilities (total short-term liabilities). In this way, the company will have sufficient liquidity to settle its payments.

From this we can interpret that:

• A ratio of less than 1 means that the company cannot meet all its short-term debts. In other words, the company has more debt than liquidity and, therefore, there is a risk of default.
  
  
• A ratio higher than 1 is not ideal either, as it may mean that the company has an excess of unproductive assets, which is neither good nor profitable.

⚠️ If the cash ratio result is less than 0.3, the company is in a critical situation and urgent action should be taken.

💡 How to improve the ratio? Try to set shorter collection periods or negotiate longer payment periods, among others.

☝ Having an accounting software allows you to visualise and control your financial indicators from a customised and automated dashboard that is easy to interpret.

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Other important financial ratios

To conclude, once the cash ratio is known, it is also appropriate to present other ratios that can be of help in analysing the state of your company.

Liquidity ratio

The liquidity ratio is very similar to the cash ratio, as it also serves to determine the solvency of the company.

However, to measure the liquidity ratio, we will take into account all current assets and debts falling due in the short term.

🔵 Liquidity ratio formula :

Immediate availability ratio

The immediate availability ratio is still an indicator that measures the entity's capacity to meet its short-term debts. In this case, it will assess the situation in terms of the company's liquidity.

🔵 F ormula for the readily available ratio :

Debt ratio

The debt ratio establishes the company's dependence on external financing. In other words, it compares external financing and its equity.

🔵 Debt ratio formula:

Collateral Ratio

This last ratio is particularly interesting as it indicates whether a company is more or less likely to go bankrupt.

To do this, it takes borrowed funds (debts to banks, for example) and compares them with real resources (those the company already possesses).

🔵 Collateral ratio formula:

Tell us, what ratios do you use in your company?