One of the liquidity ratios used in business is the cash ratio. It is a much more effective tool for small business than the traditional current or quick ratio. Although the cash ratio is more difficult to manipulate in small business, most entrepreneurs miscalculate the result. This resource paper is designed to explain to the business entrepreneur the basic formula, how to properly apply the formula and educate the reader in calculating the ratio from financial reports of a small business. To fully grasp the cash ratio, it is encouraged the reader complete the prerequisites as follows:
* Business Ratios – Introduces the 21 ratios used in business by groups including the liquidity group of which the cash ratio is a member.
* Current Ratio – An all-encompassing liquidity ratio more appropriate to big business.
* Quick Ratio – A more refined liquidity ratio focusing on true short-term (30 days or less) ability to meet obligations.
The cash ratio is more appropriate in small business than the traditional current ratio. To appreciate this, the reader must first understand its formula.
Cash Ratio Formula
The cash ratio is designed to evaluate the ability of a business to pay its obligations immediately, as in today. Solvency is essential in business and with small business the owner must constantly maintain a vigilant watch over liquidity (ability to pay its bills). The cash ratio identifies this ability.
The formula is simple, all cash available divided by current liabilities that are immediately due. Ideally, any value greater than 1:1 will work. Naturally the higher the ratio the greater the liquidity. To illustrate, look at this basic small business balance sheet.
April 30, 2016
Accounts Receivable 21,600
Sub-Total Current Assets $43,000
Fixed Assets 20,000
TOTAL ASSETS $63,000
Accounts Payable $12,000
Credit Cards Due 2,000
Accrued Expenses 3,000
Line of Credit -0-
Long-Term Debt 15,000
TOTAL LIABILITIES 32,000
TOTAL LIABILITIES AND EQUITY $63,000
With this illustration the cash ratio is as follows:
Cash Ratio = Cash
Cash Ratio = $18,200
Cash Ratio = 1.07 : 1
This appears easy to evaluate and simple to understand. The reality is much more than this. Remember the formula is designed to identify the ability to meet current obligations right now. This formula can dramatically change in one day.
Notice the balance sheet is dated the 30th. Most small businesses rarely if ever record recurring monthly obligations until they are due. This results in a miscalculation of the ratio. ACME is no different. On the 1st of May the rent is due and is paid. The rent payable was not in the accounts payable on April 30th. Suppose the rent is $2,500. Nothing else changes, so what is the cash ratio on the night of May 1, 2016?
Cash is now equal to $18,200 minus $2,500 or $15,700. The cash ratio equals $15,700 divided by $17,000 or .924 : 1. This is a significant change in one day.
Examples of recurring items throughout the month that affect the cash ratio include:
* Tax Obligations
* Distribution Payments
* Loan Payments
* Automatic Withdrawals (bank fees, annuity payments etc.)
On the flip side of this equation are sudden cash increases such as payments from customers on amounts they owe the company. Sometimes though the cash is a result of the change in current liabilities. Notice ACME has a line of credit. Suppose on the 30th of April, ACME draws $10,000 out to augment cash. What is the cash ratio on April 30th?
Cash is equal to $28,200. Current liabilities are equal to $27,000 ($17,000 plus $10,000).
Cash Ratio = $28,200 = 1.04 : 1
Notice that the ratio decreased? Why? The answer lies in the 1:1 relationship increasing both sides of the equation. In effect, volatility is going to exist with this ratio. It is inherent in its very basic limitations. Knowing that volatility exists, why have this formula and how does the small business entrepreneur properly use the ratio?
Cash Ratio Application
The formula is one of the pure business ratios as cash is truly the only asset with 100% valuation. All other assets, even current assets, cost money and time to turn into cash. As a few examples illustrate below.
Accounts Receivable – Customers are granted a period of time to pay their invoice from the company. Companies with frequent activity and large volumes of invoices will get cash everyday as somebody will pay on their account each day. But to turn the entire receivables into cash immediately means the company must sell them (called ‘Factoring’ in business) at a deep discount, often 8 to 20 percent.
Inventory – Inventory customarily comprises two groups, raw materials and finished goods. Finished goods are typically sold to customers on account, again a long period of time to turn the asset into cash. This is even longer with raw materials. If a business needs to liquidate any inventory, the discounts frequently exceed 50% and often take several days to complete.
Fixed Assets – The problem with fixed assets is the limited market for the asset and the difficulty in communicating the asset’s availability. Even the most commonly traded fixed assets, vehicles, takes several weeks to find a buyer and often the asset is sold at a discount.
If interested in learning more about liquidity read the following series on working capital to understand how assets are turned into cash.
With bigger business operations the cash ratio is more stable and more predictable as volume of activity makes it easier to generate cash each day. Small businesses (those with sales of less than $20 Million per year) and micro businesses have greater volatility with cash but utilize this ratio to address solvency. Solvency is the ability to pay the bills immediately or as they come due. Bills include the following:
1) Accounts Payable
2) Credit Cards
3) Accrued Expenses including payroll taxes, payroll benefits, other taxes and legal obligations
4) Lines of Credit
5) Current Portion of Long-Term Debt (principal payments)
6) Recurring Charges
Some guidance is necessary at this point to fully understand the definition of current liabilities as defined in context with the cash ratio.
Not every current liability is due today or even this week. Think of accounts payable and the respective terms from the vendors and suppliers. Most of them give their customers 30 days to pay the bill. So the $12,000 ACME owes may not necessarily mean ACME owes it today or even this week. It is owed within the next 30 days. This is also true with other current liabilities such as credit cards and accrued expenses.
Generally Accepted Accounting Principles (GAAP) defines current liabilities as amounts due within one year of the date of the balance sheet presentation. Technically the next 12 principal payments on any loan are included in current liabilities. The current portion of long-term debt is the account used to fulfill this function.
Instantaneous liquidity, which is what the cash ratio assesses, should not include 11 of those 12 principal installments. Only the most current principal installment requires cash to meet the obligation. The 11 remaining payments will most likely get satisfied by future cash inflows from accounts receivable and other current assets. The cash ratio is really meant to address immediate cash needs. Immediate cash needs are those due over the next seven days. When liquidity ratios are used in business performance evaluations there is a hierarchy related to these ratios as follows:
Current Ratio – The broadest of the liquidity ratios refers to a full relationship of current assets over current liabilities. It usually reflects the ability to meet obligations over the next 60 to 90 days. It is an ineffective ratio to evaluate small businesses.
Quick Ratio – This ratio is more definitive in outcome than the current ratio as it excludes inventory from current assets. This ratio is used to evaluate the ability to pay bills over the next 30 days.
Cash Ratio – This ratio has the greatest level of refinement as the only current asset used is cash. Thus the purity involved. It is a ‘Now’ ratio and reflects the ability to meet obligations over a very short horizon of time – less than a week. For small business, it is a ‘today’ ratio. Therefore with small business, it is very difficult to affect a ratio that measures the current moment.
Business owners and entrepreneurs use this ratio to assist them in managing cash flow for the short-term. The numerator is all existing cash excluding marketable securities. The denominator is not all current liabilities but those amounts due over the next week including recurring obligations. Include projected payroll amounts, tax obligations and payments for loans and accounts. Here is an example of how ACME evaluates its cash ratio for the week of April 30th, 2016.
Cash on hand is equal to $18,200.
Current liabilities due over the next seven days:
Accounts Payable $9,218 (from a customized A/P report)
– Rent Due 2,500
– Payroll Due on Friday 4,680 (includes taxes)
– Sales Tax 204
– Retirement Plan Payment 715
Loan Payment 389 (current portion and interest)
Total Current Liabilities Due $18,797
The cash ratio is equal to $18,200 OR .968 to 1.
This means the owner must scramble to meet the cash obligations by week’s end as the cash ratio is less than 1:1. In a pinch, he can use his line of credit to meet the obligation but it behooves him to try and collect some accounts receivable money by week’s end and avoid drawing on his line of credit.
Now that the formula is fully understood; how does an owner/entrepreneur use the formula?
The formula’s value is interpreting the results over a long period of time. Actually a look back of 52 or 104 weeks is ideal. Over time management will begin to feel the benefit of cash ratios significantly greater than 1:1. Ideally 3:1 creates a comfortable zone of stress free financial operations. Tracking this value weekly and watching it increase towards a 3:1 ratio is the goal.
Remember, there is a lot of volatility with this ratio. One week it may be 2:1 and the next week less than 1:1. Look at a trend line over time operating within a zone over that time period. It should increase slowly towards a higher value (trend upwards). The best way to envision this line is like looking at stock price line over time. It is constantly up and down with daily closings but over time the investor wants a continuous increase in value.
Calculating the Cash Ratio From a Balance Sheet
A big mistake for any business person, investor or entrepreneur is evaluating a business utilizing the cash ratio as a barometer of business performance. This is a classic novice entrepreneurial error. There are several reasons.
1) The cash ratio is an instantaneous calculation only reflecting that moment in time.
2) The formula is highly volatile as often recurring items are not yet posted as liabilities.
3) Cash is easily affected by daily activities especially in small business.
What is best is to evaluate the cash ratio based on its trend line over time, ideally two years. Most businesses do not track this trend line. The owner, investor or entrepreneur must use available information. Most small businesses will have monthly (interim) financial reports. Take the last two years of balance sheets (24 reports) and create your own trend line.
Simply use the cash balance as the numerator and one-fourth (1/4) of the current liabilities as the denominator in calculating the ratio. Remember the ratio is really a short time period formula and since there are four point three (4.3) weeks in a month, using a quarter of the value of current liabilities is a good approximation of the denominator value.
THE CASH RATIO IS ONLY AN EFFECTIVE TOOL IF MEASURED OVER SEVERAL TIME PERIODS. THE MORE FREQUENT THE TIME PERIODS AND THE LONGER THE LOOK BACK TIME FRAME THE MORE RELIABLE THE INTERPRETATION OF THE RESULTS.
If using the ratio as an investment tool, it should be used along with the other 20 business ratios to provide insight of the investment’s value. DO NOT use this ratio in isolation to make a business decision of any sort.
Summary – Cash Ratio
The cash ratio is one of the liquidity ratios used in business. It is simply the existing cash divided by all current liabilities. It is fraught with flaws especially its application. First off, its precision is highly volatile as it only reflects a single moment in time. In small business, recurring items are often omitted in the current liabilities value thus skewing the result more favorable.
Secondly, novice entrepreneurs will fail to modify the denominator to the dollar value due over the next seven days. The more refined dollar amount paints a more accurate picture of the cash ratio. The quick and current ratios are suited to longer time periods of 30 and 90 days respectfully.
Finally users often fail to consider the trend line as more informative than the most current calculation. The trend line over the last two years, even with high volatility between data points, provides a more comprehensive understanding of the small company’s ability to pay its financial obligations.
Use the cash ratio as one of many different ratios when evaluating the financial performance of any business. If used in isolation, the user will more than likely misinterpret financial performance. Act on Knowledge.