The cash ratio is another measurement of a company’s liquidity and their ability to meet their short-term obligations. The formula for the cash ratio, like the current and the quick ratio, uses current liabilities as the denominator in the formula:
(cash + marketable securities) divided by current liabilities
The elimination of accounts receivables used in both the current and quick ratios, and the elimination of inventories that are part of the numerator of the current ratio, leaves us with a ratio that shows the level of the firm’s cash and near-cash investments relative to their current liabilities.
The cash ratio is almost like an indicator of a firm’s value under the worst-case scenario where the company is about to go out of business. This ratio tells creditors and analysts the value of current assets that could quickly be turned into cash, and what percentage of the company’s current liabilities these cash and near-cash assets could cover.
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.