Understanding which loans a business can pay off in the short term is essential for long-term success - freeing up cash flow to fuel growth and avoid bad debt.
Part of this process can be achieved by calculating a cash ratio.
In this article, Stenn explains what a cash ratio is, how it can benefit businesses, how to accurately forecast a cash ratio with helpful examples, and the importance of liquidity for businesses.
What Is a Cash Ratio?
A cash ratio is a measurement of a company's liquidity, calculated by comparing its cash or other similar assets with its current liabilities to assess the business' viability to pay back short-term debts.
The formula is mainly useful to financers when attempting to decide how much money they would be willing to provide a business.
Cash Ratio Formula
The cash ratio formula is a simple calculation to perform, but it's important to get it right to accurately forecast a business' ability to pay back short-term loans.
There are two additional variants of this formula, too - each with unique benefits. The three formulas are as follows:
- Cash Ratio: Cash + Cash Equivalents / Current Liabilities
- Quick Ratio: Current Assets - Inventory / Current Liabilities
- Current Ratio: Current Assets / Current Liabilities
When looking at a produce wholesaler, for example, its cash ratio would consider available cash (in this case, £3,000), plus cash equivalents, like assets that can be sold, or money owed to them (£3,000).
First, we add those two totals together (£6,000) and then calculate the business' current liabilities owed, also known as debts (£3,000). So, the cash ratio of the wholesaler would be 6000:3000, or, to make it easier, 2:1. This would also be displayed as '2'.
A 'quick ratio' would be similar, but we take away any inventory from current liabilities. So, in the case of this business, £2,000 of those equivalent assets are inventory. So, combining both available capital and assets, the total instead would be £4,000 (not £6,000). This would make the quick ratio 4000:3000, or more simply 4:3, or accurately '1.3'.
The 'current ratio' only takes into account current assets and current liabilities. Unfortunately, £1,000 of the current assets cannot be liquidated before 90 days. This leaves the current assets at £5,000. So, the ratio would be 5000:3000, '5:3' or more accurately '1.6'.
Cash vs Quick vs Current Ratio
A cash ratio can be further refined into two separate categories - the 'quick' ratio or the 'current' ratio.
The current ratio divides current assets by current liabilities, giving no projections about potential future assets and liabilities. This means it provides a company with an idea of its cash ratio in its current state and includes accounts like inventory and cash receivable. For companies with a strong stock inventory, the current ratio will be naturally higher.
However, a quick ratio excludes the company accounts and, therefore, is a more conservative and stringent projection of a company's ability to pay back short-term loans. It only includes company assets that can be liquidated in less than 90 days for a quicker payout. For a company with a strong stock inventory, it's natural for a quick ratio to be lower than average.
How To Interpret Cash Ratio
If a cash ratio is equal to or greater than 1, it means a company has the resources and ability to pay off small, short-term debts.
A ratio above 1 is often preferred by loan providers, and a ratio of 0.5 or below is likely to turn most of them away, as this means a company has roughly twice as much short-term debt as it does available assets to pay it off.
What Is a Good Cash Ratio?
While there is no precise figure for a cash ratio that is considered ideal, a realistic favoured cash ratio is generally between 0.5 and 1. This suggests that the business is capable of paying its short-term debts and freeing up liquid capital.
If the result is below 0.5 then it's unlikely a lender will take a risk on a business, as they would look to avoid offering finance to those that risk being unable to make repayments.
So, generally, a ratio between 0.5 and 1 will put a business in a better position to qualify for funding.
Limitations of Using Cash Ratios
Despite how useful cash ratios can be for financers, they do have their limitations.
The cash ratio formula is rarely used in financial reporting or by analysts assessing a company for its overall viability, because a business may provide more to the industry than what it possesses in assets. It is both unrealistic and risky for a company to maintain excessive levels of liquid capital and cash assets to be used on short-term loans.
Likewise, a cash ratio analysis doesn't consider the size of a business or take into consideration uniform accounting. Both are necessary for accurate overall business analysis.
The Importance of Liquidity for Businesses
The reason the cash ratio formula is so useful for businesses is down to the value of liquidity.
Availability of cash and asset liquidity is extremely important for both importers and exporters, which require access to cash quickly to meet financial obligations such as paying manufacturers or logistics partners.
Due to popular deferred payment terms in the import and export industries, many companies may find themselves in need of liquid capital to cover everyday business costs.
Similarly, in many industries such as e-commerce and SaaS markets, which experience unique risks such as security and compliance considerations and fluctuations in demand, liquidity is key in navigating unexpected disruption.
The cash ratio formula allows businesses to routinely manage their liquidity and react at the first signs of vulnerability to avoid missing payments or accruing bad debt.
Access Immediate Liquid Capital with Stenn
Are you a business engaged in overseas trade with delayed payment terms? Do you need a liquid capital injection to help cover your own accounts payable in the short term or to fund business growth?
Stenn finances invoices for hundreds of small and medium-sized importers and exporters with manageable payment terms, while also providing revenue-based financing for e-commerce and SaaS businesses.
Apply for financing with Stenn today or find out about the other financing options available to your business in our Resource Hub - including guides to:
- Invoice financing
- Revenue-based financing
- Stock financing
- Business lines of credit
- Alternative lending options for e-commerce businesses
Frequently Asked Questions (FAQs)
Q: How Can a Company Improve its Cash Ratio?
A: Improving the current cash ratio of a business should be a primary objective if they are looking to secure a short-term loan grant. It can be as simple as paying off current liabilities, while current assets need to be increased. This increases the amount of liquid capital available to the business compared with its short-term debts - making it more attractive to finance providers.
Q: Is a High or Low Cash Ratio Better?
A: A higher cash ratio means that a company has more liquid capital available and lower short-term liabilities in need of payment, while a lower cash ratio means that there is a higher amount of liabilities and less cash on hand as an asset. Therefore, it is more desirable to have a higher cash ratio than a lower one.
Q: What Causes a Low Cash Ratio?
A: A cash ratio reflects a business' ability to pay off short-term debts. So, a low cash ratio means that the amount of short-term liabilities a business has is either similar to or higher than the number of assets it has to pay off those liabilities. A low cash ratio means that a business is less likely to be able to pay off short-term loans.
Q: What Is a Net Cash Ratio?
A: A net cash ratio is another formula capable of estimating a business' ability to pay back short-term loans. The formula for a net cash ratio is net cash minus liabilities. It's also a helpful formula for businesses in determining how much cash will be left after paying off all transactions.
Q: Is a Cash Ratio a Percentage?
A: A cash ratio is a simple and easy-to-understand representation of how well a company can pay back short-term debts and assess its viability for further loans by comparing assets and liabilities. While a cash ratio is displayed as a ratio, and not a percentage, it's relatively similar in how it converts a complex idea into an intuitive and accessible figure.
Q: What Does a Cash Ratio of 0.2 Mean?
A: If a cash ratio is 0.2, it means that a company likely has more current liabilities than it does cash or cash assets to pay them off. This can present a big problem for finance providers, who will be less likely to offer funding to a company that has more current liabilities to manage. However, businesses with high stock are likely to have a lower-than-average ratio, so many finance providers do take into account this wider context when deciding on whether or not to offer a company funding.
About the Authors
This article is authored by the Stenn research team and is part of our educational series.
Stenn is the largest andfastest-growing online platformfor financing small and medium-sized businesses engaged in international trade. It is based in London, provides financing services in 74 countries and is backed by financial giants likeHSBC,Barclays,Natixisand many others.
Stenn provides liquid cash to SMEs within the global financial system. On stenn.com you can apply online forfinancing and trade credit protectionfrom$10 000 to $10 million (USD). Onlytwo documentsare required.No collateralis needed andfunds are transferred within 48 hoursof approval.
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