‘Cash ratio’ is used to measure company’s liquidity. To start from terminology, liquidity means the ability to pay up debt and obligations taken. The higher the liquidity, the more resources a company has to satisfy its creditors. Liquidity is achieved by having cash and cash equivalents, accounts receivable and inventory at least at stabile levels. The higher those levels, the more liquid a company may be deemed.

Company’s liquidity using the cash ratio is therefore measured using the following formula – cash and cash equivalents are divided by current liabilities. Essentially, since cash is the main resource all debt is paid up with, it reflects just how quickly a company can satisfy all its creditors. However, the problem with this ratio is the sheer fact that it only includes cash and no other current yet very liquid asset. As accounts receivable and inventory are usually highly collectable and tradable, the cash ratio shows the very conservative point of liquidity – pure cash resources against liabilities.

This ratio shows whether the company has enough cash to cover for its short-term liabilities in due time. Obviously, the lower the result, the stronger the indication the company may have financial difficulties. We say ‘may’ because it does not necessarily mean bankrupt or serious financial difficulties, however if the company fails to get this situation under control with other means of financing or business decisions, this is an indication of imminent financial problems.

As such the cash ratio is also giving a good overview of the efficiency the company is run with, however, what must be always noticed, is the industry a company is in. One must compare ratios with companies in similar industries as every sector has unique characteristics when it comes to financial ratios.