Cash ratio or cash coverage ratio is the liquidity ratio which use to measure the ability of the company to pay off its current liabilities with cash or cash equivalent. As compare to the current ratio or quick ratio, cash ratio is more restricted because instead of assets only cash require to pay off debt.
Creditor looks for the cash ratio that’s why they want that the company has the cash balance to maintain payoff all the debt which are due. For the debt servicing inventory and account receivable are not guaranty because both take time. But for the creditor, cash is grantee which always available.
When we divide the sum of cash and cash equivalent by the total current liabilities then we get the cash coverage ratio.
Cash Ratio=(Cash + Cash equivalent)/Total current liabilities
On the balance sheet, some companies take cash and cash equivalent at the same place but some list them separately. Assets and investment which may be converted into cash in the 90 days are called cash equivalent. GAAP consider these values equivalent because these are so close to cash. There are the current liabilities given in the above formula which show in the balance sheet separate from the long term liabilities.
Cash ratio calculated the ability of the company to pay off its current liabilities with cash or cash equivalents. So we can say that this ratio uses to show them in the per cent current liabilities.
If the current ratio of the company is 1 then the cash and cash equivalent of this company are the same as current debt. If the cash ratio is greater then one then the company can pay all the current liabilities with cash and cash equivalent. But if cash ratio is below the 1 then it is very difficult for the company to pay off its current liabilities with cash and cash equivalent. So the company needs the loan to pay off current debt.
If the cash ratio is more liquid then the company can easily pay off its current debt. The creditor gives priority to those companies which have a greater ratio than 1 because those companies can easily repay the loan.
There is a restaurant which needs loans for remodelling its dining rooms. Restaurant applies for loans of $100,000. explanation of earning of this listed in the balance sheet.
current tax payable =1,000
current long term liabilities=$10,000
For the calculation of the cash ratio of this restaurant, we need the above values.
From the above result, it is clear that the restaurant has cash and cash equivalent from which restaurant can pay off the 75% of current liabilities. The cash flow ratio of this restaurant is high because of which during a year it maintains the high cash balance.
On the bash of high cash ratio, there are many chances for the restaurant to get success for getting a loan from the bank.
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