The cash ratio is the most strict and conservative short-term liquidity ratio — the other two being the current ratio and quick ratio. The cash ratio refines a company’s liquidity by only measuring cash, cash equivalents, and highly liquid investments against current liabilities. The ratio ignores accounts receivables and inventories. It’s calculated as:
Cash ratio = (cash + cash equivalents + invested funds) / current liabilities
Assume a firm has $100,000 in cash, $40,000 in cash equivalents, $100,000 in invested funds, and $80,000 in current liabilities. The cash ratio is:
($100,000 + $40,000 + $100,000) / $80,000 = 3
This means that the company has $3 in cash and cash-like assets to cover every $1 in current liabilities. The higher the ratio the better. New small businesses should strive for higher ratios as it implies strength and some breathing room. A declining cash ratio is a sign of upcoming trouble.