What is the cash asset ratio?

The ABC Company reports the following information on its balance sheet:

• Cash on hand: $140,000
• Marketable securities (i.e. cash equivalents): $100,000
• Accounts receivable: $90,000
• Inventory: $50,000
• Short term liabilities = $250,000

The XYZ Company reports the following information on its balance sheet:

• Cash on hand: $200,000
• Marketable securities (i.e. cash equivalents): $100,000
• Accounts receivable: $10,000
• Inventory: $40,000
• Short term liabilities = $250,000

Both companies have delivered earnings reports that are making analysts concerned about the solvency of their respective companies. In order to assess the company’s ability to meet short-term debt obligations, analysts will use liquidity ratios. However, the financial picture that emerges will depend on which ratio is used.

If they use the Current Ratio, which includes both accounts receivable and inventory, the companies stack up as follows:

• Current Ratio (Company ABC): 380,000/250,000 = 1.52
• Current Ratio (Company XYZ): 350,000/250,000 = 1.4

If they use the Quick Ratio, which excludes inventories, the companies stack up like this:

• Quick Ratio (Company ABC): 1.32
• Quick Ratio (Company XYX): 1.24

However, when analysts use the more stringent Cash Asset Ratio, the companies stack up like this:

• Cash Asset Ratio (Company ABC) = 0.96
• Cash Asset Ratio (Company XYZ) = 1.2

A Cash Asset Ratio of 1 means that there is just enough cash to meet short-term (or current) liabilities. What this tells investors is that Company XYZ has higher liquidity to meet their short-term debt obligations with room to spare. Company ABC, while having more total assets, has essentially just enough liquidity to meet their short-term obligations, and maybe not enough.

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The Cash Asset Ratio also called the Cash Ratio, is intended to give a "worst case" scenario look at a company's financial picture. This focus on the worst case is both the benefit and the limitation of the ratio. Many businesses will argue, correctly, that the Cash Asset Ratio is not a realistic picture of how their company operates. And, in support of that, a cash asset ratio that is too high can mean that a company is not making efficient use of their cash.

In the real world, analysts and investors will choose the ratio that is most meaningful for that industry or sector. For example, in some sectors, a Cash Asset Ratio of 0.96 may not be of much concern at all while in another sector a Cash Asset Ratio of 1.2 may be considered too low.

Although commonly used in evaluating the finances of a business, ratios such as the cash asset ratio can be used as a personal financial ratio to help individuals understand the difference between their net worth and their ability to handle short-term debt obligations.

Introduction

When we review our personal finances, the worst case scenario is never far from our mind. We can look at our net worth (what we have in our mutual funds, real estate, insurance, etc.) and be lulled into a sense of complacency. However, when we take an objective look at our finances and get to the heart of the matter, the question becomes are we bringing enough income, or have access to cash, to meet our monthly expenses and give ourselves the financial freedom we desire?

It’s the same way with a business. Although a business may report a sizable revenue figure, that money may not be available to the company in the form of cash or cash equivalents. If a company lacks cash on hand to meet their short-term debt obligations (defined as obligations they will have to pay in less than one year), they are at a higher risk of having financial problems. In order to assess the financial health of a company, financial analysts and investors will use ratios. Among the most stringent of these ratios, and the topic of this article is the cash asset ratio. The cash asset ratio is a measurement of how solvent a business is (i.e. their ability to meet short-term debt obligations with the cash or cash equivalents they have available to them). In this article, we’ll take a close look at the cash asset ratio including showing the formula, defining why it’s important, and show how it differs from other common liquidity ratios. We’ll also take a look at where liquidity ratios fit into the broad area of fundamental analysis and review the limitations of the cash asset ratio.

Example of cash asset ratio

The XYZ Company reports the following information on its balance sheet:

• Cash on hand: $200,000
• Marketable securities (i.e. cash equivalents): $140,000
• Short term liabilities = $250,000

Their cash asset ratio will be:

200,000 + 140,000/250,000

340,000/250,000

Cash Asset Ratio = 1.36

How to interpret the cash asset ratio

As with most ratios, a cash asset ratio that is equal to 1 represents an equilibrium state. This means that a company has exactly the same amount of current liabilities as it does cash and cash equivalents.

A cash asset ratio that is lower than 1, indicates a state where the company’s current liabilities are greater than the cash or cash equivalents they have on hand. By itself, this may not be cause for concern. However, it does indicate that further research is needed to look for specific reasons that may affect their balance sheet. Some of these may be the extension of longer-than-normal credit terms with suppliers and efficiently-managed inventory.

A cash asset ratio that is greater than 1 indicates a state where the company’s current cash and cash equivalents are sufficient to meet their short-term obligations.

Limitations of the cash asset ratio

As stated above, the cash asset ratio is intended to give investors a worst-case scenario regarding a company’s ability to pay their short-term obligations. However, many analysts and investors would hold the opinion that, in most cases, a company sitting on a large amount of cash could find more productive uses for that cash including returning it to shareholders in the form of dividends, initiating a share buyback program, or making an investment in research and development. For this reason, many investors may only look at this ratio if they perceive the company to be in financial trouble.

Also, like any ratio, a company’s cash asset ratio should be looked at compared to its industry and sector. In some cases, a higher or lower cash asset ratio is normal.

The final word on cash asset ratio

The cash asset ratio is a liquidity ratio that creates a worst case scenario for a business and its cash flow. A healthy business should have enough assets to meet its short-term debt obligations. However, in the world of financial accounting, assets like accounts receivable and inventory are not always the best measure of a company’s solvency, particularly if the business is in distress.

The cash asset ratio, therefore, only accounts for cash and cash equivalents when assessing a company's ability to meet its short-term debt obligations. For this reason, it is considered one of the most stringent measurements that analysts use. And that also, frankly, is a reason why some analysts don't use it unless the company is showing other signs of financial problems. For an otherwise healthy company, a cash asset ratio that is too high can also be a concern because it shows that the business is not efficiently using their cash on hand, or their management is not being imaginative enough to make investments in the company’s future growth. Also, a company’s cash asset ratio must be viewed with regard to other companies in their industry or sector in order to be properly interpreted.