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Wednesday, April 20, 2011

Cash Ratio: Good Measure of Liquidity

How much cash do you have in the bank? Can you pay all of your current bills and still have a positive balance?

If so you are considered highly liquid, meaning enough of your assets are either cash or easily converted to cash.

For stock investors, a company’s liquidity is an important consideration in looking for potential investments.

Companies that have good liquidity are able to ride out bumps, the economy may put in their way.

The question for stock investors is how do you measure liquidity.

Cash Ratio

The cash ratio is the most conservative ratio for measuring liquidity is often used during periods of economic turmoil.

The cash ratio is easy to calculate. It is:

Cash plus easily marketable securities divided by current liabilities.

Current liabilities are defined as those bills due within one year, such as bills to vendors, suppliers, daily operating expenses, and so on.

You can find the values for this equation on the balance sheet.

The cash ratio should be close to 1 and higher is better.

Ignores Assets: The reason the cash ratio is considered a very conservative view of a company’s liquidity is that it ignores such values as inventory (which turns over at least once a year for most companies).

The cash ratio also ignores the daily cash generation of the business as it sells products and services.

Why use the cash ratio?

In difficult times, cash is the most important asset many companies possess.

If a company has a ready supply of cash, it can survive sudden drops in sales that might put another less liquid company out of business.

The cash ratio is a good gauge of how a company can weather difficult times.

It is not a good ratio to use when considering the value of a company because it excludes valuable assets such as inventory and property. It is not a good ratio to use by itself, because much is missing from the total health of the company.

However, it is a good signal that a company is worth further consideration or a red flag that a company with a poor cash ratio may lack the liquidity to survive a difficult economy.