How to Calculate and Improve Your Cash Ratio for Business Success?

Suppose, you get involved in the management of a small business. All the results are fantastic as sales increase, invoices are being sent and the bank account looks healthy. Then suddenly you get started, when a new bill comes in and you have to pay it off immediately. It comes to your mind all of a sudden that most of the money is out of your access as it is owed to you by the clients and it is in the form of the inventory. It means there is a shortage of cash. 

In short, the cash ratio focuses on the ability of the company to pay the shortest-term obligations with the highest liquidity. In this write-up, we are discussing the necessary and importance of the cash ratio and its computation, and as a result the ways to develop it. This blog will show the connections of this parameter to financial sustainability, the investors’ interest, and the growth plane of the business. 

What is the Cash Ratio?

The cash ratio is a measurement of the liquidity level of a company to pay off its short-term liabilities by cash and its equivalent in slot. In contrast to other liquidity measures, the cash ratio, on the other hand, does not include notes and accounts receivable, but only focuses on cash and short-term securities. Formula for the Cash Ratio: 

Cash Ratio = Cash and Cash Equivalents / Current Liabilities

Example:

Let us further imagine that a small company contains $50,000 in cash and cash equivalents and they have $40,000 in short-term liabilities. The calculation for this may be as follows: 

Cash Ratio = 50,000 / 40,000 = 1.25

This shows the company having $1.25 in cash where the company also had $1 of short-term liabilities, this means they have a pretty solid position as for the liquidity. 

Why is the Cash Ratio Important?

A cash ratio forms a financial togetherness that is based on figures but is really more about the company’s proficiency in budgeting and efficiency at handling capital on one hand and the paying off of debts on the other. What a good business cash ratio gives is a clear outlook on contingent problems: 

1. Measures Financial Stability

A comfortable cash ratio is the one which allows for the mutual settlement by business with the short-term obligations from the existing funds not penning second capacity funding or selling of assets. Which comes out ultimately to the business’s strong liquidity and it does need for such an eventuality. 

2. Enhances Credibility with Investors and Lenders

A potent cash ratio confirms to all investors and lenders that the project is appropriately stashed. A high-quality cash ratio may be seen as an essential key to get capital when looking for funding or partnerships. 

3. Prevents Over-Leveraging

Companies, which provide a few cash ratios, have a tough time with incredible short-term obligations, which takes the whole business to default. By keeping it, one knows himself/herself as the greatest mastermind of the financial condition and structure of one’s endeavor. 

4. Facilitates Better Decision-Making

The operation of the company and its ability to produce goods, employ workers, and make investments in new projects are all ancillaries to the fact that right information about liquidity avails a business person the chance to make a good choice. 

5. Provides a Safety Net in Economic Downturns

A decrease in the otherwise-thriving market situation caused by volatility can make cash flows not be steady. Thus, short cash is acting like a stress reliever in this situation as it presents an opportunity for the firm to go without much downsizing.

How to Improve Your Cash Ratio?

In case your cash ratio is not as well as it should be then don’t bother to panic because there are several things that you can do to improve it. Here are some practical steps: 

1. Optimize Cash Flow Management

• Rediscover that payment usually occurs in the middle of the term if you send an early invoice with clear but not rigid payment terms and an option for payment within 7 days. 
• To decrease invoicing problems you can try the automatic billing system and draw the clients’ attention to reducing delays respectively. 
• With accurate forecasting data, try to prevent the negative cash flow bottlenecks of accounts payable and accounts receivable. 

2. Reduce Unnecessary Expenses

• Elaborate on your business spending and identify those that are not beneficial to the overall business. 
• Revise the terms of payment with your suppliers to more favorable ones by any means, for instance, extending deadlines. 
• Try to govern stingily by saying no to many subscriptions, overheads, and other unnecessary things. 

3. Build a Cash Reserve

• Make sure that you save some of your income for your savings account. 
• Exclude all the unforeseen expenses from the funds that you put aside for covering emergencies, and thus they should be your last priority. 
• The additional liquidity for reinvestment in the business has to be preceded by a higher level of working capital which ensures a DC ratio of 1:1 level. 

4. Diversify Revenue Streams

• Increase your cash flow by providing several goods or services that interest the customers who value what you are doing in the business. 
• Think about opening up new markets and obtaining facilities to sell online which will increase your revenue of the company. 
• Get involved in the marketing that yields a high return on investment and gives results in the shortest possible time. 

5. Negotiate Favorable Payment Terms with Suppliers

• Pay the funds to your suppliers on time, and thus, the money needed for the company will not be blocked. 
• Establish strong liability relationships with suppliers as they give you a flexible payment arrangement along with good terms for a longer period. 
• Benefit from economies of scale and thus bring down the cost of production as a result of making bulk purchases.

6. Use Short-Term Financing Wisely

• Opt for the so-called trade credit or invoice factoring. 
• Businesses occasionally opt to use credit lines to manage their cash flow in the short term. 
• The alternative of high borrowed money that is offered at high-interest rates is the one that you surely should not indulge in. 

Cash Ratio vs. Other Liquidity Ratios

Getting to know besides other liquidity ratios like the quick ratio followed can bring a better and clearer image of the financial health of a firm.

1. Cash Ratio vs. Current Ratio

• Cash Ratio: Considers only cash and cash equivalents. 
• Current Ratio: It is the sum of all current assets, including accounts receivable and inventory. 

Contrasting Point: The current ratio provides a more comprehensive view, while the cash ratio is a more cautious measure. 

2. Cash Ratio vs. Quick Ratio

• Quick Ratio: Contains cash, accounts receivable, and marketable securities without inventory. 
• Cash Ratio: Deals only with cash and cash equivalents. 

Contrasting Point: The quick ratio is more lenient than the cash ratio but also tighter than the current ratio.

Also Read: What is Cash Flow? Understanding the Basics

Frequently Asked Questions (FAQs)

1. What are the negatives of the cash ratio?

The cash ratio is a measure that does not capture all of the resources a company has, including inventory and receivables, which are liquid enough to be transformed into cash quickly. As a result, it might undervalue the company’s liquidity in some cases. 

2. Is it possible for the cash ratio to be negative?

Yes, if the company’s current liabilities exceed cash and cash equivalents, it would be a negative cash ratio situation causing a warning of bankruptcy. 

3. How safe is the cash-inferiority? A cash ratio of more than 1 generally indicates a healthy condition since the company possesses enough cash to pay off its debts. That being said, too high cash ratios can be an indicator of the company’s incurrence in ineffective cash utilization. 

4. Is a greater cash ratio recommended to be in all cases? To some extent. A solid liquidity position is a plus, but the cost of having excessive definite dead money could float off profitable investment vehicles. The target of a company is a well-mixed liquidity situation. 

Conclusion: A Strong Cash Ratio Can Support Your Business Growth

The cash ratio is an important financial metric that helps companies understand the financial position and the ability to meet obligations in the short period. Such is the case when a company holds a cash ratio that is high it is not only more trustworthy, but also that it has enough liquidity for unexpected payments. In this case, it should be noted that it may be possible that the company is not utilizing cash in the best way. The cash ratio is a tool that is provided here, which is a formula that assesses a business’s financial health, liquidity, and ability to meet its debts. 

Acquiring a good relationship with your suppliers and securing auto financing will allow you to move along the entire supply chain without disruptions. Credlix makes global supply chain liquidity more feasible for businesses by managing them and optimizing their working capital as well as improving their cash flow. Also, Credlix enables companies to attain optimal levels of liquidity for the business process. Your cash ratio scores will improve and the business will become ready for future challenges. Be sure to keep an eye on it and take steps in advance to boost your financial stability.

Also Read: How Credit Facilities Can Support Your Business Cash Flow