Cash Ratio or Cash Coverage Ratio (Formula, Examples) | Calculation

hello everyone welcome to the channel of
Wallstreetmojo. Wtch the video till the end and also if you are new to this
channel then you can subscribe us by clicking the bell icon. Friends we are
going to discuss important ratio that’s called cash ratio or cash coverage ratio
which is mostly related to the liquidity of the company as you can see the cash
coverage ratio it measures what the liquidity of the firm, how much liquid it
is? what is the portion of the cash they have and other cash and cash equivalents. So if company has higher cash ratio it is it is likely that it will be able
to pay its short-term liabilities and vice-versa. Now if we look at the above
graph we know that Starbucks has the highest cash ratio that is 0.468 X in
financial year 2016 as compared to Colgate and Procter & Gamble but
what does it mean by cash coverage ratio does it matter if the ratio of the
company is more than 1 we’ll find out by this by this tutorial.
what is cash ratio see the cash ratio is used to measure the liquidity of firm and
it gives us a quantitative relationship between cash and cash
equivalents with the current liabilities of the company the question remains what is the good measure of cash coverage ratio should it be more than 1 or less
than 1 if the cash ratio is more than 1 would it indicate there is an
inefficient in inefficiency in utilizing the cash or on more profits or the
market is saturating. If the cash ratio is less than 1 would indicate that the
firm has utilized the cash efficiently or they have not made enough sales to
have more cash so to resolve all this. Let’s evaluate cash ratio with help of formula and example. So cash ratios formula let’s evaluate now the cash ratio formula is as simple as it can be just
divide the cash and cash equivalents by the current liabilities and you will you
would have your cash ratio or cash coverage ratio so let’s write the formula the
cash ratio formula is equal to saying we write cash plus cash equivalents divide
by the total current liability the total current Liabilities ok So this is
going to be our cash ratio formula. Now mostly firms show cash and cash
equivalents together in the balance sheet but few firms show cash and cash
equivalents separately but what cash equivalents really means I mean see
according to GAAP cash equivalents are investments and other assets which can
be converted into cash within 90 days or less
thus they get included in the cash coverage ratio see current liabilities
are the liabilities which are due in the next twelve months or less so let’s have
a look at the cash and cash equivalents and current liabilities that any firm
considers to include in their balance sheet. Cash and Cash equivalents under
cash the firm include coins and paper money, undeposited receipts, checking
accounts and money order see and under the cash equivalents the organization
take into account money market mutual funds, treasury securities, preferred
stocks, which have maturity 90 days or less bank certificates of deposits and
commercial papers. So what is current liabilities include see under current
liabilities the firm would include account payables, sales tax payable,
income tax payables, interest payables, bank overdrafts, payroll tax payables,
customer deposits and grants, accrued expenses, short-term loans,
current maturities of long term debts and so on and so forth. So let’s
interpret the cash ratio let’s say the cash and cash equivalents is greater
than the total current liability that means the organization has more cash
that is more than one in terms ratio then they need to pay off the
current liability it’s not always a good situation to be as it is as it denotes
that the form has not utilized the assets to its fullest extent. if the cash
and cash equivalents is equal to current liabilities this is a second situation
that means firm has enough cash to pay of the current liabilities. If the cash
and cash equivalents is less than the current liabilities then this is the
right situation to be in terms of the firms perspective because this means the
firm utilizes its assets well to unprofits. So even if it’s useful ratio
as it strips of all the uncertainties that is receivables inventories etc to
turn into cash to pay off the current liabilities from current assets and
focuses on only cash and cash equivalents. So most of the financial
analysts don’t use cash ratios to come out to the final conclusion about the
firms liquidity positions. Let’s take an example to illustrate this. In this
particular example you know our primary concern would be to see the liquidity
positions of the firm from two perspective first we look at which
company is in better situation to pay off the short-term debt and second we
look at the company’s company has better utilize its short term assets. So let’s
go to the sheet two and see the example as you can see there a couple of things
that are given so now let’s go to the next sheet that is sheet 2 where we will
evaluate the example. As you can see there are two companies company X and
company Y with their cash the amount of cash and cash equivalents that are given
this company x and y should be over here at the account receivable is 1,000 and
5,000 inventory’s, the account payables, current taxes payable and current
long-term liabilities. So let’s evaluate this now if we have all the things that
in front of us. So let’s evaluate the cash coverage ratio and based on that we
will be evaluating other things so the formula is cash plus cash equivalents. So
let’s add the cash plus cash equivalents and do control R so this will be our a
that is the numerator and the total current liabilities that will be B so
the total current liability is going to be account payable the current tax
payable and current long-term liabilities so that is the total current
liabilities okay. let’s calculate the cash coverage ratio
that is the cash and cash equivalents divided by the total as you can see the
total liabilities and press control R. You can see the cash and cash.
I mean the cash coverage ratio is 0.55 and 0.19 for company and B so
now from the above example we’ll be able to make some conclusion. First you can
say that the I mean first the company which come is in better position to pay
off the short-term debt for sure not having its uncertainty it surely company X because the cash and cash equivalents of company X is much
more than company Y compared to the respective current liabilities and if we
look at the cash ratio of both the companies we would see that the cash
ratio of company X is 0.55 and whereas the cash coverage ratio of company Y is
just 0.19 so if we include current ratio to the perspective that is current
ratio is equal to current assets upon current liability company Y is it
better position to pay of the short-term debt so if we consider that account
receivables and inventories could turn into cash within a short period of time.
So a current ratio will close enough to fall in 0.81. So even if
company x has more cash they have lesser account receivable as you can see even
if they have more cash they have lesser account receivables and inventories from one
perspective it is good position to be as nothing is locked up major part has
been liquidated but at the same time more cash ratio and less current ratio
means compared to company Y company X could have better utilize the cash lying
for asset generation from this perspective Company Y has better
utilized their cash. The cash coverage ratio calculation of the nestlé’s
example if you can if you want to take now you may have understood the meaning of cash coverage ratio. In this section we’ll take an
example from an industry so you can understand how this ratio actually works
here we’ll take into account the raw data and we’ll calculate the ratio for
two consecutive year. Now in this if you look at the balance sheet you would see
that there are two sets of information that are important to us in terms of
determining the cash ratio. The first is the two years later of cash and cash
equivalents see the highlighted yellow in the balance sheet above and the
second data which is useful to us in the total current liabilities for the year
2014 and 2015 that is also highlighted so now we would
determine this ratio by using the simple formula and we have mentioned that in in 2014 Nestle’s cash coverage ratio is close enough to if we calculate
7448 divided by 32895 that’s 0.23
and in 2015 it’s coming close enough to 0.15. So if we compare
the cash coverage ratio of this two years we would see that in 2015 the
ratio is lesser that is I mean that’s 0.15 compared to 0.23 in 2014
the ratio may be better utilization of cash in the generational profits.
On the other hand we note that in 2014 Nestlé’s had more cash to pay off the
short-term debts than it had in 2015. So let’s now compare how nestles cash
coverage ratio is compared to the competitors like Hershey’s and so on and
so forth. We note that in this particular chart that nestles ratio
has been fairly stable ranging between 0.14x to 0.25X so that is Nestle
case and then Darren’s ratio is the lowest among its competitive competitors at 0.056X and Hersheys ratio has been variable in the past 10 years the cash
coverage ratio was between 0.45 to 0.80 between 2011 2015 however the most recently Hersheys cash
ratio has dipped to around 0.156X so now let’s evaluate the limitation of
the cash ratio from the above discussion it’s clear that the cash ratio cash
coverage ratio could be one of the most one of the best measuring grid of the
liquidity for the firm but there are very few limitations of cash covered
ratio which may become the reason for infamous nature first of all most
companies think that the usefulness of the cash coverage ratio is limited even for
a company which has portrayed low cash ratio may portray much higher current
and quickly show at the end of the year. In some countries cash coverage ratio of
less than 0.2 is considered healthy and as cash coverage ratio
portrayed to perspective it is difficult to understand which perspective to look
at if the cash coverage ratio of a company is less than one what would you
understand has it utilized its cash well or it has more capacity to pay of its
short-term debt that’s the reason in most of the financial analysis cash
coverage ratio is used along with the other ratios like quick ratios and
current ratio. So let’s make a conclusion over here having talked about
the limitations – cash ratio could be less useful than the other liquidity ratio
but if you still want to check how much cash is lying around in the company it’s
good to use this guide to find out the cash ratio on your own. So that’s it for
this particular topic if you have learned and enjoyed watching this video
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