Cash Ratio or Cash Coverage Ratio (Formula, Examples) | Calculation
Benefits of using the cash coverage ratio
One method that businesses may use to determine their assets is the cash coverage ratio. Using the cash coverage ratio offers the following benefits:
What is cash coverage ratio?
The cash coverage ratio evaluates a company’s capacity to settle its liabilities with its available cash. It is how you can measure a businesss liquidity. The cash coverage ratio includes only cash and cash equivalents. It does not include things like accounts receivable or inventory.
Cash coverage ratios are particularly preferred by creditors because they demonstrate a company’s capacity for prompt debt repayment. Other computations that take into account things like assets or inventory don’t always provide a reliable forecast of payment capacities. It may take longer to liquidate long-term assets or inventory, making it more challenging to use the proceeds to pay debts. Interest coverage ratio, debt service coverage ratio, and asset coverage ratio are additional metrics used to assess a company’s financial stability.
How to calculate the cash coverage ratio
The steps below can be used to calculate the cash coverage ratio:
1. Calculate all cash and cash equivalents
A balance sheet typically contains information about cash and cash equivalents. Depending on your company’s accounting procedures, these figures may appear together or separately on the company’s financial statements. Assets or investments that can be quickly converted into cash, typically in less than 90 days, are referred to as cash equivalents. Treasury bills, money market funds, or government bonds may be examples of this.
2. Divide by the total current liabilities of the company
Subtract the total current liabilities from the total amount of cash and cash equivalents. This provides the cash coverage ratio. Make sure to only include the company’s current liabilities, not its future obligations. These figures should be shown on the balance sheet, and the majority of businesses list them apart from other debt. Accounts payable, unpaid sales taxes, and accrued expenses are examples of current liabilities. It would also include short-term loans.
3. Analyze the calculation
You can use the ratio to assess your company’s capacity to settle debts. When the cash coverage ratio is one, the company only has enough cash to pay its current liabilities. If the ratio is greater than 1, the company has the resources to pay off its current debts and still have money left over. If the ratio is less than 1, it means that there is not enough money on hand to pay off the current debt.
A brand can determine how close they are to having an even cash coverage ratio by multiplying a ratio of less than one by 100 to convert it into a percentage. For illustration, a company with a 0 cash coverage ratio 75 can cover 75% of its debt. This could be significant as you put practices in place to raise your cash coverage ratio.
4. Make improvements to your ratio
Many businesses use the cash coverage ratio to strengthen their financial position. A ratio of one can represent financial health. A ratio of less than one may cause companies to think about ways to boost sales or lower overall debt. While a ratio greater than one shows that a company has the resources to pay off debts, most businesses don’t keep a ratio much higher than equal.
Example of calculating the cash coverage ratio
Here is an example using the cash coverage ratio calculation:
As Anderson Home Improvements weighs their financing options to enter a new market, they want to determine their cash coverage ratio. They gather the necessary data from the balance sheet, including their cash and cash equivalents. The company calculates that they have $180,000 in cash and cash equivalents worth $20,000 on hand. They then determine their total amount of cash available by performing the following calculation:
Cash + Cash Equivalent = Total Amount Of Cash Available
$180,000 + $20,000 = $200,000
This calculation gives them the total amount of cash available. The second step is to divide the first number by the current liabilities, which are also found on the balance sheet. Their liabilities equal $180,000. To determine the cash coverage ratio, they perform the following calculation:
Total Amount of Cash Available/Current Liabilities = Cash Coverage Ratio
$200,000/$180,000 = 1.11
Using this calculation, the cash coverage ratio is 1. 11. This indicates that they currently have the money to pay off all of their debt, which is advantageous for potential investors.
What is cash coverage ratio formula?
The calculation is as follows: Interest Expense (Earnings Before Interest and Taxes + Non-Cash Expenses) = Cash Coverage Ratio.
Do you want a high or low cash coverage ratio?
A ratio of 1 covers interest costs, but it also means that there isn’t enough money left over to cover other expenses. Owners of businesses should strive for a ratio of 2 or higher, which means that interest costs can be paid for twice as much.