Definition:

The cash ratio is a liquidity metric that measures a company's ability to cover its short-term liabilities with its most liquid assets, specifically cash and cash equivalents.

Formula:

Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities

How to use the metric:

The cash ratio is used by investors and analysts to assess a company's short-term financial health. A higher ratio indicates a strong liquidity position, suggesting the company can easily meet its short-term obligations without selling inventory or other assets.

Limitations:

The cash ratio can be overly conservative, as it only considers cash and cash equivalents, ignoring other liquid assets like receivables. It may not provide a complete picture of a company's liquidity if it holds significant non-cash liquid assets.

Applies to:

The cash ratio is particularly relevant in industries where liquidity is critical, such as banking, finance, and insurance, where companies need to maintain high levels of cash to meet regulatory requirements and unexpected demands.

Doesn't apply to:

It may not be as applicable in industries with longer operating cycles, such as manufacturing or real estate, where companies typically hold more inventory and receivables, and less cash, as part of their normal operations.

Summary:

The cash ratio is a stringent measure of liquidity, focusing solely on cash and cash equivalents to assess a company's ability to meet short-term liabilities. While useful in certain industries, it may not fully capture liquidity in businesses with significant non-cash liquid assets.