Question

Please describe the cash ratio with example. Why this term is useful in accounting?

It should be exact 7 sentences with concrete explanation

Answer 1

In accounting, cash ratio refers to a liquidity measure that depicts the ability of a company to cover its short-term obligations (i.e. current liabilities) with only cash and cash equivalents. It is computed as: [Cash + Cash equivalents] / [Current liabilities]

For example:

XYZ Company balance sheet shows:

Cash: $10,000; Cash equivalents: $20,000; Accounts payable: $12,000; Short-term debt: $10,000; Inventory: $30,000; Accounts receivable: $5,000

Current liabilities = Accounts payable + Short-term debt= $12,000 + $10,000 = $22,000

Cash ratio = [Cash + Cash equivalents] / [Current liabilities]

Cash ratio = [$10,000 + $20,000] / $22,000 = 1.36

The cash ratio above 1 indicates that the company is sound to pay off its short-term obligations with cash and cash equivalents, and still have funds left over

The cash ratio is useful in accounting because it is a quick and effective approach to know if a company could have potential short-term liquidity concerns. The creditor’s preference is for high cash ratio, as it depicts that their debt can be easily paid by the company.