Cash Ratio
Hi, before this video, you should already understand the words and concepts found in
Financial Statements.
So these financial statements are the balance sheet and the income statement.
You should have also already watched my other free video on the Current Ratio.
All right, so the topic for this video is the Cash Ration which is one of the liquidity
ratios.
Remember you can always go back to MBAbullshit.com.
All right, so this video discusses and analyses the cash ratio which is one of my free videos
on liquidity, profitability and market value ratios which include these ratios over here.
And after this you can check out my next videos MBAbullshit.com on Financial Leverage which
include this and on Turn-over Ratios which include this.
All right, so let’s get down to it.
So let’s start with a story.
Let’s say that ABC company has $200 and $800 in current liabilities.
What is its cash ratio?
Very simple.
It is simply $200 divided by $800.
So where dis we get the $200?
It is the $200 in cash.
$800?
It is the $800 in current liabilities, not all liabilities.
Now you notice up here we only put the cash amount and not all the current assets of the
company.
Okay?
so basically what does this mean?
What would our cash ratio be?
Very simple.
It would be 0.25.
So it’s similar to the current ratio, but we only compare cash with current liabilities
instead of all current assets to current liabilities.
Why?
Because you cannot easily use all of your current
assets to pay your debts.
But you can pay your debts with cash right now.
so you can use this cash right now to pay for all of these current debts right now.
Okay?
So that’s the importance of it.
So what does this mean?
What does our 0.25 cash ratio mean?
It means that the company has 25 percent the amount of cash right now to pay for its liabilities
due within the next 12 months.
Okay, remember liabilities due within the next 12 months is called our current liabilities.
Or in another way, the company has enough cash to pay for 25 percent of all liabilities
due within the next 12 months.
So this indicates, not only indicates; I used the word “indicates,” because it’s not
100 percent sure, It indicated that the company will not have any trouble paying 25 percent
of its debt for the next 12 months.
The cash of the company is more than enough; sorry, it’s just enough to pay for 25 percent
of the current liabilities for the next 12 months.
So I should have a 25 percent over here.
Anyway, not more than, okay.
So if the cash ration is high, why is this good?
Well, it’s good for creditors such as banks, which loan money to the company, which need
to be paid back within the next 12 months.
This indicates that they can easily get paid back.
If the cash ratio is high, why is this bad?
It may indicate inefficiency in using cash.
Why?
Think about it.
if you’re a stockholder or a shareholder or owner of the company, you want ABC company
to earn you profit using as little cash as reasonably possible.
If there’s excess cash, you want ABC company to either give you back that cash as the owner
because the company isn’t using it anyway.
Or you would want the company to invest it in other projects to earn more profit for
the company.
Okay?
This could also signal, now if you have a high cash ratio, this would also signal inability
of the company to expand or to grow; or the company is stagnating, meaning it’s stopped
its growth.
Why?
Because if a company can expand, let’s say for example it’s a fast food company.
If the company has excess cash, why do they use that cash to put up more branches of the
fast-food restaurant?
So that it could earn more money.
Maybe the company is not able to set up more branches just because there’s not enough
demand for your product anymore.
Maybe the market is saturated, meaning you have too many branches which are already open
for example.
Like what some people say is the case of Starbucks.
Some people are claiming that Starbucks over expanded; Krispy Kreme over expanded some
people say.
And because of that, they cannot open up any more branches, okay because they opened too
many branches already and there’s not enough customers to buy from the new branches anymore.
So if your company has too much cash, or your company has a high cash ratio, why does it
have a high cash ratio?
Maybe it’s because you’re no longer able to expand your business anymore.
So you’re stuck with cash instead of using that cash to grow your company.
Okay again so it could signal inability to expand or grow, or the company’s stagnation.
Now the opposite is also true; if the cash ratio is law, this could be bad.
Well it’s bad for creditors.
Again maybe banks which loan the money which need to get paid back within the next 12 months.
The company might not have enough cash to pay them.
If the cash ratio is low, why is this good?
It could indicate efficiency in using cash.
Why?
Because if you’re a stockholder, a shareholder, or owner, you want ABC company to earn you
profit using as little cash as reasonably possible.
Or, maybe your company is growing so fast, every time you make a profit or every time
you have extra cash inflow for the company, you use it to set up more branches because
there’s such strong demand for your products.
So it could indicate quick growth as well.
Good growth, so it could be good as well if your cash ratio is low.
So the important thing is to always find out why the cash ratio was low?
Why?
The cash ratio is high?
Why?
Okay so you cannot make a conclusion based on the ratio alone.
So what are the flaws of using this ratio?
Well, one is a high cash ratio may give a false sense of optimism to creditors who not
looking at the nature of the cash.
So for example your company has a high cash ratio because it has a lot of cash.
And why does it have a lot of cash?
Because it has huge bank loans with expensive interest.
So it has a lot of cash because it borrowed the cash from banks.
But in this case what if it borrowed a lot of cash from banks, is paying a lot of interest,
and the company should be using this cash for profitable projects; but it’s not.
What’s going to happen is you’re not earning much profit but your company will have to
pay a lot of expensive interest because of this cash that it’s borrowing.
Okay now, you may have enough cash to pay short-term debts, but these expensive loans
will have a strong negative impact on profitability because of the expensive interests.
So this is bad for longer term creditors, meaning what if the bank or this company has
a lot of cash which have long term loans which are payable within ten years for example,
okay?
Ten years.
If the company has a lot of cash because of long term loans which are payable for ten
years, then it will have enough cash to pay the short-term debts.
And remember, in computing the cash ratio, we only used the current liabilities, such
as short term debts.
So in this case you will have very high cash ratio, and you will be able to pay short term
debts; but there will be a strong, long term negative impact.
And this company might not be able to pay back the creditors in the long term.
Okay?
Now, so the company can go bankrupt if the total liabilities are near total assets.
And yeah, another flaw with this is that, [0:10:56] a separate one, this is a separate
one.
Even if a company has a lot of cash, it can still go bankrupt if the total liabilities
is nearly as big as the total assets; even if it has enough cash to pay the short term
liabilities.
In this case, short-term creditors will still get burned.
So a good example of this was the debt crisis in 2008.
You have companies like Leman brothers I think which had more than enough cash to pay for
all of its bond interests and bond principals within the next 12 months.
But because the liabilities were so big compared to the total assets, they were sort of like
strong handed by the government; it seems that way anyway.
They seemed to have been strong handed by the government into declaring bankruptcy even
if they had enough cash to pay for their short-term debt.
Even if they had cash to pay for their short-term debt, they were still forced in a way, forced
into bankruptcy because their total liabilities were quite big compared to their total assets.
That’s just from what I remember.
I’m not in any guaranteeing the accuracy of the Lehman brothers story.
So another flaw is that the high cash ration may give a false sense of optimism to the
creditors by not looking at the nature of the cash.
Some companies may have a lot of cash but can lose it very quickly or an expression
some people say that there companies are “burning cash.”
So an example of this is a company with very high salaries to pay or a lot of salaries
to pay.
And then another example of this might be the crisis of, I believe it happened was it
the Ford?
GM?
The big car companies in the US.
was it 2009 or 2010 I think?
They were burning a lot of cash because they had a lot of salaries to pay.
Now again I’m not guaranteeing the accuracy of the facts of the story.
That’s just from what I remember.
Okay now, unpaid salaries will not be reflected on the balance sheer or the income statement
as liabilities.
So the unpaid salaried for the rest of the year are not considered a “current liability”
because the employees work hasn’t been performed yet.
Therefore you will not see it on the balance sheet.
But you can be sure that the huge cash outflow from the salaries will definitely happen in
the new term and that can cause a company to lose a lot of cash very quickly even if
it does not have any liabilities.
Because technically an unpaid salary is not yet a liability or is not a liability until
the work has been done.
Okay?
So in this case even if the company has a lot of salaries to pay and is losing cash
so quickly like crazy because of high salaries, you might still have a high cash ratio, because
the cash ratio formula does not include unpaid salaries.
So that’s another flaw of this ratio.
A low cash ratio may give us a false sense of danger.
So an example let’s say that a company doesn’t have much cash but has a ready line of credit
from banks anyway, meaning it has a standing agreement with banks which allows the company
to borrow cash anytime it needs the cash.
It can borrow money from the bank quickly and easily and almost automatically.
All right.
So what is the traditional analysis of the cash ratio?
Well first is you compare it to the historical cash ratios of the company.
If the cash ratio’s higher now than last year’s, either it’s more stable or it’s
less risky or in a less risky debt situation than before; or its more inefficient now that
before in managing assets or managing cash.
Or both of the above.
Okay, when I say managing cash that means that the company can operate properly even
without much excess cash, or both of the above.
If the cahs ratio is lower now than last years, then either you’re in a more risky debt
situation than before, or it’s more efficient now in managing the cash.
So it doesn’t need much cash top operate properly or both of the above.
Traditional Analysis No. 2: Compare the cash ratio to that of companies in a similar industry.
If the cash ratio is higher than similar companies, then either it’s a more stable or less risky
debt situation than them, or it’s more inefficient than them in managing cash.
That’s why it needs so much excess cash to operate properly or both of the above.
If the cash ratio is lower than similar companies, then either it’s in a more risky debt situation
than them, or it’s more efficient than them in managing cash.
So it doesn’t need much cash to operate properly.
It doesn’t need much excess cash to operate properly.
Or both of the above.
Now I stressed similar industry because some industries for example the banking industry
need a lot of cash, much more cash compared to another industry such as a luxury car show
room for example; a luxury car dealer might not need so much cash because the inventory
of car dealers moves very slowly.
So they just need a lot of cash to buy the cars, or they may don’t even need to buy
the cars.
Maybe the cars are put there on consignment by the manufacturer.
But a bank needs to hold a lot of cash because it’s in the business of cash.
So you cannot compare the cash ratio of a bank to the cash ratio of another company
which is a car showroom for example, because it wouldn’t make sense.
Naturally the banks cash ratio would be much higher.
So if you want to compare the cash ratios of different companies make sure they’re
from the same industry or from very similar industries.
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