Cash flow ratio: find out if your company is solvent

The cash flow ratio is one of the financial indicators that provide insight into the company's financial situation.

Whether you are an SME or a larger company, this ratio is necessary to assess your solvency capacity.

Read on if you want to know in detail aspects such as: what is the cash flow ratio, what is it for and how to interpret it.

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What is the cash ratio?

The cash flow ratio is an effective indicator that allows us to know and measure a company's ability to pay its short-term debts. In other words, this ratio provides information on the liquid cash of a company, available in a period of less than one year.

☝️ It is essential to ascertain the liquidity of a company in order to know its financial health.

💡 The cash ratio is also known as the acid test .

What is the cash ratio used for?

In addition to determining the solvency capacity of the company, the cash flow ratio is useful for:

• To know the financial evolution of the company,
• to follow up on the accounting accounts,
• detect future payment problems,
• plan the accounting activity.

Cash flow and solvency ratios

At this point, it is pertinent to make a small clarification so as not to confuse the cash flow ratio with the solvency ratio.

Although both measure the company's ability to pay its debts, the information they convey is different:

• On the one hand, the cash ratio focuses exclusively on the liquid cash that the company may have in the short term, which will be used to pay debts.
  
  
• The solvency ratio, on the other hand, does not distinguish between terms or assets (liquid or not), but compares assets with liabilities to show the overall solvency of the entity.

How is the cash ratio calculated?

Cash ratio formula.

🔵 The cash ratio is calculated from the following formula:

Let's see in more detail what these concepts refer to:

• Available = Liquidity of the company.
• Realizable = Assets and rights transformable into cash in the short term.
• Current liabilities = Short-term debts and obligations.

☝️ All these values are found in the balance sheet (also called balance sheet) of the company.

💡 Both cash and cash equivalents are part of current assets.

Cash flow ratio interpretation and optimal values

The optimal value of the cash ratio is 1.

For this casuistry to occur, the amount of current assets (cash plus cash equivalents) must be equal to the amount of current liabilities (total short-term debts). In this way, the company will have sufficient liquidity to settle its payments.

From this we can interpret that:

• A ratio of less than 1 means that the company cannot meet all its short-term debts. In other words, the company has more debts than liquidity and, therefore, there is a risk of default.
  
  
• A ratio greater than 1 is not ideal either, as it may mean that the company has an excess of unproductive assets, which is neither good nor profitable.

⚠️ If the cash ratio result is less than 0.3, the company is in a critical situation, so it will be appropriate to take urgent action.

💡 How to improve the ratio? Try to set shorter collection terms or negotiate longer payment terms, among others.

☝ Having an accounting software allows you to visualize and control your financial indicators from a customized and automated dashboard, easy to interpret.

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Other important financial ratios

To conclude, once the cash ratio is known, it is also appropriate to present other ratios that can be of help in analyzing the state of your company.

Liquidity ratio

The liquidity ratio is very similar to the cash ratio, since it also serves to determine the solvency of the company.

However, to measure the liquidity ratio, we are going to take into account all current assets and debts due in the short term.

🔵 Liquidity ratio formula :

Immediate availability ratio

The immediate availability ratio is still an indicator that measures the entity's capacity to meet its short-term debts. In this case, it is going to assess the situation in terms of the company's liquidity.

🔵 F ormula of the immediate availability ratio :

Debt ratio

The debt ratio establishes the company's dependence on external financing. In other words, it compares external financing and its equity.

🔵 Debt ratio formula:

Collateral Ratio

This last ratio is particularly interesting as it indicates whether a company is more or less likely to go bankrupt.

To do so, it takes external financing (debts to banks, for example) and compares it with real resources (those the company already possesses).

🔵 Collateral ratio formula:

Tell us, what ratios do you use in your company?