9.7 Cash Ratios: Firms in Financial Straits
In addition to our basic financial ratios, which we know and love, there are some further cash ratios that are relevant in the larger liquidity context. These ratios are apropos to distressed companies.
Cash Ratio = Cash ÷ Current Liabilities. (CL)
Can the firm meet its liquidity needs without relying on current asset turnover and for how long? Let’s look at an example.
| 20 x 1 | 20 x 0 | |
| Cash | $30,000 | $35,000 |
| Current Liabilities | $60,000 | $40,000 |
| Cash ÷ CL | 0.5 | 0.875 |
In 20×1, this ratio has deteriorated from last year; without new cash, it can survive for only six months. It will need to rely more on other current assets in order to pay off its current liabilities than last year. This ratio is sometimes thought of as a “Doomsday” ratio due to its relevance to firms in financial distress. As long as its inventory turnover is alright, and it is collecting its receivables timely – with little or no bad debts, the firm’s liquidity may be alright.
Cash Burn Rate = Current Assets (CA) ÷ Average Daily Operating Expenses.
Operating Expenses equals COGS plus S, G, & A (Selling, General, and Administrative expenses). This sum is then divided by 365 to get the average operating expense daily figure. The resulting Burn Rate is expressed in terms of days. This ratio tells the analyst for how long the firm can rely on its current assets to pay off its current liabilities – the longer the better; the greater the number of days the better. This ratio is especially useful in analyzing start-ups that may have scarce revenues, and therefore little ability to rely on cash and other current assets.
On the other hand, if a company has too much cash, the analyst may question why the firm’s cash is not invested in productive assets. Let’s look at an example of the Burn Rate.
| 20 x 1 | 20 x 0 | |
| COGS | $50,000 | $40,000 |
| S,G, & A | $10,000 | $8,000 |
| Annual Operating Expenses (AOP) | $60,000 | $48,000 |
| Average Daily Expense (ADE) = AOP ÷ 365 | $164.38 | $131.51 |
| Current Assets | $120,000 | $110,000 |
| Burn Rate = CA ÷ ADE | 730 | 836 |
In this example, our company’s Burn Rate has deteriorated. The company’s other liquidity ratios should also be examined.