🔴 Cash Ratio in 20 minutes – Financial Ratio Analysis Tutorial

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. So remember to share us if you like us on
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