It is necessary to analyze a company’s financial position before making an investment. While reading the Balance Sheet, in the Assets, you would see the line item: Cash and Cash Equivalents.
Cash and Cash Equivalents in Balance Sheet
Cash is used as a medium of exchange. An ample amount of it shows that the company can service its liabilities without an issue.
There are multiple ways a business can generate cash:
- Product and Services sales,
- Asset sale,
- Debt, etc.
The Cash so generated is used to service the short-term liabilities. If a business doesn’t have enough cash reserves then, it would affect its day-to-day operations.
The line item is not just about Cash. It is also about Cash Equivalents. These are mainly the amount held with banks, marketable securities, Treasury Bills, etc. that have maturity of less than 90 days. Volatile securities do not form part of Cash Equivalents.
Companies that have enough Cash, tend to perform better than the companies that are running short on it.
To measure the liquidity of a company, we use the cash ratio. It takes both the line items covered above i.e. Cash & Cash Equivalents and Short-term liabilities.
Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities
A Cash Ratio of less than 1 shows that current liabilities are higher than the Cash & Cash Equivalents. On the other hand, one would think that the higher the Cash Ratio the better it is. But, a higher Cash Ratio also raises questions on how the company is managing its finances.
A higher Cash Ratio shows that the company is underutilizing its Cash and Cash Equivalents.
Understand it with the help of an example. As of March 31, 2023, Palantir Technologies Inc. has
| Cash and cash equivalents
Total current liabilities |
$
$ |
1,264,738
601,413 |
||
So, Palantir Technologies Inc. has a Cash Ratio = 1264738/601413 = 2.1
In conclusion, we have covered here Cash and Cash Equivalents in a Balance Sheet. It shows the financial health of the company. It is important to mention here that, we need to take other metrics into consideration before coming to a conclusion.
