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Analysis of Cash - Cash Equivalents in Financial Accounting
The most informative analysis of cash pertains to cash flows. Chapter “Statement of Cash Flows” examined the statement of cash flows, which summarized the inflows and outflows of cash. A firm’s ability to generate cash enables it to pay obligations as they become due, replace and expand productive assets, and provide a return to investors. Chapter “Statement of Cash Flows” described analyses that provide insights into this ability.
The balance sheet does not contain information about a firm’s cash flows. It simply indicates the amount of cash a firm holds on a given date. Nevertheless, some useful information about cash can be obtained from the balance sheet. The amount of cash on hand and the trend in the cash balance over time can be ascertained. Also, because most current liabilities are paid in cash,many analysts relate the cash balance to current liabilities. This is done via the cash to current liabilities ratio:
Cash to Current liabilities ratio = Cash / Current liabilities
Figure 5.2 contains cash-related information for OB.OB’s cash position decreased substantially from 1996 to 1997. The cash balance declined from $31,201,000 to $13,779,000. The cash to current liabilities ratio also decreased significantly, from 70.4% in 1996 to 28.5% in 1997.
| 1997 | 1996 | |
| Cash to Current liabilities ratio = | $13,779 / $48,286 = 28.5% |
$31,201 / $44,293 = 70.4% |
Figure 5.2 - Financial Statement Information
The decline in the cash balance and the cash to current liabilities ratio is potentially worrisome. What caused this decline? OB has attempted to operate more efficiently by utilizing a smaller cash balance. Recall that although firms need to maintain a cash balance sufficient to meet their obligations, excessive cash balances are undesirable because idle cash earns, at best, a modest return.Given that OB has virtually no debt, has unused lines of credit available, and has strong cash flow from operations, the decline in the cash balance should not cause alarm.
Note that the cash to current liabilities ratio is a severe test of liquidity. To see this, compare OB’s 1997 cash to current liabilities ratio of 28.5% to its current ratio, which was discussed in Chapter, “The Balance Sheet.”
Current ratio = Current assets / Current liabilities
= $131,048 / $48,286
= 2.71
Both ratios contain current liabilities in the denominator. However, because the cash to current liabilities ratio has a much smaller numerator, a lower ratio results.
Current Assets Topics
