a ratio of cash (or its equivalents) to liabilities. A measure of a company's capacity to pay off short-term debts without external capital.
Doomsday Ratio Details
The Doomsday Ratio, sometimes called the Cash Ratio, is a liquidity ratio that evaluates a company's capacity to pay off short-term debts using available capital. You can think of the Doomsday Ratio as a measure of the cash buffer a company has. In the worst-case scenario, how much longer could a firm keep paying its obligations?
The Doomsday ratio is considered a conservative measure of a company's liquidity as it only measures cash or cash equivalents. Companies do not include less liquid assets like accounts receivable, inventory, or prepaid assets.
Doomsday Ratio Equation
The Doomsday Ratio equation is Doomsday Ratio = Cash ÷ Liabilities.
Cash refers to available capital as well as all assets that a company can immediately convert to cash. Liabilities refer to Current Liabilities, those obligations which are payable within one year (alternatively within one operating cycle).
Anything below 0.75 is considered a low Doomsday Ratio. In this range, a company is at risk of not meeting obligations due to a lack of cash on hand. A Doomsday Ratio of between 0.75 and 1 is considered adequate and above 1 desirable.
Doomsday Ratio Example
A company has cash or cash equivalents of $2 million and current liabilities of $1 million. This works out to a Doomsday Ratio of 2. There are two years left until the company runs out of cash and bankruptcy is imminent. While the Doomsday Ratio can be used to quickly assess a company's ability to pay upcoming obligations, it is more commonly used to evaluate general performance by observing trends over periods of time. A consistently decreasing Doomsday Ratio can indicate an upcoming liquidity crisis.
A company has a Doomsday Ratio marginally above 1. Taken in isolation, this could be considered a strong metric. However, this company may have experienced four straight years of a gradually decreasing ratio which could imply structural problems and lead to disastrous consequences if not acted upon.
On the other hand, a company that consistently keeps a Doomsday ratio above 1 and is stable over long periods of time is a useful metric of company performance and long-term stability. The Doomsday Ratio on its own cannot accurately evaluate these situations—but it is a convenient bellwether of sorts, a clue as to where a company should direct further evaluation. Companies can also compare these metrics to competitors or industry averages where they have more context.
Significance of the Doomsday Ratio
The Doomsday Ratio is a narrow measure of a company's performance, but something a company should always keep an eye on. By tracking the ratio, a company can see what action may put them at risk of bankruptcy. However, a company shouldn't rely on the ratio alone. Rather, look at its situation as a whole.
A company that chooses to use its cash reserves for expansion may temporarily have a Doomsday Ratio below 1. This could be misleading when looked at in isolation. Indeed, it is considered poor asset utilization in many industries to keep large amounts of cash on hand. Alternatively, a company may offer unusually low credit to its consumers due to industry conditions or company strategy. This may lead to lower risk and higher cash flow that the Doomsday Ratio doesn't take into account.
Likewise, different industries have varied approaches to available cash reserves or current liabilities. You cannot apply a "one size fits all" formula like the Doomsday Ratio.
History of Doomsday Ratio
In the English language, the word "doomsday" refers to the end of the world or a time when something catastrophic will occur. In this case, the word reflects the idea of how long a company has left until "doomsday," or bankruptcy.
Of course, this is far removed from how any business would work due to increases in cash, loans or investments, etc. Despite the name, the Doomsday Ratio is rarely, if ever, used to work out a hypothetical "time until bankruptcy."
Doomsday Ratio vs. Doomsday Book
The Doomsday Book is a comprehensive record of ownership and liabilities in Early Middle Ages England. The book's name comes from the fact that the book was so comprehensive that it was considered the final authority. Doomsday ratio is far more modern and looks at a literal doomsday of sorts.