Updated July 19, 2023
Definition of Cash Equivalents
Cash equivalents are those short-term investment securities that are highly liquid, i.e., which can be easily converted into cash.
They generally have a maturity period of 90 days or less and do not have any restrictions attached to them, which makes it easy to convert them into cash in a shorter period. They usually carry a low level of risk and high credit quality.
Explanation
Cash equivalents are recorded on the balance sheet under current assets, including the financial investments that can be readily converted into cash. It provides an understanding of the company’s short-term liquidity. The level of cash equivalents indicates whether the company would be able to meet its short term-liability or not. It follows that lower cash equivalents lower liquidity and vice-versa.
Since these do not carry a high risk, therefore, they are classified as low-risk and low-return classes of investments by the investors. A company with high cash and cash equivalents is also a target for acquisitions or takeovers, as the acquiring company would have readily available money to finance its acquisition and other activities.
Examples of Cash Equivalents
Here are some examples :
- Commercial Papers: Large corporations issue a bearer instrument or promissory note to satisfy their immediate liabilities.
- Treasury Bills: Treasury bills or T- bills are generally government securities. Once the government pays the full maturity amount for the mature securities, they normally offer no interest but are issued at a discount.
- Certificate of Deposit: Banks offer certificates of deposit (CDs) to raise money from the secondary market. CDs have a fixed interest rate and a set maturity time.
- Marketable Securities: These products are exchanged on a public exchange and include both equity and debt. They are regarded as cash equivalents since their pricing is readily available on the open market.
- Other Money Market Instruments: Apart from the above, there are other money market instruments as well, such as bankers’ acceptances, bills of exchange, repurchase agreements, short-lived mortgages, asset-backed securities, etc.
What Does Not Belong in Cash Equivalents?
- The concept behind cash equivalents is that there shouldn’t be any restrictions on the particular investment instrument and that it can be easily converted into cash.
- Another exception is inventory, a current asset that cannot be readily converted into cash in a general market scenario.
Uses of Cash Equivalents
These have a number of uses, as follows:
- They can be applied to short-term obligations of the company, including account payables.
- They can be used to make purchases such as operating costs, inventory, and other items.
- They indicate the liquidity position of the company. The higher the cash equivalent, the higher the liquidity.
- They help in the financing of acquisitions.
Advantages and Disadvantages
Below are the advantages and disadvantages mentioned:
Advantages
- The company often invests to earn interest on the funds until they do not need them.
- They are highly liquid, and thus, they can be easily converted into cash at a time of need.
- Sometimes it helps in financing acquisitions of the company.
Disadvantages
- In a way, it is a loss of revenue. Suppose a company invested more cash equivalents than necessary due to market conditions or other reasons. It would undoubtedly result in a loss of income because the company would have earned a higher rate of interest if it had invested the money somewhere else.
- They generally have a lower rate of return, and they need help to keep up with the inflation rate.
Conclusion
It is clear from the above discussion that cash equivalents are an integral part of the company’s current assets and working capital. It helps maintain liquidity, meet operating expenses, and pay off short-term debts. The amount of cash equivalent on the balance sheet provides information regarding the company’s operating strategy. It differs and depends on the industry the company is operating in and its growth stage and strategy.
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