What Are Cash Equivalents?

What Are Cash Equivalents?

Let me explain cash equivalents to you directly: they are investments that companies can quickly and easily convert to cash. These are securities with solid credit quality and high liquidity, and as the name suggests, they're considered equivalent to cash because you can turn them into actual cash fast.

You'll find 'Cash and Cash Equivalents' as a line item on balance sheets in the Current Assets section. In investing, cash equivalents are one of the three main asset classes, alongside stocks and bonds. They have a low-risk, low-return profile, which makes them a safe choice for preserving capital.

Key Takeaways

The total for cash and cash equivalents always sits at the top of a company's Current Assets because they're the most liquid assets you can have. In finance, stocks, bonds, and cash equivalents form the three primary asset classes. These low-risk securities include things like U.S. government T-bills, bank CDs, bankers' acceptances, corporate commercial paper, and other money market instruments. The amount of cash and cash equivalents a company holds tells you a lot about its financial health, as it shows the ability to cover short-term obligations.

Understanding Cash Equivalents

Cash equivalents include U.S. government Treasury bills, bank certificates of deposit, bankers' acceptances, corporate commercial paper, and other money market instruments. These have short maturities, highly liquid markets, and low risk, which is why they're so useful.

They're a key indicator of a company’s financial well-being. As an analyst, I look at a company's ability to access cash and convert these equivalents quickly to gauge if it's a good investment. This liquidity means the company can pay its bills without issues. Remember, on financial statements, these liquid investments are often combined with cash to show the total holding of money and liquid assets.

Types of Cash Equivalents

Treasury bills, or T-bills, are securities issued by the U.S. Department of the Treasury that mature in one year or less. When you buy them, you're lending money to the government, which repays at maturity. They're sold at a discount and redeemed at face value, with yields coming from the difference. Minimum purchase is $100, up to $10 million for non-competitive bids.

Commercial paper is short-term, unsecured debt that big companies use to raise funds for things like payroll, with maturities from one to 270 days. It's issued at a discount and paid at full face value on maturity.

Marketable securities are financial assets you can easily convert to cash, traded on public exchanges with strong secondary markets. They have minimal price impact when traded and include T-bills, CDs, bankers' acceptances, commercial paper, stocks, bonds, and ETFs.

Money market funds are mutual funds investing only in cash and cash equivalents, offering high liquidity and excellent credit quality. They're stable, with a fixed $1 per share price, making them efficient for managing money.

Short-term government bonds are highly liquid and actively traded, issued to fund projects, but you should consider political risks, interest rate risks, and inflation.

A certificate of deposit (CD) is a savings account where you lock in capital for a period, earning a fixed interest rate. Terms range from one month to five years, insured up to $250,000 at federally-insured banks, and you might pay a penalty for early access.

Bankers' acceptances are payments guaranteed by a bank, considered cash due to low risk, often used in low-risk transactions.

What's Not a Cash Equivalent

Some current assets aren't cash equivalents if they can't be converted to cash easily or are restricted. This includes credit collateral, inventory, CDs without breakable contracts, prepaid assets, and accounts receivable.

Features of Cash Equivalents

Cash equivalents share common traits: they must be highly liquid, trading in active markets so you can convert them to cash easily. They're short-term investments, often the most liquid after cash itself. They carry low risk and volatility, though concerns like default and insurance apply. Access must be unrestricted, allowing conversion on demand without inflexible terms.

Uses of Cash Equivalents

Companies store capital in cash equivalents to meet short-term obligations, like paying operating expenses or debts. They also build emergency funds for slow business periods or economic downturns, earning returns higher than basic accounts while protecting against inflation. Higher balances prepare for business opportunities without locking into illiquid investments. Some debt agreements require maintaining liquid equivalents for better loan terms and financial discipline.

Advantages and Disadvantages of Cash Equivalents

On the advantages side, cash equivalents are more efficient than basic bank accounts, often paying higher interest with easy access. They're reliable and liquid, not meant for long-term holding, and many offer fixed interest rates for secure income, though early redemptions might incur fees.

Disadvantages include lower returns compared to longer-term investments, so for growth, you need to invest elsewhere. They're still subject to default risk by the issuer, and not all are federally insured. Early access fees can apply to some, like CDs.

Example of Cash Equivalents

Take Microsoft in 2021: they invested in and held cash equivalents throughout the year. For instance, when acquiring ZeniMax Media for $8.1 billion, it included $768 million in cash and equivalents. By fiscal year-end, they had $130.3 billion in cash, equivalents, and short-term investments, with $14.22 billion specifically in cash and equivalents, up from the previous year. They believed this was sufficient for ongoing operations.

How Are Cash Equivalents Used?

If a company has excess cash, it might invest in a money market fund, which is a collection of short-term investments earning higher yields than bank accounts. When needed, they sell portions and transfer proceeds to operating accounts.

Why Are Cash Equivalents Important?

They balance investing, risk, and liquidity, giving easy access to cash while earning some interest as companies plan long-term fund use.

What Is the Difference Between Cash and Cash Equivalents?

Cash is actual currency, while cash equivalents are interest-earning, highly liquid investments easily converted to cash, considered just as accessible due to low risk.

The Bottom Line

If a company wants to earn returns on capital while planning strategy, cash equivalents are a good choice. These short-term, low-risk, liquid investments don't yield much but beat bank accounts and convert easily to cash.