What Are Cash Equivalents?
Cash equivalents are investments securities that are meant for short-term investing; they have high credit quality and are highly liquid. Cash equivalents, also known as "cash and equivalents," are one of the three main asset classes in financial investing, along with stocks and bonds. These securities have a low-risk, low-return profile.
- Cash equivalents are the total value of cash on hand that includes items that are similar to cash; cash and cash equivalents must be current assets.
- A company's combined cash or cash equivalents is always shown on the top line of the balance sheet since these assets are the most liquid assets.
- Along with stocks and bonds, cash and cash equivalents make up the three main asset classes in finance.
- These low-risk securities include U.S. government T-bills, bank CDs, bankers' acceptances, corporate commercial paper, and other money market instruments.
- Having cash and cash equivalents on hand speaks to a company's health, as it reflects the firm's ability to pay its short-term debt.
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. All of these financial instruments often have a short maturity, highly liquid market, and low risk.
Cash equivalents serve as one of the most important health indicators of a company’s financial system. Analysts can also estimate whether it is good to invest in a particular company through its ability to generate cash and cash equivalents since it reflects how a company is able to pay its bills throughout a short period of time. Companies with large amounts of cash and cash equivalents are primary targets of bigger companies who are planning to acquire smaller companies.
When reported on financial statements, investments in these types of accounts are often lumped together with cash. Therefore, "cash & cash equivalents" includes a company's total holding of money and similar investment vehicles.
Types of Cash Equivalents
Treasury bills are commonly referred to as “T-bills." These are securities issued by the United States Department of Treasury. When issued to companies, companies essentially lend the government money. T-bills are sold from a minimum of $100 to a maximum of $5 million. They do not pay interest but are provided at a discounted price. The yield of T-bills is the difference between the price of purchase and the value of redemption.
Commercial papers are used by big companies to receive funds to answer short-term debt obligations like a corporations’ payroll. They are supported by issuing banks or companies that promise to fulfill and pay the face amount on the designated maturity date provided on the note.
Marketable securities are financial assets and instruments that can easily be converted into cash and are therefore very liquid. Marketable securities are liquid because maturities tend to happen within one year or less and the rates at which these may be traded have minimal effect on prices.
Money Market Funds
Money market funds are like checking accounts that pay higher interest rates provided by deposited money. Money market funds provide an efficient and effective tool for companies and organizations to manage their money since they tend to be more stable compared to other types of funds like mutual funds. Its share price is always the same and is constantly at $1 per share.
Short-Term Government Bonds
Short-term government bonds are provided by governments to fund government projects. These are issued using the country’s domestic currency. Investors take a look at political risks, interest rate risks, and inflation when investing in government bonds.
Certificate of Deposits (CD)
Certificate of deposits are agreements with a financial institution to provide the bank access to your capital for a specific period. In return for sacrificing liquidity over your money, the financial institution will often pay a higher amount of interest for the capital. Savers can choose their CD term (often ranging from one-month to five-years).
Bankers acceptances are forms of payments that are guaranteed by a bank rater than an individual account holder. Because the bank guarantees payments, the short-term issuance by a bank is considered close enough to cash. Bankers' acceptances are frequently used in facilitating transactions where there is little risk in either party.
Companies often store money in cash and cash equivalents in order to earn interest on the funds while they wait to use them.
Features of Cash Equivalents
Different types of cash equivalents usually have the same characteristics. Those characteristics include:
- Liquid Market: Cash equivalents must exist within liquid markets. That is because these investments must be very easy to translate to cash should the holder need to liquidate their position. If an investment is not liquid, it cannot be considered a cash equivalent. One item worth mentioning is a certificate of deposit with a specified term. Though CDs are often considered cash equivalents, a company or investor may not be able to exit their position before the CD matures. However, many CD products allow for early exit through payment of a fee of relinquish of several months of interest.
- Short-Term Investment: Cash equivalents are meant to be held for a short amount of time. Therefore, the term period of the underlying investments is often very high, and cash equivalents are often considered the most liquid current asset behind cash.
- Low-Risk/Volatility: Cash equivalents are meant to be a more efficient way for investors to use their cash on hand without incurring dramatically more risk. Though there are several considerations to take regarding default risk and FDIC insurance, cash equivalents should be low risk investments that do not see much volatility.
- Unrestricted Access: Last, cash equivalents should be relatively unrestricted, as an investor should be able to convert their cash equivalent to cash on demand. The entire purpose of cash equivalents is to have an investment that has the same liquid benefits as cash, so investments with inflexible holding terms or difficulty liquidating are not cash equivalent.
Uses of Cash Equivalents
There are several reasons a company might store their capital in cash equivalents. First, cash equivalents are part of the company's net working capital (current assets minus current liabilities), which it uses to buy inventory, cover operating expenses and make other purchases. Because cash equivalents are so each to buy and sell, a company may carry its cash balance in near-cash investments.
Cash equivalents can also act as an emergency fund for companies or investors. Again, instead of watching cash decay due to inflation in a bank account, an investor may be able to earn slightly more earnings.
Last, companies may intentionally carry higher balances of cash equivalents in the event of needing to finance an acquisition. Instead of locking capital into a long-term or volatile investment, a company can choose to deliberately sit on a pile of cash equivalents in the event it needs to quickly raise funds.
Advantages and Disadvantages of Cash Equivalents
There are certain strategic circumstances in which a company or investor would have to hold cash equivalents. However, the advantages of cash equivalents also come with several downsides.
Advantages of Cash Equivalents
Cash equivalents are often a more efficient use of capital than holding directly onto cash. Cash equivalents often earn more interest than just cash, though cash equivalents often don’t sacrifice many features or accessibility that cash has.
Cash equivalents are reported as current assets on the balance sheet. Therefore, these assets remain highly liquid in which their benefits are expected to be received in the short-term. As opposed to other types of financial or investment vehicles with no determinable timeline or very long holding requirements, cash equivalents are not meant to be held for long.
Last, many cash equivalent products have fixed rates of interest. For example, certificate of deposits lock an investor into a fixed rate for a specific period of time, yielding fixed income. During this period, the investor is guaranteed this rate of interest (ignoring any fees or fines for breaking term early). This level of security may be desirable for certain savers.
Disadvantages of Cash Equivalents
Though cash equivalents often earn higher interest or appreciation than cash, cash equivalents still have much less earning potential compared to other investments. In general, an investor should strive to have cash and cash equivalents on hand; however, capital is more likely to grow and generate business value if it is invested in the company or invested in higher yielding, riskier products.
Cash equivalents are also still subject to a little risk. Government-backed cash equivalents are backed by the faith of that respective government; should that government default, the security is at risk for loss of principle. Other investments that rely on FDIC insurance may only receive coverage up to $250,000.
Earns higher rate of earning compared to cash or many savings accounts
Has high liquidity that allows a company to convert these investments to cash very quickly
May have a fixed rate of interest depending on the underlying investment
Are generally considered among the safest types of investments
Often earns a much lower rate of earning compared to more traditional types of investments
Still subject to risk of default of any underlying or issuing entity
May not be partially or fully covered by federal insurance and is often still at risk for loss of principle
Example of Cash Equivalents
In 2021, Microsoft invested in, held, and transacted with cash equivalents throughout the year. Microsoft's use of cash equivalents include:
- On March 9, 2021, Microsoft acquired ZeniMax Media Inc for a purchase price of $8.1 billion. The purchase price included $768 million of cash and cash equivalents.
- The company held $130.3 billion of cash, cash equivalent, and short-term investments at fiscal year-end for 2021. $14.224 billion was specifically held in cash and cash equivalents, an increase from $13.576 billion held at the end of fiscal year 2020.
- The company states they believe cash, cash equivalents, and short-term investments will continue to be enough to fund operating activities.
How Are Cash Equivalents Used?
If a company has excess cash on hand, it may invest capital in a money market fund. This fund is a collection of short-term investments (i.e. generally with maturity terms six months or less) that earns a higher yield than the cash would just sitting in a bank account. When the company decides it needs the cash, it sells a portion of its money market fund holdings and transfers the proceeds to its operating account.
Why Are Cash Equivalents Important?
Cash equivalents strive to be the balance between investing, risk, and liquidity. Cash equivalents allow a company to have easy access to cash should it need to immediately sell its cash equivalents. In addition, cash equivalents allow companies to earn a little bit of interest as it plans how it will use its liquidity in the long-term.
What Is the Difference Between Cash and Cash Equivalents?
Cash is ownership of actual United States Dollars or other currencies, while cash equivalents are financial vehicles and investments that are incredibly easy to convert to cash. Cash equivalents are not the same as cash, though they have such low risk and high liquidity that a company can easily sell its cash equivalents (often not having to worry about losses) for actual money.
The Bottom Line
If a company wants to make a little bit of interest on its money as it plans its long-term strategy, it can choose to invest its capital in cash equivalents. These very short-term, low risk, highly liquid investments may not make a tremendous amount of money, though cash equivalents often earn more money than bank simply held in a savings account.