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 and include U.S. government Treasury bills, bank certificates of deposit, bankers' acceptances, corporate commercial paper, and other money market instruments.
- 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 also 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.
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.
Companies often store money in cash and cash equivalents in order to earn interest on the funds while they wait to use them.
What Cash Equivalents Are Used For
There are several reasons a company might store their capital in cash equivalents. One, they 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. They also provide a buffer for the company to quickly convert to cash if times become lean. Finally, they may be used to finance an acquisition.