Cash Equivalents

Definition

Cash equivalents are short-term, highly liquid investments that a company can quickly convert into a known amount of cash with minimal risk of value change. They appear with cash at the top of the Current Assets section on the balance sheet.

Why they matter

Holding cash equivalents lets a company earn a modest return while retaining immediate access to funds to meet short-term obligations, preserve liquidity for opportunities, and satisfy lender requirements.

Common types

• Treasury bills (T‑bills): U.S. government securities with maturities of one year or less, sold at a discount and redeemed at face value.
• Commercial paper: Unsecured short-term corporate debt, typically maturing within 1–270 days.
• Money market funds: Mutual funds that invest in cash and cash equivalents; designed to maintain stable net asset value and high liquidity.
• Certificates of deposit (CDs): Time deposits with fixed interest; considered cash equivalents only if they permit quick conversion or are short-term.
• Bankers’ acceptances: Short-term bank-guaranteed instruments used in trade finance.
• Short-term government bonds and other marketable securities with very short maturities and active secondary markets.

What is not a cash equivalent

Assets that are short-term but not readily convertible or restricted are not cash equivalents, such as:
– Inventory
– Accounts receivable
– Prepaid assets
– CDs or other instruments with inflexible holding terms or contractual restrictions

Key features

• High liquidity: Easily and quickly converted to cash in active markets.
• Short maturity: Typically maturities of one year or less (often much shorter).
• Low risk/volatility: Minimal risk of principal loss under normal conditions.
• Unrestricted access: Convertible on demand or with negligible delay or penalty.

Uses

• Meeting short-term liabilities and operating expenses.
• Maintaining an emergency fund for unexpected costs.
• Keeping funds readily available to seize business opportunities.
• Satisfying debt covenants that require minimum liquidity levels.

Advantages and disadvantages

Advantages:
– Higher yield than idle cash accounts while retaining liquidity.
– Low volatility and easy access.
– Some instruments offer fixed, predictable returns.

Disadvantages:
– Lower returns compared with longer-term or higher-risk investments.
– Subject to issuer default risk (though typically low).
– Some instruments may have early-withdrawal penalties or limited insurance coverage.

Example

Large corporations commonly report significant holdings of cash and cash equivalents. For example, a company might hold billions in cash, cash equivalents, and short-term investments to fund operations and acquisitions while preserving liquidity.

How they’re reported and distinguished from cash

On financial statements, cash equivalents are combined with cash under “Cash and Cash Equivalents.” Unlike physical cash, cash equivalents are interest-earning instruments that function as near-cash due to their liquidity and short maturities.

Takeaways

Cash equivalents provide a conservative way to earn a small return on idle cash without sacrificing ready access. They are essential for liquidity management, short-term planning, and meeting immediate obligations, though they should be balanced with longer-term investments for growth.