Cash Equivalents

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 and cash equivalents is a line item on the balance sheet, stating the amount of all cash or other assets that are readily convertible into cash. Any items falling within this definition are classified within the current assets category in the balance sheet. The two primary criteria for classification as a cash equivalent are that an asset be readily convertible into a known amount of cash, and that it be so near its maturity date that there is an insignificant risk of changes in value due to changes in interest rates by the time the maturity date arrives. If there is any question about whether a financial instrument can be classified as a cash equivalent, consult with the company’s auditors.

Cash and cash equivalents information is sometimes used by analysts in comparison to a company’s current liabilities to estimate its ability to pay its bills in the short term. However, such an analysis may be excessively conservative if there are receivables that can be readily converted into cash within a few days; in this case, receivables should also be included in the analysis.

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.

Types of Cash and Cash Equivalents

Examples of cash are as follows:

  • Coins
  • Currency
  • Cash in checking accounts
  • Cash in savings accounts
  • Bank drafts
  • Money orders
  • Petty cash

Examples of cash equivalents are as follows:

  • Commercial paper
  • Marketable securities
  • Money market funds
  • Short-term government bonds
  • Treasury bills

Breaking Down Cash Equivalent

Cash equivalents also function as one of the most relevant health metrics in the financial structure of an organisation. Analysts can even predict whether investing in a specific company is good by its ability to produce cash and cash equivalents, as it represents how a company can pay its bills in a short period.

Companies with large amounts of money and cash equivalents are primary targets of more prominent firms that plan to acquire smaller firms.

Treasury Bills

Treasury bills or “T-bills” are securities issued by the United States Treasury Department. When released to corporations, they essentially lend money to the government.

Commercial Papers

Big corporations use commercial papers to collect funds to resolve short-term debt commitments, such as the payroll of a company. They are sponsored by issuing banks or firms who agree to meet and pay the face sum on the note’s specified maturity date.

Marketable Securities

Marketable securities are financial instruments and assets that are readily convertible into cash, and thus very liquid. Marketable securities are liquid, as maturities tend to occur within a year or less and the rates at which they can be traded have minimal effect on prices.

Short-Term Government Bonds

Governments offer short-term government bonds to finance infrastructure programmes. These are issued in the domestic currency of the country. While investing in government debt, creditors take a look at political uncertainties, interest rate threats and inflation.

Net Working Capital & Net Debt Formula

In practice, the cash and cash equivalents account is excluded from the calculation of net working capital (NWC).

Net Working Capital (NWC) = (Current Assets Excluding Cash & Cash Equivalents) – (Current Liabilities Excluding Debt)

The rationale is that cash and cash equivalents are closer to investing activities, rather than the core operating activities of the company, which the NWC metric attempts to capture.

As for the calculation of net debt, a company’s cash and cash equivalents balance is deducted from its debt and debt-like instruments.

Net Debt = Total Debt and Interest Bearing Instruments – Total Cash & Cash Equivalents

Cash and cash equivalents are listed on balance sheet as “current assets” and its value changes when different transactions are occurred. These changes are called “cash flows” and they are recorded on accounting ledger. For instance, if a company spends $300 on purchasing goods, this is recorded as $300 increase to its supplies and decrease in the value of CCE. These are few formulas that are used by analysts to calculate transactions related to cash and cash equivalents:

Change in CCE = End of Year Cash and Cash equivalents - Beginning of Year Cash and Cash Equivalents
Value of Cash and Cash Equivalents at the end of period = Net Cash Flow + Value of CCE at the period of beginning

Restricted Cash

Restricted cash is the amount of cash and cash equivalent items which are restricted for withdrawal and usage. The restrictions might include legally restricted deposits, which are held as compensating balances against short-term borrowings, contracts entered into with others or entity statements of intention with regard to specific deposits; nevertheless, time deposits and short-term certificates of deposit are excluded from legally restricted deposits. Restricted cash can be also set aside for other purposes such as expansion of the entity, dividend funds or “retirement of long-term debt”. Depending on its immateriality or materiality, restricted cash may be recorded as “cash” in the financial statement or it might be classified based on the date of availability disbursements.

Moreover, if cash is expected to be used within one year after the balance sheet date it can be classified as “current asset”, but in a longer period of time it is mentioned as non- current asset. For example, a large machine manufacturing company receives an advance payment (deposit) from its customer for a machine that should be produced and shipped to another country within 2 months. Based on the customer contract the manufacturer should put the deposit into separate bank account and not withdraw or use the money until the equipment is shipped and delivered. This is a restricted cash, since manufacturer has the deposit, but he can not use it for operations until the equipment is shipped.