Cash EquivalentsExplained & Defined

Written By:
Lisa Borga

Cash equivalents consist of short-term investment securities that have maturity periods of not greater than 90 days.

These are highly liquid instruments such as treasury paper, bank certificates of deposit, and similar instruments.

There are three primary classes of assets in financial investing, and cash equivalents are one of these.

The other two are bonds and stocks.

These investment securities have a low return but are also low risk.

Explaining Cash Equivalents

Cash equivalents are one measure of the financial health of a business.

It is a good idea for investors to look at a business’s cash equivalents when deciding whether to invest in a company because this can give investors an idea of whether or not a company is likely to be able to pay its bills in the short term.

Cash equivalents come in five different types.

These are commercial paper, money market funds, government bonds, marketable securities, and Treasury bills.

Commercial Papers

Commercial papers are a type of promissory note that large companies may issue in order to satisfy short-term obligations.

These are a promise on the part of a bank or company that they will pay the amount listed on the note by the provided maturity date.

Marketable Securities

These are financial assets that can be quickly and easily converted into cash, which means that they have a degree of liquidity.

These financial assets reach maturity within at most one year, and their price is readily available on the public exchange, making them a cash equivalent.

Money Market Funds (MMF)

MMF investments work very similarly to a checking account but provide a far higher rate of interest accrual on deposited funds.

They are also far more stable than similar investments such as mutual funds and provide an easy and effective way for companies to invest capital in a cash equivalent.

Government Bonds

Short-duration government bonds are issued by governments in order to fund cash-intensive projects.

These will be provided in the currency of the issuing government and are often a secure investment for a cash equivalent.

However, investors must consider any political unrest, inflation, or other risks before making an investment in government bonds.

Treasury Bills

Treasury bills, also known as T-bills, are securities that the United States Department of Treasury issues.

When the Treasury issues these bonds to companies, the government is basically borrowing money from the company.

Treasury bills are sold in $100 increments.

The government does not pay interest on treasury bills but does discount them.

Therefore, the difference between the price paid for the T-bill and the price it is redeemed for is the yield.

The Importance of Cash Equivalents

A company may choose to keep its capital stored within cash equivalents for a few different reasons.

This includes offering a source of liquidity that can allow them to meet unexpected expenses such as equipment failure or natural disasters as well as other short-term debts.

A company may also choose to acquire cash equivalents in order to build capital for an acquisition in the near future.

While money is stored in a cash equivalent for any of these reasons, companies can benefit from the ability to earn interest; however, typically less than what they could have earned from long-term investments.

Key Takeaways

• Cash equivalents are a business’s short-term assets that can easily be converted into a predictable amount of cash.
• The amount a business has in cash equivalents and cash is included on the balance sheet on the first line because these items are the business’s most liquid assets.
• Cash equivalents and cash are one of the three main asset classes.