Cash Equivalents

What is a Cash Equivalent?

Cash equivalents, in general, are highly liquid investments having the maturity of three months or less, have high credit quality and are unrestricted so that it is available for immediate use.

Cash Equivalent

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Cash Equivalents Examples

Let’s discuss the following examples.

Cash Equivalents Examples

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Equity investmentsEquity InvestmentsEquity investment is the amount pooled in by the investors in the shares of the companies listed on the stock exchange for trading. The shareholders make gain from such holdings in the form of returns or increase in stock value.read more such as stocks, bonds, and derivatives are excluded from equivalents unless they are, in substance, cash equivalents, for example, preference shares acquired within a short period of their maturity and with a specified redemption date.

If the T-bills can’t be converted to cash because of debt covenants or some other agreement, the restricted T-bills must be reported in a separate investment account from the non-restricted T-bills on the balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more or a note to account mentioning the same should be included in the notes of account.

Difference Between Cash and Cash Equivalents

Here are the key differences –

  • Cash: Cash is money in the form of currency. This includes all bills, coins, and currency notes.
  • Cash equivalents: For an investment to qualify as an equivalent, it must be readily convertible to cash and be subject to insignificant value risk. Therefore, an investment normally qualifies as a cash equivalent only when it has a short maturity of, say, three months or less.
Cash and cash equivalents

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Tesco Example

Tesco example from the 2017 annual reportAnnual ReportAn annual report is a document that a corporation publishes for its internal and external stakeholders to describe the company's performance, financial information, and disclosures related to its operations. Over time, these reports have become legal and regulatory requirements.read more – Included in cash is £777m that has been set aside for completion of the merger with Booker Group Plc. This cash is not available to the Group and must be held in ring-fenced accounts until released jointly by the Group and its advisors on the satisfaction of the complete terms of the merger.

Example 1

Accounting entry: The balance sheet shows the amount of cash and cash equivalents at a given point in time. The cash flow statement explains the change in cash over time. E.g., if a business spends $200 to purchase raw material, it will record as the increase of $200 to its raw material and a corresponding decrease to its cash and its equivalents.

Importance of Cash and Cash Equivalents

#1 – Liquidity Source

Companies keep these for the purpose of meeting short-term cash commitments rather than for investment, or other purposes. It is an important source of liquidity. Thus companies want a cash cushion to weather unexpected situations such as a shortfall in revenue, repair or replacement of machinery, or other unforeseen circumstances not in the budget.

Liquidity ratio calculations are important to determine the speed with which a company can pay off its short-term debt. Various liquidity ratio includes cash ratioCash RatioCash Ratio is calculated by dividing the total cash and the cash equivalents of the company by total current liabilities. It indicates how quickly a business can pay off its short term liabilities using the non-current assets.read more, current ratioCurrent RatioThe current ratio is a liquidity ratio that measures how efficiently a company can repay it' short-term loans within a year. Current ratio = current assets/current liabilities read more quick ratio.

Let us say that if there is a company XYZ with Current ratio: 2.3x, Quick ratio: 1.1x, and Cash ratio: 0.6x. Can you comment on the liquidity of the company?

Interpretation: Of the three ratios, the cash ratio is the most conservative. It excludes receivables and inventory given that these are not as liquid as cash. In the example above, the quick ratio of 0.6x means that the company only has $0.6 of liquid assetsLiquid AssetsLiquid Assets are the business assets that can be converted into cash within a short period, such as cash, marketable securities, and money market instruments. They are recorded on the asset side of the company's balance sheet.read more to pay for every one dollar of current liability.

#2 – Speculative acquisition strategy

Another good reason for its pile-up is for near-term acquisition. As an example, consider cash balance in the 2014 balance sheet of Apple Inc.

  • Cash = $13.844 billion
  • Total Assets = $231.839 billions
  • Cash as % of Total Assets = 13.844 / 231.839 ~ 6%
  • Total Sales in 2014 = $182.795
  • Cash as % of Total Sales = 13.844 / 182.795 ~ 7.5%
Example 2

source: Apple SEC Filings

Interpretation: Investment of $13.844 bn (cash) + $11.233 bn (short-term investments) + $130.162 bn (long-term investments) totals $155.2 bn. Combination of all these indicates that Apple might be looking for some acquisition in the near term.

Good or Bad to Have?

+Maturity and Ease of Conversion: This is advantageous to have this is from the business perspective because a company can use these to meet whatever short-term needs might arise.

+Financial Storage: Unallocated equivalent is as a way to store the money until the business decides what to do with it.

-Loss of Revenue: Sometimes, companies set aside amount in equivalents, which exceeds what was necessary to cover immediate liabilities, depending on market conditions. When this happens, the company loses out on potential revenue, as money that could have produced a higher return elsewhere was committed to the cash account.

-Low Interest: Many equivalents bear interest. However, the interest rate usually is low. The low rate of interest makes sense given that equivalents involve low risk. However, it also means that equivalents struggle to keep up with inflation.

Final Thoughts

The amount of cash and cash equivalents a company holds has implications for the company’s overall operating strategy. Many theories exist about how much companies should hold. However, the same depends on the industry and the stage of growth. The current ratio and the quick ratio help investors and analysts compare company cash levels in relation to certain expenses.

Cash Equivalents Video

This has been a guide to what is Cash Equivalent? Here we discuss cash equivalent examples like banker acceptances, commercial paper, treasury bills, etc., along with practical cases of Tesco and Apple.  Here we also discuss its importance and whether it is good or bad? You may also have a look at these articles below to learn more about accounting –

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