Cash Equivalents

What is Cash Equivalent?

Cash equivalents, in general, are highly liquid investments having the maturity of three months or less. To be classified as a cash equivalent an item must be unrestricted so that it is available for immediate use.

Cash Equivalents Examples

The full examples of cash equivalents include the following items with maturity dates that are typically three months or less.

• Banker acceptance: A banker’s acceptance (BA) is a short-term debt instrument issued by a company that is guaranteed by a commercial bank.
• Commercial paper: An unsecured source of funding issued by a corporation and is generally short-term in nature. These are typically used for the financing of short-term business requirements such as accounts receivable, inventories and short-term liabilities.
• Treasury bills: A Treasury bill (T-Bill) is a short-term debt obligation backed by the Treasury Dept.of the U.S. government. T-bills generally have a maturity of less than one year and are sold in denominations of $1,000 up to a maximum purchase of $5 million.

Equity investments such as stocks, bonds, and derivatives are excluded from equivalents unless they are, in substance, cash equivalents, for examples of cash equivalents preference shares acquired within a short period of their maturity and with a specified redemption date.

If the T-bills or any examples of cash equivalents 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 sheet 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 an 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 Equivalent Example (Tesco)

Tesco cash and cash equivalent example from the 2017 annual report. 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.

Accounting entry: The balance sheet shows the amount of cash and cash equivalents at a given point in time, and the cash flow statement explains the change in cash over time. For example, if a business spends $200 to purchase of raw material, that is recorded as an 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

Cash equivalents are held for the purpose of meeting short-term cash commitments rather than for investment or other purposes and are 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 ratio, current ratio quick ratio.

• Cash ratio: (Cash and equivalents + Marketable securities) ÷ Current liabilities
• Current ratio: Current assets ÷ Current liabilities.
• Quick ratio: (Current asset – inventory) ÷ Current liabilities.

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, cash ratio is the most conservative as it excludes receivables and inventory given that these are not as liquid as a cash. In the example above, the quick ratio of 0.6x means that the company only has $0.6 of liquid assets 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 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%

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 the 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, but it 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. Current ratio and the quick ratio help investors and analysts compare company cash levels in relation to certain expenses.

Recommended Articles

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 –

• 3 Main Types of Negative Covenants
• Net Debt Formula
• Current Ratio vs Quick Ratio Difference
• List of Current Liabilities on Balance Sheet
• Off-Balance Sheet Financing