What Are Cash Equivalents? Definitions, Type & Examples
Cash equivalents are short-term investments that are highly liquid and can be readily converted into cash. They serve as an alternative to holding cash and provide a modest return. This article will provide an overview of what cash equivalents are, the different types, their key characteristics, examples, and frequently asked questions. The goal is to help readers understand this common asset class.
What Are Cash Equivalents?
Cash equivalents are short-term investments that can generally be quickly converted into cash. The maturity period of cash equivalents is 3 months or less. Cash equivalent investments include bank certificates of deposit, Treasury bills, commercial paper, marketable securities, money market funds, short-term government bonds, and banker's acceptances. Holding cash equivalents provides flexibility to companies and investors to meet short-term obligations.
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Types of Cash Equivalents
There are several common types of cash equivalent investments, offering liquidity and relatively low risk over a short-term period.
Certificate of Deposit (CD)
A certificate of deposit or CD is a savings certificate issued by a bank or credit union. CDs offer a fixed interest rate in return for keeping the money on deposit for a set period of time, often from 3 months to 5 years. The bank can not withdraw the money during the CD’s term, providing stability, and CDs are FDIC insured. Interest rates tend to be higher than regular savings accounts. CDs are very low risk and provide guaranteed returns, making them a common cash equivalent.
Treasury Bills
Treasury bills, also called T-bills, are short-term U.S. government debt obligations backed by the Treasury Department with maturities of one year or less. The U.S. government sells T-bills at a discount from face value, and they pay the face value when they mature. Investors can earn interest from the difference between the purchase price and maturity value. T-bills are considered risk-free and the most liquid debt security in the world.
Commercial Paper
Commercial paper is an unsecured, short-term debt instrument issued by corporations and financial institutions. Maturities are typically less than 270 days. Companies issue commercial paper to meet short-term liabilities. They are only backed by the creditworthiness of the issuer. However, companies with high credit ratings find it relatively easy to sell commercial paper to investors. The yields are higher than short-term government debt.
Marketable Securities
Marketable securities are financial instruments that are liquid and tradable on public exchanges or over-the-counter markets. They include commercial paper, negotiable certificates of deposit, treasury bills, and actively traded debt securities. Marketable securities can readily be converted into cash at current market prices. The liquidity makes them ideal cash equivalents.
Money Market Funds
Money market funds are a type of mutual fund that invest in highly liquid, low-risk securities like commercial paper, certificates of deposit, and treasury bills. Money market funds seek to limit exposure to losses by diversifying holdings and only buying short-maturity investments. They offer higher returns than regular savings accounts while allowing easy access to your money. Minimum investments and withdrawal penalties are lower.
Short-Term Government Bonds
Some view short-term government bonds as cash equivalents due to their high liquidity and active trading in the securities market. These bonds are issued by a government to finance various governmental initiatives. When contemplating investments in government bonds, investors must carefully assess factors such as political risks, interest rate fluctuations, and inflation.
Banker's Acceptance
A banker's acceptance is a short-term credit investment created by a non-financial firm and guaranteed by a bank to make payment. The bank provides irrevocable payment assurances for the maturity value. Banker's acceptances are backed by the bank. They are low-risk, negotiable money market instruments used by companies to fund global trade. Banker's acceptances mature in 6 months or less.
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Cash Equivalents Quick Reference Comparison
Pros:
- Liquidity: Cash equivalents such as money market funds, short-term government bonds, and commercial paper are easily convertible into cash. This means that investors can quickly access their funds when needed.
- Safety: Cash equivalents are generally considered low-risk investments due to their short-term nature and the creditworthiness of the issuers.
- Flexibility: Investors can easily adjust their cash equivalents portfolio according to their financial needs and market conditions.
- Passive Income: Cash equivalents often generate interest income, providing a passive source of revenue.
- Capital Preservation: Cash equivalents are designed to preserve the initial investment, making them an attractive option for investors who are concerned about capital losses.
Cons:
- Low Return: Cash equivalents typically offer lower returns compared to other investments, such as stocks and bonds.
- Inflation Risk: The purchasing power of cash equivalents may decrease over time due to inflation.
- Market Risk: Despite their low-risk nature, cash equivalents are still subject to market fluctuations, which may affect their value.
- Limited Growth Potential: Cash equivalents generally do not offer significant growth potential, making them less attractive for long-term investment goals.
- Opportunity Cost: Investing in cash equivalents may limit the potential for higher returns elsewhere, especially during periods of economic growth.
Example of Cash Equivalents
Here is an example of cash equivalents on a company's balance sheet:
For instance, let's say a company called XYZ Inc., has built up a large cash balance of $5 million for an upcoming expansion project. Rather than keep the cash in a low interest-bearing checking account, the company invests some of it in cash equivalents to earn extra yield. Specifically, it does the following:
Purchases $2 million of 90-day commercial paper that yields 4% annually. This provides quick access to cash in 3 months if needed.
Buys $1 million of 60-day T-Bills yielding 2.5% annually. These can easily be sold on the secondary market.
Invests $500,000 in a money market fund that yields 3% annually while allowing daily liquidity.
Puts $1 million in a 3-month certificate of deposit (CD) yielding 3.5% annually, providing higher returns for funds not immediately needed.
The cash equivalents provide significantly higher income than a checking account while retaining flexibility. The company can liquidate them if it needs cash for its expansion project.
Similarly, an individual investor like Mr. Johnson can purchase a short-term government bond for a low-risk investment that generates interest income.
FAQ About Cash Equivalents
- What is the main difference between cash and cash equivalent?
Cash refers to physical currency and coins, while cash equivalents are financial instruments that are easily convertible to cash, such as money market funds, short-term government bonds, and commercial paper. Cash equivalents are considered an extension of cash, as they can generally be quickly transformed into cash without losing value.
- What are the risks of cash and cash equivalents?
The primary risk of cash is the potential for theft or loss, while cash equivalents carry risks related to market fluctuations, credit risk (if the issuer defaults), and liquidity risk (the inability to convert the asset into cash quickly). Cash equivalents are generally considered low-risk investments due to their short-term nature and the creditworthiness of the issuers.
- What are cash equivalents under GAAP?
Under Generally Accepted Accounting Principles (GAAP), cash equivalents are defined as short-term, highly liquid investments that mature within three months or less from the date of purchase and are readily convertible into known amounts of cash. These investments typically include money market funds, short-term government bonds, and commercial paper, which meet the criteria for classification as cash equivalents.
