Definition of Cash and Cash Equivalents
Cash and cash equivalents are those items which are recorded in the balance sheet of the company and refers to the value of the assets of the company which are held in cash or can be easily convertible to cash i.e. bank accounts and marketable securities like debt securities where the maturity date is less than 90 days, treasury bills, commercial papers and short term government bond.
Explanation of Cash and Cash Equivalent
Cash and cash equivalent offer a high level of liquidity to the company. They are generally a part of the balance sheet of a company and refers to the value of the asset of the company which is either held in cash or near to cash equivalent like short term bonds, treasury bills, commercial papers, etc. which have maturity date for a small period of time which is generally less than three months or 90 days’ time. Marketable securities and money market holdings are equivalent of cash because they are highly liquid and are not exposed to material deviations in value. A company with a healthy sum of cash and cash equivalent in its balance sheet is generally considered efficient enough or capable enough to meet its short-term obligations. Cash equivalents are generally denoted for those assets whose maturity time is less than three months or 90 days.
Types of Cash and Cash Equivalents
The different types of cash and cash equivalents are as follows:
- Bank Account: Cash stored in the bank account is the best example for this discussion because it is one of the most liquid assets for the company and can be a lot of help for the company to repay back its short-term obligations. It is defined as money in the form of currency, coins, and notes. A demand deposit plays a rile here which is defined as a kind of account from where fund can be withdrawn at any point in time without informing the business.
- Foreign Currency: Companies which have a lot of forex transaction may face certain exchange risk and thus it is better to convert the currency to the reporting currency for the purpose of financial reporting. The gains made in the mode of conversion can also be considered as cash or cash equivalent but any kind of loses made in the mode of conversion are reported as “accumulated other comprehensive income”.
- Cash Equivalents: These are an investment made that can be easily converted to cash and must be of the short term usually with a maturity period of not more than three months or 90 days. They must be of the highest liquidity in nature and should be easily sold in the market. The buyers of such an asset class must be easy to access. Certificate of deposit can be considered as cash equivalent provided the maturity date is less than 90 days. Preferred shares of equity can also be considered as an example of a cash equivalent. Treasury bill, commercial papers, and short-term bonds are also an example of a cash equivalent.
Example of Cash and Cash Equivalents
Example of cash and cash equivalents are given below:
- Cash: Cash in the form of currency notes, coins and bills are considered the highest level of liquid asset
- Certificate of Deposit: Certificate of deposits with a maturity period less than 90 days are also an example of cash and cash equivalent.
- Commercial Papers: Commercial papers issued by corporates are also considered as a cash equivalent.
- Treasury Bills: Treasury bill which is a government back up security can be also considered to have a high level of liquidity.
- Short Term Bonds: Bonds having a maturity period of less than 90 days are an example of a cash equivalent.
Cash and Cash Equivalents Note to Financial Statement
Cash and cash equivalent are generally recorded in the balance sheet of a company under the current asset section with the same name as cash and cash equivalent and only the overall value is shown. The break up of the overall sum is provided by a note at the end of the financial statement. The cash and cash equivalent will generally bear a number beside its total, which generally describes the serial number in the notes section to understand the break up of the cash and cash equivalent.
Example:
As we see serial number 18 means in the balance sheet the cash and cash equivalent total was mentioned with serial number 18 against it which act as a reference to the user to refer to the notes section serial number 18 to understand the breakup.
Advantages
Some of the advantages are as follows:
- It offers the highest level of liquidity available to the management of the company
- It can be used to repay the short-term obligations and other minor operating expenses as and when it is needed.
- A company with a healthy balance of cash and cash equivalent is perceived to perform well and manage its resources.
- During mergers and acquisitions, this component plays a major role in the valuation of the company.
- It helps in borrowing as the lender will look at the cash and cash equivalent portion of the company to take it as a sort of commitment by the company.
- The extra cash be used as a form of a dividend to be issued to the shareholders.
Disadvantages
Some of the disadvantages are as follows:
- The company may tend to misuse this excess balance in the wrong way and end up utilizing the entire balance.
- Too much of cash may also resemble that company is not paying dividends to its shareholders and instead of retaining back the money.
- Retaining cash and cash equivalents doesn’t fetch a good interest rate so ideally it means that the investment there is reaping a kind of loss which if invested in some other instrument may have given more returns.
- In business handling, a lot of cash in foreign exchange may eventually lead to an exchange loss while converting it to the reporting currency.
Conclusion
Cash and cash equivalent are an important component of a balance sheet and resembles the financial health of a company. It can be used to pay off short term obligation very easily without any kind of borrowing needed. It is also an important component for the shareholders because this can also be used to pay back dividends to the shareholders.
Recommended Articles
This is a guide to Cash and Cash Equivalents. Here we also discuss the definition and types of cash and cash equivalents along with advantages and disadvantages. You may also have a look at the following articles to learn more –
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