Cash and cash equivalents, found in the balance sheet, represent the total value of assets that can be quickly converted into cash. Any assets meeting this criterion are categorized as current assets. To qualify as a cash equivalent, an asset must be easily convertible into a specific cash amount and be close enough to its maturity date that there's minimal risk of value fluctuations due to changes in interest rates by the time it matures.
Cash and Cash Equivalents Meaning
Cash refers to legal tender, bills, coins, checks received but not yet deposited as well as both checking and savings accounts. However, cash equivalents consist of short-term investment securities that mature less or within ninety days, including bank certificates of deposit, banker’s acceptances, Treasury bills, commercial paper, and so many other money market instruments.
The main characteristic that differentiates cash and cash equivalents from other current assets (for example, marketable securities and accounts receivable) is that these last ones are not easily convertible into cash. However, some marketable securities may qualify as cash equivalents depending on a particular company’s accounting rules.
Types of Cash Equivalents
Cash equivalents encompass various financial instruments easily convertible to cash, often found in the portfolios of businesses and individuals. Here are some common types:
Treasury Bills (T-bills):
Short-term securities issued by the US Department of the Treasury, maturing in a year or less. Purchasers lend money to the government, which is repaid at maturity. T-bills are sold at a discount and redeemed at face value.
Commercial Paper:
Unsecured, short-term debt used by large corporations to fulfill immediate financial obligations. Companies issue commercial paper at a discount and pay the full face value upon maturity, which can range from one to 270 days.
Marketable Securities:
Highly liquid financial assets, including T-bills, CDs, stocks, bonds, and ETFs, traded on public exchanges. They have maturities of one year or less and are easily convertible to cash without significantly affecting prices.
Money Market Funds:
Mutual funds exclusively investing in cash equivalents. They offer stability and liquidity, making them valuable tools for managing funds compared to other types of investments.
Short-Term Government Bonds:
Liquid securities issued by governments to fund projects. They are traded actively, but investors should consider political and interest rate risks.
Certificate of Deposit (CD):
A savings account with a fixed term and interest rate, limiting access to the deposited amount for a specific period.
Banker's Acceptance:
Payment guaranteed by a bank, often used in low-risk transactions, making it akin to cash due to the bank's assurance.
Nature of Cash Equivalents
Easily Converted to Cash:
Cash equivalents are designed to meet short-term business needs and are not intended for long-term investments.
Convertible to a Known Amount:
A cash equivalent must not only be convertible to cash but to a specific, predetermined amount. This means the price should be fixed or subject to minimal fluctuations in the market.
Low Risk:
Cash equivalents are short-term, low-risk instruments that can be quickly converted to cash. Typically, these investments have maturities of less than three months to minimize risks associated with market changes.
Excluding Equity Investments:
Cash equivalents do not typically include equity investments, with the exception of preference shares acquired shortly before their maturity date with a specified redemption date.
Significance of Cash in Daily Transactions
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Cash represents a tangible asset and serves as a highly favored method of payment worldwide due to several reasons.
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Cash allows for direct, immediate payments, granting the freedom to spend without involving third parties.
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The use of cash is secure, as it doesn't necessitate any third-party intermediaries. It minimizes the risk of identity theft and fraud because it operates independently of electronic accounts.
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Cash is an effective tool for managing one's budget.
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In emergencies, such as medical treatments or situations where internet access is unavailable, cash proves to be invaluable.
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Cash eliminates transaction fees and the potential challenges associated with chargebacks that can occur with credit or debit card transactions.
Criteria for Identifying Cash Equivalents
To qualify as a cash equivalent, the following conditions must be met:
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The investment should mature in a period not exceeding three months. If the maturity duration surpasses three months, it should be categorized as a different form of investment.
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The investment instruments should be highly liquid, meaning there should be a substantial number of potential buyers available in the market at any given time.
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The market price of these instruments should be readily available, ensuring easy conversion into a specific amount, and this market price should remain relatively stable, not subject to significant fluctuations.
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These instruments should involve minimal risk and should retain their value even in the face of fluctuating market conditions.
