Cash equivalents: Overview, definition, and example
What are cash equivalents?
Cash equivalents refer to short-term, highly liquid investments that are easily convertible into known amounts of cash and are subject to an insignificant risk of changes in value. Typically, these are investments with a maturity of three months or less from the date of acquisition, meaning they are short-term in nature and can be quickly converted into cash without significant loss of value. Examples of cash equivalents include Treasury bills, money market funds, and commercial paper.
For example, a company may invest its excess cash in a money market fund, which is considered a cash equivalent because it can be quickly converted into cash with minimal risk of losing value.
Why are cash equivalents important?
Cash equivalents are important because they provide businesses and investors with a way to maintain liquidity while earning a return on their idle cash. By holding cash equivalents, companies can ensure that they have the necessary funds available to meet short-term obligations, such as paying bills or covering operational expenses. At the same time, these investments allow companies to earn interest or returns, though they remain highly liquid and easily accessible.
For financial statements, cash equivalents are often grouped together with cash on the balance sheet, providing a clearer picture of the company’s total liquid assets. For businesses, effectively managing cash equivalents helps optimize cash flow and ensures operational flexibility.
Understanding cash equivalents through an example
Imagine a corporation with $5 million in excess cash that it doesn’t need for immediate operational expenses. The company might choose to invest $3 million in Treasury bills, which have a maturity of 90 days. These Treasury bills are considered cash equivalents because they can be easily converted back into cash at any time before they mature, with minimal risk of loss.
In another example, a small business may place its surplus funds in a money market account, which provides a modest return and can be accessed quickly if needed. The funds in this money market account are also considered cash equivalents because they can be quickly liquidated into cash if the business needs to cover short-term expenses.
An example of a cash equivalents clause
Here’s how a clause like this might appear in a financial policy or accounting statement:
“For purposes of this Agreement, cash equivalents shall include short-term, highly liquid investments with an original maturity of three months or less, including, but not limited to, Treasury bills, money market funds, and commercial paper, all of which are readily convertible to cash and subject to an insignificant risk of changes in value.”
Conclusion
Cash equivalents are an essential part of a company's liquidity management strategy, providing a way to maintain access to cash while still earning returns on short-term investments. These assets are easily convertible into cash with minimal risk, ensuring businesses can meet their financial obligations without sacrificing growth potential. Properly managing cash equivalents allows businesses to optimize their cash flow, maintain operational flexibility, and ensure that they have the necessary funds available for day-to-day expenses.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.