Cash and cash equivalents are cash plus short-term investment instruments that you can immediately cash and have minimal risk of changes in value. You can find this account in the top row of assets on the balance sheet.
What are the components of cash and cash equivalents?
In accounting, cash refers to cash such as petty cash (coins and paper money) and cash in hand. Companies can use it to pay obligations immediately.
Meanwhile, cash equivalents are short-term investments with a minimum interest rate risk. These instruments are highly liquid, and companies can convert them quickly into cash. They are also quite close to maturity, usually less than 90 days. Because of these characteristics, their value is unlikely to change when companies convert to money. Commercial paper, banker acceptances, and money market funds are examples.
Why are cash and cash equivalents important?
Cash has the highest liquidity. Because companies don’t need to convert them to other forms to use. Companies can use it directly for various purposes, such as paying salaries, buying raw materials, and paying off debt.
Imagine when you have money and gold bars in hand. With that money, you can spend it on anything and anytime. All sellers of goods will be willing to accept it as a means of payment.
This is not like gold. When you want to use it, you need to convert it to an amount of money. The seller does not wish to accept gold as a means of payment. And to turn gold into some money, you need time. For this reason, gold is less liquid than cash.
Because of liquidity reasons, people say cash is king. With ample money, companies can use it for anything, including:
- Paying interest and paying off debt to reduce the company’s financial leverage
- Buying capital goods to increase production capacity and future growth
- Acquiring other companies without having to owe
- Paying operating costs and distribute dividends
In short, cash allows companies to exploit business opportunities when they arise.
That’s different from cash-poor companies. They need time to make money, so they cannot capture business opportunities immediately. They need to sell products from inventory, convert the accounts receivable to cash, or sell assets. Or, they issue bonds or shares to raise capital. It takes time, and opportunities may have disappeared when the company has raised money.
How do companies report cash and cash equivalents in financial statements?
In general, on the balance sheet, companies report them based on amortized cost or fair value. Amortized cost is historical cost adjusted for amortization and impairment. Meanwhile, the fair value is based on the amount that the company gets when exchanging it for a fair transaction.