What’s it: A cash equivalent is a financial asset that can easily be converted to cash and have minimal risk of changing prices. Because of this nature, companies combine cash accounts with cash equivalents into one: cash and cash equivalents. You can find it in current assets on the balance sheet.
Holding cash equivalents serves two purposes at once. First, companies can use it to meet short-term liquidity needs, such as cash. Second, the company obtained some return on investment, in contrast to holding only cash such as banknotes and coins.
What are the characteristics and examples of cash equivalents
Cash equivalents include highly liquid instruments with maturities of less than 90 days. The risk associated with changes in value due to changes in interest rates is minimal because they are close to maturity. So, the company can estimate its value when converting it.
Examples of cash equivalents are deposits with maturities of less or equal to three months. They are not extended continuously (rollover). Other examples are banker’s acceptance, short-term commercial paper, and other money market instruments.
Why are cash equivalents important
Cash equivalents provide financial cushion during difficult times. Companies with large amounts of cash or cash equivalents can better get through tough times when sales are low.
Less liquidity risk. An increase in cash equivalents indicates that the company has higher liquidity. Companies with higher liquidity are considered healthier and have less risk. Companies can quickly pay off short-term obligations.
Cash equivalents fall into the current assets section of the balance sheet. They contribute to a company’s working capital, which is the same as current assets less current liabilities. Working capital is essential to finance operations in the short term, such as inventory and operating expenses.
Companies are more flexible in responding to market opportunities. Companies can expand at any time without having to borrow too much.
Acquirers are also pleased to acquire the target company with ample cash and cash equivalents. In a leveraged buyout transaction, the acquirer can use the target company’s cash to pay off its debt. It is easier for acquirers to convince lenders to lend money because the target company has a large and stable cash flow.
How to measure and report cash equivalents
Cash equivalents may be measured at amortized cost or fair value.
- Amortized cost is equal to historical cost adjusted for amortization and impairment.
- Fair value equals the amount of assets that could be exchanged in a fair transaction between willing and informed parties, according to IFRS. Under GAAP, fair value is based on the exit price – the price received when the asset is sold.