Cash equivalents are investments that can be very easily turned into cash, examples being deposits on the money market or current bank accounts. These assets are regarded as very safe and liquid investments and are taken into account in computing the liquidity ratio of a company.
Cash equivalents are liquid assets that may be quickly converted to cash, owing to the existence of very active markets where they may be readily exchanged for cash. The advantage of holding cash equivalents is that, unlike cash, many of them will earn a return in the form of interest, while at the same time, they retain many of the the advantages of holding cash. Cash equivalents are available to be turned back into cash at very short notice to meet any unexpected liabilities arising and maintain the liquidity of the enterprise. The types of asset that can be regarded as cash equivalents include bank money market deposits, certificates of deposit and Treasury Bills that have a short term (typically less than three months) remaining until maturity at the time when they are acquired.
One of the main disadvantages of holding cash equivalents is that the amount of interest that can be earned on these investments is much lower than rates of return that can be earned elsewhere by holding more long-term, non-liquid assets. This of course reflects the fact that cash equivalents are a very safe investment that does not normally run very much risk of loss of the original capital invested.
For this reason, the rates of interest are low to reflect the low risk of the investments. It is, therefore, not good management policy to hold large amounts of cash equivalents all the time, but instead the position should be actively managed by assessing the short term liabilities becoming due within a relatively short period ahead and ensuring that sufficient cash equivalents are kept to cover these liabilities but that excess amounts of cash or cash equivalent are invested in assets that earn a higher return.
Part of the treasury function in an enterprise is to keep an ongoing forecast of cash flow and to identify how much cash will be needed at each point in the foreseeable future. The amount of funds kept as cash and cash equivalents can then be managed so that just enough is kept to meet the short term liabilities but any excess funds above this amount are invested in assets that have a higher yield.
This cash management function is vital to any enterprise however large or small, and keeping funds in the form of cash equivalents is an integral part of the strategy of an enterprise. This cash management function requires careful attention especially at a time when an enterprise is expanding and paying a considerable amount of cash on new assets and inventory. An enterprise whose cash management is not given enough attention may find itself in a non-liquid and insolvent position even though the business is potentially profitable. This frequently happens to enterprises in the first few years of their existence.
Why They Are Needed
The required amount of cash equivalents will depend on the type of business and the risk that it will suddenly be confronted by liabilities that require payment at short notice. For example, a retailer that is dealing in fast moving consumer goods and turning over its stock very rapidly would have less need for cash equivalents to protect its liquidity, because in a situation where it is faced by unexpected short-term liabilities it could convert its stock into liquid assets quickly enough to cover the liabilities.
By contrast, a retail operation that is dealing in relatively slow-moving, high value stock which cannot be turned over very quickly may have to consider holding larger amounts of cash equivalents to meet short term liabilities as they become due. In such a business, a good indication of its liquidity would be gained by computing the liquidity ratio, found by dividing current assets minus inventory by current liabilities. If sufficient cash equivalents are held, the liquidity ratio may be kept at a value above 1.0 and the enterprise can have some confidence that it will be in a position to meet its short term liabilities as they fall due.
Another factor that may influence the amount of cash equivalents held by an enterprise is its ability to collect its debts within a reasonable time. If the enterprise has problems collecting its debts, and has a high occurrence of bad debts, it may not be easy for the enterprise to convert its debtors into cash in a short enough time period to ensure that it can meet its short term liabilities. In this case, in addition to tightening up its credit control and debt collection procedures the enterprise should also consider holding relatively high levels of cash equivalents.
Cash equivalents are included for accounting purposes under current assets on the balance sheet. Some enterprises prefer to categorize them together with cash in a heading called "cash and cash equivalents." This may help to emphasize the liquid nature of these assets and to show potential investors and other users of the enterprise's financial statements that the cash equivalents are to be taken into account in measuring the liquidity of the enterprise.
The current assets of a company will frequently be classified according to their liquidity, and cash equivalents are clearly more liquid than any of the other current assets except cash. Other types of current assets such as debtors may not be easily turned into cash, as it may be difficult to collect all the debts within a limited time period and some will remain outstanding as bad debts. If the debts are sold to a factoring company, this will involve a significant discount. The inventory of the enterprise, depending on the type of industry, is likely to be even more difficult to turn into cash. Even if the business is making large amounts of cash sales it will still require some time to turn over the inventory.
The need for cash equivalents is, therefore, clear even if the enterprise holds significant current assets in the form of debtors and stock, and the presentation of the cash equivalents in the financial statements should be clear enough to show the users of the accounts that these are assets with a high liquidity.
"Chapter 6: Cash and highly liquid investments" in Principles of Accounting - retrieved at http://www.principlesofaccounting.com/chapter%206.htm
"Cash equivalents" on Your Money Counts (HSBC) - retrieved at http://www.yourmoneycounts.com/ymc/goals/investing/cash_equivalents.html
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