What are a company's cash equivalents?

Cash equivalents are securities intended for short-term investment and are an important indicator of a company's financial well-being. Analysts can estimate the suitability of an investment in a particular company by the company's ability to access cash and quickly convert cash equivalents. Let's look at what cash equivalents are and how to interpret them in company documents.

What are cash equivalents?

Cash equivalents are securities intended for short-term investment. Typically, they have strong credit quality and are very liquid. True to their name, they are considered cash equivalents because they can be quickly converted into real cash. Cash equivalents are an important indicator of a company's financial well-being. Analysts can estimate the suitability of an investment in a particular company by the company's ability to access cash and quickly convert cash equivalents. This liquidity reflects a company capable of paying its bills. Companies with large amounts of cash and cash equivalents may be prime targets for larger companies with acquisition plans.

Characteristics of cash equivalents

Different types of cash equivalents usually have the same characteristics. These features are

• management : Cash equivalents must be traded in liquid markets. This is because these investments must be very easy to convert into cash. If an investment is illiquid, it cannot be considered a cash equivalent.
• Short term investment: Cash equivalents must be capable of being quickly converted into cash. Therefore, the investment term is usually very short. Cash equivalents are often considered the most liquid current asset after cash.
• Low risk/volatility: Cash equivalents are intended as an efficient investment for available cash that does not carry much risk. Although there are several considerations to take into account regarding default risk, cash equivalents are typically low-risk, low-volatility investments.
• unrestricted access: The conversion of cash equivalents into cash must be unlimited. An investor must be able to convert their cash equivalent into cash upon request. The goal of cash equivalents is to provide the same liquid benefits as cash. Investments with inflexible holding periods or lack of liquidity are not cash equivalents.

Types of a company's cash equivalents

The different types of cash equivalents can be categorized as follows:

Treasure letters

Treasury bills are securities issued by the Treasury Department of each country that mature in one year or less. Companies, financial institutions and individuals that buy Treasury bills lend the government money that it returns when it matures. 

Negotiable values

Marketable securities are assets and financial instruments that can be easily converted into cash and are therefore very liquid. They are traded on public markets and usually have a significant secondary market. Marketable securities may have maturities of one year or less and the rates at which they may trade have a minimal effect on prices. 

Commercial paper

Commercial paper is short-term (less than a year) unsecured debt used by large companies to obtain funds to meet short-term obligations, such as payroll. Companies issue commercial paper at a discount to face value and promise to pay the full face value on the maturity date indicated on the note. 

Bank acceptance

A banker's acceptance is a form of payment guaranteed by a bank and not by the account holder. Since the bank guarantees payments, this short-term issuance by a bank is considered cash. Banker's acceptances are frequently used to facilitate transactions where there is little risk to either party.

Money market funds

Money market funds are investment funds that invest only in cash and cash equivalents. They are very liquid investments with excellent credit quality. Money market funds are an efficient and effective tool that companies and organizations use to manage their money as they tend to be more stable compared to other types of funds, such as mutual funds. 

Uses of cash equivalents

Being liquid assets that can be used in the short term, cash equivalents have a series of uses, such as:

To meet short-term obligations

Cash equivalents are part of the company's net working capital (current assets minus current liabilities), which it uses to pay operating expense bills, purchase inventory, service debt, and make other purchases.

Create an emergency fund

Like people, businesses should keep enough cash readily available to meet unexpected expenses that may arise, for example, when business is slow or the economy stumbles. Investing in cash equivalents gives businesses the security of having cash when they need it and provides a return. The interest earned is usually higher than a basic bank account and provides some protection against inflation.

As required by debt agreements

Some lenders may require that, in exchange for a loan, a business maintain a certain amount of liquid cash equivalents. This financial restriction is intended to protect the financial interests of the lender in case business slows down. It can also lead to better loan terms (due to lower risk) for the company that accepts it. Additionally, a company can benefit from the discipline of saving through cash equivalents.

Be prepared for future projects

Companies can intentionally hold higher balances of cash equivalents so they can take advantage of business opportunities when they arise. Rather than locking up capital in a long-term, illiquid and perhaps volatile investment, a company may choose to invest more cash in cash equivalents in case it needs funds quickly.