What are Cash and Cash Equivalents?

Definition

Cash and cash equivalents (CCE) are defined by both U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) as highly liquid assets that can be easily converted into cash within a short period, typically within 90 days or three months.

To qualify as a cash equivalent, an asset must meet two primary criteria:

• High Liquidity: The asset must be easily convertible into cash without significant loss in value.

• Short-Term Maturity: The asset must have a maturity date within three months or 90 days from the date of acquisition.

Examples of Cash and Cash Equivalents

Cash includes physical currency, bank accounts such as checking, savings, and money market accounts.

Cash Equivalents, on the other hand, include:

• Commercial Paper: Short-term debt issued by companies to raise funds.

• Short-Term Government Bonds: Government securities with maturities less than three months.

• Money Market Funds: Investment vehicles that pool money to invest in low-risk, short-term debt securities.

• Certificates of Deposit (CDs): Time deposits offered by banks with fixed interest rates and maturity dates.

• Banker’s Acceptances: Short-term credit instruments used to finance international trade.

• Marketable Securities: Stocks, bonds, or other securities that can be quickly sold for cash.

Characteristics of Cash Equivalents

Liquidity

One of the key characteristics of cash equivalents is their high liquidity. This means these assets can be quickly converted into cash without a significant loss in value. For instance, if a company holds commercial paper that matures in two months, it can easily sell this paper on the market to raise cash if needed.

Short-Term Maturity

Another critical characteristic is their short-term maturity. Cash equivalents must have a maturity date within three months or 90 days from the date of acquisition. This ensures that these assets can be converted into cash quickly to meet short-term obligations.

Low-Risk Profile

Cash equivalents are also characterized by their low-risk profile. These assets typically have minimal exposure to changes in interest rates and market conditions. For example, short-term government bonds are generally considered very low-risk because they are backed by the creditworthiness of the government.

Financial Impact and Reporting

Balance Sheet Presentation

On a company’s balance sheet, CCE are listed under current assets. They are usually the first item listed on the assets side due to their high liquidity, indicating that they can be quickly converted into cash to meet immediate obligations.

Impact on Liquidity Ratios

CCE play a significant role in calculating various liquidity ratios:

• Cash Ratio: (Cash + Cash Equivalents) / Current Liabilities

• Current Ratio: (Current Assets) / Current Liabilities

• Quick Ratio: (Current Assets – Inventory) / Current Liabilities

These ratios help investors and analysts assess a company’s ability to meet its short-term obligations. For example, a high cash ratio indicates that a company has ample liquidity to cover its debts.

Net Working Capital and Net Debt

When calculating net working capital (NWC), CCE are excluded because NWC focuses on the difference between current assets and current liabilities excluding cash and cash equivalents. However, CCE are considered when calculating net debt, which is total debt minus cash and cash equivalents. This distinction highlights how CCE affect a company’s overall financial health and leverage.

Financial Modeling and Practical Applications

Consolidation in Financial Models

In financial modeling, short-term and long-term marketable securities can be consolidated due to their liquidity and impact on cash balances. This consolidation helps in accurately reflecting the company’s cash position and its ability to meet short-term obligations.

Real-World Examples

Companies like Amazon and Apple manage their CCE carefully. For instance, Amazon often holds significant amounts of cash and cash equivalents to fund its operations and invest in new ventures. Similarly, Apple maintains a large cash reserve which allows it flexibility in making strategic investments or returning value to shareholders through dividends or share buybacks.