Cash and cash equivalents are essential metrics that form a huge portion of a company’s operating plan. Companies with higher cash and cash equivalents in the balance sheet can overcome the crisis more conveniently than those companies which are cash strapped.
Read the following to know the cash and cash equivalents meaning and examples.
What are Cash and Cash Equivalents?
Cash and cash equivalents are the lined items on the business balance sheet which describe the amount of an organization’s cash or other assets. These items can be liquid cash or components that can be easily converted into cash. Assets that can be liquidated in less than 90 days, or three months, are considered cash equivalents. Cash and cash equivalents fall under the current assets category in the balance sheet.
The following are the two criteria for a current asset to be classified as a cash equivalent:
- an asset should be readily convertible to cash-in-hand with relatively known value (low risk)
- an asset (marketable securities, bank accounts, short-term government bonds, commercial paper, and Treasury bills) that is near to its maturity date with an insignificant risk of changes in value due to any changes in interest rates.
In other words, the cash and cash equivalents refer to currency cash, cash-like investments, and physical cash found in bank accounts. The cash and cash equivalent line item is always viewed as a current asset, and it is the first item on the balance sheet’s assets side.
Now, let’s see some cash and cash equivalents examples.
Examples of Cash
A company with a healthy amount of cash and cash equivalent in its balance sheet is considered capable enough to meet its short-term responsibilities.
First, let’s discuss some cash examples.
Currency
Coins or currency are monetary units used to exchange goods, debt, or services. Companies that do a lot of forex transactions may be exposed to some exchange risk. Thus, it’s best to convert the currency to the reporting currency for accounting and auditing purposes. Profits obtained during currency conversion can be considered cash or cash equivalents, but any losses obtained during conversion are named as “accumulated other comprehensive income.”
Accumulated Other Comprehensive Income (OCI) – unrealized gains and losses reported in the equity section of the balance sheet.
Bank Account
The ideal illustration for this discussion is cash stored in a bank account. Since it is one of the company’s most valuable liquid assets and can effectively help the company repay its short-term obligations. This money can be the currency, coins, and notes. A demand deposit that is defined as an account from which funds can be withdrawn at any moment without prior notice plays a pivotal role here.
Money Order
A money order is a certificate that allows the designated payee to receive cash on demand and is generally issued by a government or banking institution. In fact, a money order works similarly to the check where the person who purchased it can halt payment.
Money orders are widely accepted and easily converted to cash, and they are often used by people who do not have access to a standard checking account. These are acceptable as a means of payment for modest debts (personal and business) and can be purchased for a small service fee from most institutions. A money order has the benefit of being pre-paid. As a result, people prefer them over checks.
Petty Cash
Petty cash is a little sum of money that can be used to pay modest expenses. Each department of large organizations may have its petty cash fund. Office supplies, customer cards, flowers, and staff lunch expenses can all be paid with a petty cash fund. The main advantages of petty cash are that it’s quick, convenient, and can be easily used. Vulnerability to theft and misuse is the markable disadvantage of these funds. So, companies should monitor and balance it periodically.
Bank Overdrafts
The overdraft permits the customer to keep paying bills even if there isn’t enough money in their account. It works the same way as any other loan: the account holder pays interest and is usually charged a one-time insufficient funds fee.
When a customer’s account balance reaches zero, some banks offer overdraft protection; it eliminates insufficient funds charges, but it typically comes with interest and additional fees.
Examples of Cash Equivalents
Here are some examples of cash equivalents
Commercial papers
Commercial Paper (CP), issued as a promissory note, is an unsecured money market instrument. CP was introduced in India in 1990 to allow highly rated corporate borrowers to diversify their sources of short-term borrowings and provide an additional financial instrument to investors. The Reserve Bank of India has issued several directives that govern the allotment of CP. The maturity period of most commercial paper ranges from a few weeks to months, with an average of roughly 30 days.
Marketable Securities
Marketable securities are financial instruments with high liquidity that can be sold or converted into cash within a year of purchase. These securities are issued by businesses to raise funds for operating expenses or business expansion. At the same time, companies invest in marketable securities to generate short-term income with cash on hand.
Two types of market securities are:
- Marketable debt securities
- Marketable equity securities
Money Market Fund (MMF)
A money market fund is similar to a mutual fund that invests in high-quality and short-term financial instruments. MMF is not safe as cash, but it is considered extremely low-risk on the investment spectrum. It generates some income (taxable or tax-free, based on the portfolio) but cannot expect a few capital gains. Money market funds can be used as a place to keep money temporarily before investing elsewhere.
Short-duration Government Bonds
The central and state governments of the country issue short-term bonds to finance their needs and regulate the money supply. Governments use bonds as a strategy when they require funds for infrastructure development and government spending. These bonds will be sold to the public, inviting investments.
The government will repay the principal amount and interest as mentioned in the bond at the specified maturity date. These bonds are issued under the supervision of the Reserve Bank of India (RBI).
Some types of government bonds:
- Treasury bills
- Cash management bills
- Dated Government securities
- Fixed-rate bonds
The Bottom Line
Cash and cash equivalents are the essential factors that play a vital role in the liquidity (a company’s ability to raise cash when it needs it) of a business. All businesses should have enough cash and cash equivalents on hand to cover their liabilities when they are due.