Cash Equivalents Definition, Purpose, Types, and Features

Many businesses struggle with managing cash equivalents efficiently, leading to liquidity issues. According to Forbes, a study performed by Jessie Hagen of the U.S. Bank found that 82% of businesses fail because of poor cash flow management.

Cash equivalents, such as treasury bills and money market funds, help businesses maintain liquidity. These assets can be converted into cash quickly, ensuring financial stability. However, manually tracking cash flow can be time-consuming and prone to human errors.

Accounting software simplifies cash equivalent management with real-time tracking and automation. It ensures accurate reporting, reduces risks, and improves decision-making, allowing businesses to maintain strong financial health effortlessly.

Willing to know more about cash equivalents, their purposes, types, features, and how to manage them effectively? Find your answer in the article below.

What Are Cash Equivalents?

Cash equivalents are short-term, highly liquid assets that can be quickly converted into cash with minimal risk. Many businesses use these assets to maintain liquidity and cover short-term expenses without disrupting operations.

These assets are classified under the current assets section on a company’s balance sheet because they provide immediate access to funds. With a low-risk, low-return profile, cash equivalents ensure financial stability while earning small returns.

Cash equivalents show how financially stable the company is. Investors can check if a company can quickly access cash and convert assets when needed. Such liquidity means that the company can soon pay its bills. Companies with lots of cash and cash equivalents can attract more prominent companies to acquire them.

Features of Cash Equivalents

Even though cash equivalents have different types, examples, and forms, all of them bear the same features or characteristics. The characteristics of cash equivalents include:

1. Highly liquid
   Cash equivalents can be converted quickly into cash without significant loss in value. If an investment is not liquid, it cannot be considered as cash equivalents.
2. Low-risk and stable value
   Cash equivalents involve minimal risk of losing value, making them a safe place to park excess cash. They should also be stable because, unlike stocks or other volatile investments, they maintain a predictable value.
3. Short-term maturity
   The term of investment in cash equivalents is very short to ensure quick access to funds. Typically, cash equivalents mature within 3 months or less.
4. Easily convertible to cash
   Cash equivalents should be easily convertible to cash without restrictions, allowing investors to access funds on demand. Investments with rigid holding terms or low liquidity do not qualify as cash equivalents.

Cash vs Cash Equivalents

Although it has the same “cash” word, cash and cash equivalents have differences. Here are the significant differences between cash and cash equivalents:

The Importance of Cash Equivalents

A company is recommended to store some of its capital in cash equivalents. Here is the importance of storing some of the capital to cash equivalents:

1. Ensures liquidity and meets short-term obligations
   Cash equivalents provide businesses with immediate access to funds. By maintaining a balance of cash equivalents, companies can cover operational expenses, pay invoices, purchase inventory, and service debt on time, keeping daily operations running smoothly.
2. Reduces financial risk and builds emergency reserves
   Cash equivalents act as a safety net during economic downturns or unexpected expenses to help businesses manage financial uncertainty. Companies gain an advantage by keeping readily available cash to manage unforeseen challenges without interrupting their operations.
3. Supports business growth and investment opportunities
   Companies with sufficient cash equivalents can swiftly seize new opportunities, such as expansion, asset acquisition, or new projects. Rather than locking funds in long-term, illiquid investments, they keep cash accessible for strategic moves whenever needed.
4. Enhances financial stability and attracts investors
   A substantial cash equivalent signals financial health, which attracts investors and lenders. Some debt agreements require liquid assets, leading to better loan terms. This disciplined financial approach supports long-term stability and growth.

There are so many accounting system types that can be beneficial for your business, especially for maintaining the importance of your company’s cash equivalents. Some of them are enterprise accounting software and cloud accounting software.

Types of Cash Equivalents

There are several common types of cash equivalents. All of them provide the same characteristics: offering liquidity and relatively low risk over a short-term period.

1. Banker’s acceptance
   A company issues a banker’s acceptance as a short-term debt instrument, and a bank guarantees it. Because of this guarantee, it is considered a cash equivalent. It facilitates transactions with minimum risk for either party.
2. Money market funds
   Money market funds are mutual funds that invest in short-term, low-risk securities. They are very liquid investments and provide a safe way to earn small returns while maintaining high liquidity. Unlike other types of funds, money market funds tend to be more stable.
3. Short-term government bonds
   Short-term government bonds, issued by the government with maturities of one year or less, carry minimal risk since the government backs them. However, investors must consider political risks, interest rate risks, and inflation when investing in government bonds.
4. Certificate of deposit (CD)
   A CD is a time deposit offered by banks. An investor deposits money for a fixed period, from one month to five years, in exchange for a guaranteed interest rate. While it offers higher returns than a savings account, withdrawing before maturity may result in penalties.
5. Commercial paper
   Commercial paper is an unsecured, short-term debt issued by big companies to finance day-to-day operations. It typically matures from one to 270 days and is considered a safe investment for companies with strong credit ratings.
6. Marketable security
   Marketable securities are liquid financial instruments that can be sold quickly in public markets. They have maturities of one year or less, and the prices at which they can be bought or sold have minimal effect.
7. Treasury bills
   Commonly referred to as T-bills, Treasury bills are short-term government securities issued by the United States Department of the Treasury. Their maturities range from a few days to one year.

By purchasing T-bills, companies or individuals lend money to the government, which repays the amount at maturity. The bills are sold at a discount and redeemed at face value upon maturity.

What is Not a Cash Equivalent?

There are some exceptions for classifying short-term assets and current assets as cash equivalents if they’re restricted from being converted to cash or if they can’t quickly turn into money. Those assets are:

1. Account receivable
   Account receivable refers to money that customers who have already received goods or services but haven’t paid yet need to pay to the company. Since the company must wait for payment, it is not immediately available as cash, so it is not considered cash equivalents.
2. Unbreakable certificate of deposits
   Not all certificates of deposit (CD) qualify as cash equivalents. If a CD has a term longer than 3 months and cannot be withdrawn before its maturity, it is not considered a cash equivalent because the money is not easily accessible.
3. Inventory
   Inventory is goods that the company holds before they are sold. Since it takes time for them to be converted to cash and there’s no certainty of the amount that the company will receive, inventory is not considered as cash equivalents.
4. Credit collateral
   Assets used as collateral for a loan cannot be considered cash equivalents since they are not freely available for the company to use. Since the lender has a claim on the assets, the company cannot easily convert it to cash until the loan is repaid.
5. Prepaid assets
   Prepaid assets are payments made in advance for goods or services that will be used in the future, such as rent or subscriptions. Since they cannot be quickly converted into cash, they are not considered cash equivalents. They are considered assets.

The many types of cash equivalents and non-cash equivalents sometimes confuse business owners like you about how to manage them. For that, you need to use the best accounting software to make it easier for you to manage your cash equivalents.

Advantages of Cash Equivalents

Storing your company’s capital to cash equivalents has so many benefits. Here are the advantages of cash equivalents for your companies:

1. It can be accessed quickly
   Cash equivalents can be turned into cash quickly since they are highly liquid. Cash equivalents benefit companies that need immediate funds to cover emergencies, expenses, or unexpected opportunities.
2. Efficient use of capital
   Cash equivalents allow businesses to earn small returns while maintaining liquidity. Keeping a large sum of idle cash in a bank account only gives the cash little to no return.
3. Fixed interest rates
   Many cash equivalents, such as certificates of deposit (CDs), offer a fixed interest rate over a specific period. It guarantees a predictable return and ensures steady earnings without market fluctuations, making investors feel secure and stable.

Disadvantages of Cash Equivalents

While investing in cash equivalents has its advantages, cash equivalents also come with its flaws. Here are the disadvantages of cash equivalents:

1. Subject to inflation
   The interest earned on cash equivalents may not always keep up with inflation. The return rate might be lower than the inflation rate. If inflation is higher than the interest earned, the actual value of the money decreases, meaning you can buy less with the same amount in the future.
2. Lower return
   Cash equivalents typically have lower returns compared to other investment methods, such as stocks, bonds, or other long-term investments. It means businesses and investors might miss out on higher profit opportunities.
3. Limited growth potential
   Financial institutions design cash equivalents for liquidity and safety, not for long-term growth. Since these assets have short-term maturity, they do not increase in value over time, making them unsuitable for wealth accumulation.

Example of Cash Equivalents

Cash equivalents, even though they come in many forms, share the same characteristics: high liquidity, low risk, and short-term maturity. Below is one of the cash equivalents examples.

Imagine a company named ABC Electronics, a mid-sized electronics manufacturer with substantial cash reserves. This company wants to maintain a liquidity policy to ensure it can meet short-term obligations while earning a small return on its funds.

ABC Electronics then invests in a money market fund to park some of its excess cash. ABC Electronics has $500,000 in these funds. The company also holds $300,000 in U.S. Treasury Bills that mature in two months. Then, the company also has $200,000 in a 3-month Certificate of Deposit.

ABC Electronics’ total cash equivalents are $1,000,000. Cash equivalents represent liquid assets that can easily be converted into cash within a short period. They help ABC Electronics manage its short-term liquidity needs while earning interest on idle funds.

ABC Electronics lists these assets under cash and cash equivalents on its balance sheet, providing investors and creditors with a clear understanding of the company’s liquidity position.

From this example, you can see that managing cash equivalents without an accounting system is time-consuming and error-prone, potentially reducing your business efficiency and income. Choosing a system with limited functionality may lack the necessary features for proper cash equivalent management.

Optimize Cash Equivalents Management with HashMicro Accounting Software

One of the best accounting software that can maintain the importance of cash equivalents is HashMicro. With its advanced financial management system, HashMicro helps businesses track, manage, and report cash equivalents efficiently and automatically. HashMicro provides a free demo for you to try.

One of the software providers that provides accounting system is HashMicro. HashMicro Accounting Software provides you with the key features for simplifying cash equivalent management ensuring accurate tracking and forecasting. Some of the comprehensive features are:

1. Financial dashboard provides a real-time view of cash balances, receivables, and payables, helping businesses monitor liquidity effectively.
2. Cash flow forecasting helps predict future income and expenses, ensuring businesses maintain sufficient cash equivalents for smooth operations.
3. Fast bank reconciliation automates transaction imports, reducing errors and ensuring cash equivalent records remain updated.
4. Accrual & amortization automates complex calculations, ensuring precise financial reporting without human errors.
5. Peppol e-invoice streamlines invoicing with Singapore’s Peppol, ensuring timely payments that improve cash flow and maintain healthy cash equivalent levels.
6. Analytical reporting generates real-time insights, allowing businesses to make data-driven decisions about cash equivalent management.

Conclusion

Cash equivalents are one of the pivotal components of financial accounting management. By being knowledgeable about cash equivalents and their importance, types, and advantages, companies can manage their cash flow efficiently, leading to improved liquidity.

Establishing the best accounting software can make a significant difference in managing your company’s cash equivalents. HashMicro Accounting Software offers advanced and comprehensive features to integrate cash flow management, from cash flow forecasting to analytical reporting.

Book our free demo to discover how HashMicro can help you manage your cash equivalent!

Frequently Asked Questions About Cash Equivalents

• How do you analyze cash and cash equivalents?

  For an asset to qualify as a cash equivalent, it must meet two criteria: it must be highly liquid, allowing easy conversion into cash, and it must have a short maturity period, typically maturing in three months or less.

• How do you audit cash and cash equivalents?

  To audit cash and cash equivalents, the auditor should physically verify cash balances on the balance sheet date. If feasible, the auditor can conduct a surprise check before or after the balance sheet date.

• How to calculate cash equivalents?

  Companies enter cash and cash equivalents as current assets on the balance sheet. They calculate the total value by adding all cash accounts and any highly liquid investments that can be easily converted into cash and qualify as cash equivalents.