So you’ve been digging into your company’s latest balance sheet, and there’s something you see listed under current assets that you’re not super sure about:
Cash and cash equivalents.
Cash seems pretty self-explanatory, but what about cash equivalents? What’s the difference? Why are these two assets lumped together? What gets included and excluded from the cash and cash equivalents account?
In this article, we’re going to answer all of those questions.
We’ll explain what cash and cash equivalents are, discuss different types and exclusions, and outline how to calculate them.
What are cash and cash equivalents?
Cash and cash equivalents are listed under current assets at the top of the balance sheet. They are the most liquid assets a company possesses, meaning they are most easily usable to make purchases or pay down debts.
Where things get a little tricky is in determining what is a cash equivalent and what isn’t.
It would seem, for example, that money in your bank account is the equivalent of cold hard cash, right?
Not quite. In the business finance world, the money in your company bank accounts is considered cash, as is the actual cash you have on hand, such as petty cash for small daily expenses or currency (both banknotes and coins) you may be holding for whatever reason.
So, what’s a cash equivalent?
Cash equivalents are defined as short-term investments that can be quickly converted into cash while incurring a minimal loss in value. For example, if your company has money market funds (such as stock in another company) that are easily converted into cash, this would be considered a cash equivalent.
For an asset to be considered a cash equivalent, it must meet two key criteria:
- Highly liquid. The asset must be able to be converted very easily into cash.
- Short maturity period. The asset typically matures in three months or less.
Assets like treasury bills, commercial paper, and some Certificates of Deposits (CDs) are considered cash equivalents.
The importance of cash and cash equivalents
Accurately defining and managing cash and cash equivalents is crucial for cash flow management and financial reporting.
From a reporting perspective, it's crucial that businesses accurately recognize and categorize their current assets to ensure the balance sheet is presented accurately. This helps investors and creditors gauge a company’s financial health and risk level.
For managing business operations, keeping on top of cash and cash equivalents is important for liquidity management. These highly liquid assets are essential for covering a company’s immediate financial requirements, like meeting payroll or paying bills and debt obligations.
A healthy balance of cash and cash equivalents helps businesses meet short-term liabilities without facing liquidity issues.
There is also a consideration of long-term business investment.
Keeping an eye on cash and cash equivalents helps a business understand if it has excess cash that should ideally be placed in cash equivalents to generate returns while preserving liquidity or potentially be invested in long-term growth strategies.
Types of cash and cash equivalents
So, what kinds of assets might fit into the cash and cash equivalents account?
Here are seven examples. The first two are considered cash, while the remaining five would fall into the cash equivalent bucket:
- Cash on hand. Physical currency is kept on-site for immediate use like an office’s petty cash supply or a cash float kept in a register at a physical store.
- Cash in the bank. Any funds held in bank accounts that can be readily accessed for transactions, such as savings, checking, and money market accounts.
- Short-term investment. Investments that can be easily converted to cash within a short time period (less than three months), such as treasury bills (t-bills), commercial paper, and Certificates of Deposits.
- Money market funds. Mutual funds invest in highly liquid short-term securities that provide returns in the form of dividends and are easily converted to cash.
- Banker’s acceptance. Short-term credit instruments that are guaranteed by a bank. These are often used in trade finance.
- Marketable securities. Stocks and bonds that can be sold and converted to cash quickly.
- Overdraft protection. Though this is technically a liability, some companies will classify overdraft protection as a cash equivalent due to its immediate liquidity.
Exclusions from cash and cash equivalents
Additionally, here are some of the most common assets you’ll find listed on the balance sheet that are not considered cash or cash equivalents.
- Long-term investments
- Restricted cash
- Bank overdrafts
- Accounts receivable
- Inventory
- Prepaid expenses
- Post-dated checks
- Certificates of deposit (CDs) with long maturity
- Investments in equity securities
- Convertible debt
How to calculate cash and cash equivalents
Calculating cash and cash equivalents is a pretty straightforward process. Here’s what the formula looks like:
Cash and Cash Equivalents = Cash on Hand + Cash in Bank + Short-Term Investments (mature in 3 months or less)
The process is pretty simple, then:
- First, count up your cash on hand, including cash registers, petty cash, or other notes and coins you may be holding onto.
- Then, grab your bank account balances and add up any demand deposits.
- Finally, you’ll want to look at your short-term investments, those that have a maturity of three months or less, including treasury bills, commercial paper, short-term CDs, and money market funds.
- Then, you simply add all of those up to get your total cash and cash equivalents.
Cash vs cash equivalents
What separates cash from cash equivalents? If both are highly liquid, what exactly is the difference?
In business finance, cash refers to both the physical currency (notes and coins) your business has on hand, and any balances and deposits in accounts that are readily available for use.
Cash equivalents, on the other hand, are short-term, highly liquid investments that can be quickly converted into cash. The difference lies in the fact that cash equivalents must first be converted into cash.
As such, while they are highly liquid, they are less liquid than actual cash.
Beyond definitions, there are some important distinctions between cash and cash equivalents.
Cash can be used instantly, making it accessible for any kind of payment or transaction. Cash equivalents can take as long as three months to convert (if it takes longer than that, it is not considered a cash equivalent).
Moreover, cash carries virtually no risk, since it doesn't fluctuate with interest rates or market conditions in the same way that certain investments, even short-term ones, do.
Improving cash flow management
Getting on top of cash and cash equivalents is critical to improving cash flow management.
Knowing what kinds of liquid assets you have on hand to service debts and pay your short-term liabilities is a clearly important part of managing business cash flow.
Modern finance tools like BILL can provide even more insight into how your business is managing cash flow, with real-time reporting, future-focusing forecasting, and spend management functionality.
Discover BILL’s integrated platform today.
FAQ
How are cash and cash equivalents reported in a company's financial statements?
Where do you find cash and cash equivalents reported on your company’s financial statements?
You’ll see them reported as a single line item on the balance sheet, listed under current assets. This classification reflects the liquidity and availability of cash and cash equivalents to meet short-term financial obligations.
You can also look at the cash flow statement for a more detailed analysis of how cash is generated and spent over the previous financial period.
What does a negative cash and cash equivalents balance mean?
A negative cash and cash equivalents balance is typically not a good sign.
Common reasons for a negative cash and cash equivalents balance include:
- Overdrawn bank accounts
- Liquidity problems (an inability to pay suppliers, employees, and debts)
- Cash flow mismanagement (cash outflows are significantly higher that cash inflows)
- Over reliance on borrowed funds like credit facilities or short-term loans
- Cash flow timing issues (when there is a mismatch between when expenses are due and when revenue is received)
