Ultimate Guide to Cash and Cash Equivalents

If you’re an avid follower of the markets, you’ve probably heard about cash and cash equivalents (CCE). You may have even heard about Apple’s legendary multi-billion dollar cash hoard.

If you’re a bit of a beginner and most of that last sentence created more questions than answers, we’re going to discuss cash and cash equivalents.

Next time it comes up, you’ll know why it’s important and how it can affect not only a company’s books but also your investment decisions.

What Is Cash?

Cash is extremely straightforward, even in this context.

While few companies have stacks of cash lying around, some do keep vaults where cash is held.

In most cases, cash would be represented much in the same way that you would store cash: bank accounts.

You might know these as your checking, current, or savings accounts, depending on where you are in the world.

What About Cash Equivalents?

This is the part of the phrase that you may need a bit of clarification on.

Cash equivalents are assets and instruments that can either:

• be treated very similarly to cash, or
• they can easily be turned into cash very easily.

Here are the general requirements for an asset to be considered a cash equivalent:

• The maturity is less than 3 months (90 days)
• It must be easily exchanged for cash, and
• It must NOT be reserved for a specific/explicit purpose (i.e., it mustn’t be “restricted cash”)

The reasons for opting for cash equivalents rather than pure cash is that businesses can almost always achieve a better interest rate by investing in cash equivalents.

While these will almost never achieve inflation-beating returns, reducing inflation losses as much as possible is one of the goals of a good chief finance officer (CFO).

And cash equivalents assist in that endeavor.

What Types of Cash Equivalents Are There?

The actual types of cash equivalents vary depending on which country the firm operates in. That being said, here are 3 of the most common cash equivalents:

• Certificates of Deposit (CD)
• Commercial Paper
• Money Market Securities

Let’s now consider each of these individually.

Certificates of deposit (CD)

Most investors have held some form of a CD at some point along their journey. They’re called “Fixed Deposits” in some countries (e.g., India).

Certificates of Deposit are essentially savings accounts with the condition that money may not be withdrawn for a specified period of time.

In exchange for locking the funds for a specific period of time, savers earn higher rates of return in the form of higher interest rates.

Essentially, banks need money in order to lend it elsewhere. So they will pay a slightly higher rate for the privilege of guaranteed cash on hand.

Companies with huge cash figures may opt for these because the money may not be needed anytime soon. And it can accrue relatively good interest for a safe investment.

Crucially, for a Certificate of Deposit to be considered “cash equivalent”, it will typically need to have a lock-in period of no more than 90 days.

Exceptions can and do apply, but a 90 day window is a pretty decent rule of thumb.

Commercial Paper

Commercial paper is a type of unsecured debt issued by companies in order to fund short-term operations.

Companies receive money today and promise to pay a higher lump-sum payment in the near future.

You can actually think of commercial paper as a simplified Zero Coupon Bond in that there’s just one single lump-sum payment (“par value”) in the future. And that’s in exchange for money received today.

Unlike Zero Coupon Bonds, which typically have maturities greater than 1 year…

Commercial Papers will tend to have maturities of between 90 and 270 days for the most part.

Money Market Securities

Money market securities are essentially short-term securities issued by governments and large corporations. The ratings of these securities (like bonds) is typically strong.

The low-risk nature of these securities, coupled with the fact that their maturity dates are usually short-term, makes them acceptable “equivalents” to cash.

The interest rate earned from these securities will also help offset the effects of inflation and the time value of money.

What Does CCE Mean For Corporations?

In the corporate world, companies use cash and cash equivalents to fund:

• their working capital needs, and
• their long-term financing and investment requirements

Funding working capital needs is largely akin to funding operational requirements.

Fundamentally, companies need to make the best use of the cash and cash equivalents they have available to them.

Hoarding cash and not investing it will give investors grounds to ask the company to either:

• pay out dividends, or
• buyback shares.

Investing the cash in negative NPV projects is also not constructive.

Like with individuals in a sense, companies need to optimally allocate their cash and cash equivalents to earn the highest “bang” for their “buck”.

What Does CCE Mean for Investors?

Cash and cash equivalents gives analysts and investors a way to decide whether a company will be able to cover its short-term liabilities.

One could even argue that it signals the strength of a firm’s ability to meet its long-term debt obligations.

It’s important to note that cash and cash equivalents is a current-asset (not a non-current asset).

And since it shows up in the Balance Sheet (which represents a firm’s assets, liabilities, and equity at a specific point in time)…

It’s possible for a company to look like it cannot afford its long-term debt obligations when in reality, it can.

Notwithstanding that, it’s fair to say that generally speaking…

Firms with positive working capital are better bets vis-a-vis those with negative working capital.

Is Excessive Cash and Cash Equivalents a Good Thing?

That depends on the company. Large corporations must keep cash on hand because short term expenditures can be staggeringly high.

Alternatively, if the company feels that there is some kind of change coming in the market…

They may start divesting from risky assets and hoard cash in order to adopt a more defensive posture.

As a general rule of thumb, holding cash and cash equivalents is okay as long as the company can deliver a return that is greater than what shareholders could’ve earned if they had the cash and cash equivalents themselves (instead of the company).

Remember that companies are ultimately owned by shareholders.

And they exist to maximise the value of the firm.

If the company doesn’t earn a high enough return, that’s a loss for shareholders, and moves away from value maximisation.

Thus, if a company isn’t able to deliver a rate of return that’s greater than the cost of capital, it should simply return the funds to shareholders.

Where is Cash and Cash Equivalents Found on a Financial Statement?

Cash and cash equivalents is found in 2 financial statements, including:

• the Balance Sheet (aka Statement of Financial Position), and
• the Cash flow Statement (aka Statement of Cash flows)

In the Balance Sheet, Cash and Cash Equivalents is placed under Current Assets.

In the Cash flow Statement, CCE is reported at the very end of the statement.

Generally speaking, both figures must be equal. In some rare instances, accounting conventions can result in differences between the two figures.

Restricted Cash vs Unrestricted Cash

It’s important to note that CCE does not include restricted cash.

Restricted cash will show up inside the notes to financial statements as opposed to on the balance sheet itself.

Restricted cash is set aside for a specific purpose by a company and is not available to spend “on the fly” or for any reason.

It’s a bit like if you kept money in a savings account completely separate from any of our other accounts. And that money is specifically for the purpose of buying a house, for example.

It’s still technically cash, but we’ve taken that out of our calculations of money we can freely use so that we can buy that house later on.

Companies treat cash in similar ways.

Wrapping Up

Companies need cash just like you and I. But they keep their cash in a way that requires it be described as “cash and cash equivalents.”

Cash is straightforward, representing easily accessible money in a bank account.

Cash equivalents can be a tad bit more complicated. But they’re not “rocket science” by any means.

Essentially, these assets need to have very short-term maturities, be very easily converted into cash, and not be earmarked for a specific purpose within the company.

Hopefully, this makes sense. If any part isn’t quite clear, please re-read the article.

That’s a wrap from us for this one though. Have a great time learning!