Cash Equivalents

Cash equivalents are investments securities that are for short-term investing, and they have high credit quality and are highly liquid.

Cash equivalents, also known as "cash and equivalents," are one of the three main asset classes, along with stocks and bonds. These securities have a low-risk, low-return profile and include U.S. government Treasury bills, bank certificates of deposit, bankers' acceptances, corporate commercial paper and other money market instruments.

Cash equivalents also serve as one of the most important health indicators of a company’s financial system. Analysts can also estimate whether it is good to invest in a particular company through its ability to generate cash and cash equivalents, since it reflects how a company is able to pay its bills throughout a short period of time. Companies with large amounts of cash and cash equivalents are primary targets of bigger companies who are planning to acquire smaller companies.

There are five types of cash equivalents: Treasury bills, commercial paper, marketable securities, money market funds and short-term government bonds.

Treasury bills are commonly referred to as “T-bills." These are securities issued by the United States Department of Treasury. When issued to companies, companies essentially lend the government money. T-bills are provided in denominations of $1,000 to $5 million. They do not pay interest but are provided at a discounted price. The yield of T-bills is the difference between the price of purchase and the value of redemption.

Commercial papers is used by big companies to receive funds to answer short-term debt obligations like a corporations’ payroll. It is supported by issuing banks or companies that promise to fulfill and pay the face amount on the designated maturity date provided on the note.

Marketable securities are financial assets and instruments that can easily be converted into cash and are therefore very liquid. Marketable securities are liquid because maturities tend to happen within one year or less and the rates at which these may be traded have minimal effect on prices.

Money market funds are like checking accounts that pay higher interest rates provided by deposited money. Money market funds provide an efficient and effective tool for companies and organizations to manage their money since they tend to be more stable compared to other types of funds like mutual funds. Its share price is always the same and is constantly at $1 per share.

Short-term government bonds are provided by governments to fund government projects. These are issued using the country’s domestic currency. Investors take a look at political risks, interest rate risks and inflation when investing in government bonds.

There are several reasons a company might store their capital in cash equivalents. One, they are part of the company's net working capital (current assets minus current liabilities), which it uses to buy inventory, cover operating expenses and make other purchases. They also provide a buffer for the company to quickly convert to cash if times become lean. Finally, they may be used to finance an acquisition. Companies often store money in these readily convertible securities in order to gain interest while they wait to use it.