What Is Cash Equivilance – Explaine Like I’m Five

Written by Olly Milicich in Uncategorized

What Are Cash Equivalents?

Cash equivalents are special types of investments that can be quickly turned into cash. They are very safe and don’t lose value easily. Think of them like having money you can easily access, such as a savings account, but these investments earn a little more money than just leaving cash in your pocket. For something to be considered a cash equivalent, it must meet two important rules:

  • It has to be easy to convert into cash.
  • Its value shouldn’t change much, even when interest rates go up or down.

Examples of Cash Equivalents

There are many different types of cash equivalents that businesses or individuals might use. Some of the most common ones include:

  • Treasury Bills (T-Bills): These are like IOUs from the government that promise to pay you back in 90 days or less.
  • Commercial Paper: Large companies issue this short-term debt, meaning they borrow money and agree to pay it back, often within 30 to 270 days.
  • Money Market Funds: These funds invest in very safe, short-term financial products and allow companies to access their money quickly.
  • Certificates of Deposit (CDs): A type of bank savings account where your money is locked for a short time, but you can take it out early without a penalty if it’s a short-term CD.

Liquidity and Stability

Cash equivalents are prized because of their liquidity and stability. Liquidity means that these investments can easily and quickly turn into cash without losing any value.

Stability means they don’t change much in price, making them a safe place for companies to store their money if they need it soon.

For example, businesses often use cash equivalents to pay for everyday things like salaries or bills because they know the money will be there when they need it.

Exclusions from Cash Equivalents

Not every short-term asset can be classified as a cash equivalent. Certain items are excluded:

  • Stocks and Long-Term Bonds: Even though these can sometimes be sold quickly, their prices can go up or down, which makes them risky.
  • Inventory or Accounts Receivable: These aren’t considered cash equivalents because they aren’t guaranteed to turn into cash quickly.
  • Restricted Cash: This is money that a company can’t use freely, like money set aside for a specific purpose, so it’s not included.

Practical Applications

Cash equivalents are super helpful for companies because they give them access to money when they need it. Businesses can use cash equivalents to pay for short-term needs, like payroll or unexpected expenses, without worrying about losing value. Companies also look at financial ratios like the current ratio or quick ratio to check their ability to pay off short-term debts. Cash equivalents are an important part of these calculations.

Financial Reporting

When a company shows its financial health on a balance sheet, cash and cash equivalents are listed together under current assets. This helps people understand how much money the company has on hand or can quickly turn into cash. Seeing cash equivalents on the balance sheet can give investors and analysts confidence in the company’s ability to manage its short-term finances.

Regulatory and Accounting Standards

Both U.S. GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards) have strict rules about what can be counted as a cash equivalent. These rules make sure that companies classify their assets the same way, ensuring everyone understands exactly what’s being reported. This consistency helps investors compare different companies’ financial health.

Risks and Limitations

Even though cash equivalents are low-risk, they aren’t completely free from issues. For example, if inflation goes up or government policies change, the value of some cash equivalents, like government bonds, could be affected. Companies need to find a balance between holding too much cash (which doesn’t grow the business) and holding too little (which might leave them without enough money to cover sudden expenses).

TL:DR

Cash equivalents are short-term, low-risk investments that can be easily converted into cash, like treasury bills or money market funds. Businesses use them to manage immediate financial needs while keeping funds safe and accessible. They’re reported as part of a company’s current assets on balance sheets.

Reference Videos

https://www.youtube.com/watch?v=4Pxr_ZoZ050
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