Definition — what cash equivalents are
Cash equivalents are very short-term, high-quality investments that a company or investor can convert into cash quickly and with minimal risk of price loss. On a company’s balance sheet they are typically grouped with cash in the Current Assets section. These instruments sit between literal cash (notes, coins, demand deposits) and longer-term investments such as bonds or equities.
Key points
– Purpose: provide liquidity for near-term needs while earning a small return.
– Risk/return: low risk, low expected return.
– Liquidity: actively traded or otherwise readily convertible to cash.
– Typical maturities: very short (often measured in days to months; many instruments have maturities up to a year).
Common types of cash equivalents
– Treasury bills (T-bills): short-term U.S. government securities sold at a discount and redeemed at face value upon maturity.
– Commercial paper: unsecured short-term promissory notes issued by corporations to fund immediate liabilities.
– Marketable securities: liquid assets traded on public markets; when very short-term and high quality they act like cash equivalents.
– Money market funds: mutual funds that invest in cash and cash-equivalent instruments; designed to preserve principal and provide liquidity.
– Short-term government bonds: actively traded government debt with short remaining maturities that some treat as cash equivalents.
– Certificates of deposit (CDs): bank time deposits with fixed terms; insured at federally backed banks up to applicable limits.
– Bankers’ acceptances: time drafts guaranteed by a bank, often used in trade finance and treated like cash because of the bank’s guarantee.
Why companies and individuals use cash equivalents
– Meet short-term obligations (payroll, suppliers, taxes).
– Hold an emergency reserve without foregoing all returns.
– Keep funds ready for planned projects or acquisitions.
– Satisfy debt covenant requirements that mandate minimum liquid assets.
How cash equivalents differ from other current assets
Some short-term assets are not cash equivalents if they cannot be freely converted to cash (for example, assets subject to withdrawal restrictions or contractual lockups). Cash equivalents specifically imply convertibility with minimal delay and minimal loss of value.
Features to expect in a true cash equivalent
– Very short time to maturity.
– High credit quality (low default risk).
– Active secondary market or explicit contractual convertibility.
– Minimal price volatility over the holding period.
Advantages and disadvantages
Advantages
– Preserves principal while earning modest returns.
– Maintains ready liquidity to meet unexpected needs.
– Usually lower volatility than stocks or longer-term bonds.
Disadvantages
– Low returns compared with longer-term or higher-risk investments.
– May not keep up with inflation over time.
– Some instruments carry purchase minimums or early-withdrawal penalties (e.g., CDs).
Short checklist for evaluating whether an asset is a cash equivalent
– Maturity: Is the remaining life very short (days to a few months)?
– Liquidity: Can it be sold or redeemed quickly at little/no loss?
– Credit quality: Does a high-quality issuer or guarantee back it?
– Market: Is there a reliable secondary market or an explicit redemption mechanism?
– Restrictions: Are there any contractual or regulatory restrictions that prevent conversion to cash?
Small worked example — T-bill holding-period return and simple annualization
Scenario: You buy a 90-day Treasury bill for $99.50 and it redeems at $100 at maturity.
– Holding-period return (HPR) = (Redemption price − Purchase price) / Purchase price
= (100.00 − 99.50) / 99.50 = 0.005025 → 0.5025% for 90 days.