Cash and Cash Equivalents Dynamics Simplified

Cash and cash equivalents are highly liquid assets that are readily convertible into known amounts of cash and are typically held by businesses and investors for short-term investment or liquidity purposes. They are recorded on a company’s balance sheet and are classified as current assets.

Cash

Definition

• Cash refers to physical currency such as banknotes and coins, as well as balances held in checking accounts and petty cash funds.
• It represents the most liquid form of money and is readily available for immediate transactions and payments.

Characteristics

• Tangible: Cash exists in physical form, including paper currency and coins.
• Immediate Availability: Cash can be used instantly to settle debts, make purchases, or withdraw from ATMs.
• Low Risk: Cash is considered a low-risk asset because it is not subject to market fluctuations or credit risk.

Cash Equivalents

Definition

• Cash equivalents are short-term investments that are highly liquid and have a maturity date, typically within three months or less from the date of purchase.
• They are considered as good as cash because they can be quickly converted into cash with minimal risk of loss in value.

Examples

• Treasury bills (T-bills)
• Commercial paper
• Money market funds
• Short-term government bonds
• Certificates of deposit (CDs) with a maturity of three months or less

Key Differences

• Liquidity: While both cash and cash equivalents are highly liquid, cash is the most liquid asset, as it includes physical currency and funds in checking accounts, readily available for immediate use. Cash equivalents, on the other hand, are short-term investments that can be quickly converted into cash.
• Risk: Cash equivalents are typically considered to have slightly more risk than cash because they are subject to market fluctuations and may have a slightly longer maturity period. However, they are still considered low-risk investments compared to other asset classes.
• Purpose: Both cash and cash equivalents serve as a source of liquidity for businesses and investors. They are used to meet short-term financial obligations, cover operating expenses, and take advantage of investment opportunities that may arise.