Cash and Cash Equivalents

Cash and cash equivalents refer to the sum of a company’s cash on hand, demand deposits, and short-term highly liquid investments.

The following equation shows the composition of cash and cash equivalents:

Cash and Cash Equivalents = Cash on Hand + Demand Deposits + Short-term Investments

Cash refers to cash on hand and demand deposits. Demand deposits are the amounts held in bank accounts which can be withdrawn right away.

Cash equivalents are short-term highly liquid investments which can be readily converted to known amounts of cash and which carry an insignificant amount of risk of change in value. An investment is cash equivalent only if it is primarily acquired with the objective of cash management. They almost always have a very short maturity, say up to three months, and rarely include equity investments.

Only under IFRS, bank overdrafts may sometimes be included in (subtracted from) cash and cash equivalents if they are integral to a company’s cash management activities.

Cash and cash equivalents and statement of cash flows

The statement of cash flows prepared by a company reconciles its cash and cash equivalents balance at the start of a period with their balance at the end of the period. The company may either present cash and cash equivalents as a single line item on the statement of financial position (in which case a breakup is shown in the notes) or separately as short-term investments and cash.

As cash equivalents are considered part of cash, any conversion from cash equivalents to cash at bank or from cash at bank to cash on hand is not reflected in the statement of cash flows as a cash inflow or outflow. The statement of cash flows also shows the impact of movement in foreign exchange rate on cash and cash equivalents held.

The cash and cash equivalents balance impacts a company’s cash ratio, the ratio of cash to current liabilities; and current ratio, the ratio of current assets to current liabilities. A higher cash ratio shows that the company is expected not to face any difficulty in paying its very short-term liabilities.

Examples

  1. A $20 million term deposit by a company for 1 month would qualify as a cash equivalent because the maturity value is known and there is very low risk of change in value.
  2. A saving deposit for 6 month would not qualify as a cash equivalent particularly if the interest rate environment is volatile. This is because the duration involved and the interest rate situation may cause the value of the investment to fluctuate between today and the maturity date.
  3. A company made a large payment from one of its bank accounts which is not the entity’s primary bank account. This resulted in a negative balance in the bank account but the company informed the bank that it would replenish the funds within a week. The management does not expect the balance to turn negative again any time in near future. This overdraft would most-likely not meet the definition of cash equivalents.
  4. An investment today in preferred stock which is due to mature within 1 month is a cash equivalent because the maturity value is known and there is low risk of change in value during a week’s time.

by Obaidullah Jan, ACA, CFA and last modified on
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