What are Cash and Cash Equivalents?

Every company registered in India must compile and publish its financial statements at the end of every financial year. The balance sheet is one of the many important financial statements that companies publish each year. It lists the various assets that the company owns and the liabilities that the company owes. 

Among the various categories of assets are cash and cash equivalents, which are often the most overlooked. However, as an investor, this particular category of asset can give you a plethora of useful insights into the company and its financial health. Continue reading to learn everything about cash and cash equivalents and what you can infer from them. 

What are Cash and Cash Equivalents?

Cash and cash equivalents are one of the many categories of assets a company can have. Here’s a more detailed overview of what these two entail. 

• Cash 

It includes cash that a company holds in its physical form, in bank accounts and as deposits.

• Cash Equivalents

Cash equivalents include a wide range of highly liquid assets with short-term maturities, meaning that they can be quickly converted into cash. Although cash equivalents do tend to fluctuate in value, the price changes are either very low or insignificant. Some of the different subcategories of cash equivalents include – 

• Negotiable Instruments

A negotiable instrument is a document that guarantees payment to the person specified in the instrument. Some examples of negotiable instruments include promissory notes, traveller’s cheques and bank cheques, among others. The specified person can convert the negotiable instrument to cash by presenting it either to the instrument’s issuer or to a bank. 

• Money Market Instruments 

Money market instruments are short-term debt instruments issued by companies or governmental organisations. Investors can either hold these instruments until maturity or liquidate them prematurely by trading them in an exchange. 

Some common examples of money market instruments are Commercial Papers (CPs), Treasury bills (T-bills) and Certificates of Deposit (CDs). Here’s a more detailed explanation of these three money market instrument examples. 

• Commercial paper is a debt instrument that companies issue with maturities ranging from 15 days to up to a year. 
• The Treasury bill is a debt instrument issued by the Reserve Bank of India with three different tenures – 91 days, 182 days and 364 days. 
• Certificates of deposit are also debt instruments with short-term maturities with tenures between 3 months and a year. 

What are Some Features of Cash Equivalents?

Cash equivalents have some unique characteristics that set them apart from other categories of assets. Let’s delve a little deeper into some of the key features that make them unique. 

• High Liquidity

One of the major features and advantages of cash equivalents is their ability to be quickly converted into cash. Market-linked cash equivalents like T-bills can be liquidated by trading them on an exchange, whereas other cash equivalents like cheques and promissory notes can be converted to cash by presenting them to a bank or the issuer respectively. 

Also Read More About Liquidity Ratio

• Definite Amount 

When you liquidate cash equivalents, you know the exact amount that you’re likely to realise from the sale. Unlike other assets, there’s hardly any ambiguity involved. 

• Short Tenure

Another characteristic of cash equivalents is their short tenures. Most instruments have very short maturities of 3 months or less. However, there are a few cash equivalents with tenures ranging up to a year. 

• Less Risk 

Due to their nature and short maturities, cash equivalents are often considered to be very low-risk investment options. The value of the assets often doesn’t undergo any significant changes throughout their tenure. In the case of certain cash equivalents like T-bills and certificates of deposit, the risk of default is very low. 

• Non-Equity Investments 

Cash equivalents don’t feature any equity component. However, companies may categorise preference share investments under cash equivalents if the investment was made very close to the shares’ maturity or redemption date. 

What does a Cash Flow Statement Indicate about Cash and Cash Equivalents?

The cash flow statement is another one of the most important financial statements of a company. It provides you with a summary of the various cash inflows and outflows within a company during a specific period of time. 

Analysing the cash flow statement can also give you key insights into how a company has utilised or managed its cash and cash equivalents. The statement provides cash inflow and outflow data over three major heads – operating activities, investing activities and financing activities. 

Additionally, you can also get to know whether a company has a positive net cash flow or a negative net cash flow for a specific period. A positive net cash flow suggests greater cash inflows compared to outflows, whereas a negative net cash flow suggests the contrary. The information you gather from a company’s cash flow statement can be used to gain insights into a company’s financial health and the management’s prowess at managing the various obligations.  

Conclusion

As you can see, cash and cash equivalents are some of the most important components that you, as an investor, need to look into when fundamentally analysing a company. Merely analysing the changes in cash and cash equivalents and the cash flow statements of different financial years can give you a comprehensive overview of a company’s financial health and liquidity situation.

A company should ideally have enough cash and cash equivalents to cover all or most of its current (short-term) liabilities. Possessing too few cash reserves indicates poor liquidity and the inability of the company to tide over its debt obligations, whereas extremely high levels of cash and equivalent reserves indicate inefficient financial management. 

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