A cash equivalent is a short-term, highly liquid investment that can be converted into a known amount of cash at short notice and carries only an insignificant risk of changing in value. Typical examples are Treasury bills, high-grade commercial paper and shares in a money market fund. Companies report them together with cash in a single balance-sheet line, "cash and cash equivalents".
The term comes from accounting standards rather than from investment practice. Under IFRS it is defined in IAS 7, Statement of Cash Flows, and under US GAAP in ASC 230. Both standards use the same core test and the same rule of thumb: an investment normally qualifies only if it has a maturity of three months or less from the date it was acquired. Longer or riskier holdings are reported as a short-term investment instead.
Cash equivalent in plain terms
Picture the money a household keeps for emergencies. Some is notes in a drawer. Some sits in a savings pot that pays a little interest but can be withdrawn next week for exactly the amount put in. That second pot is not cash, but for planning purposes it might as well be.
A company's cash equivalents are that second pot. They earn a small return instead of sitting idle, but the company can count on getting a known amount back almost immediately. Something whose price could swing, such as shares in another company, does not qualify, even if it could be sold within a day, because nobody knows what it will be worth next week.
The accounting definition
IAS 7 defines cash equivalents as "short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value". It adds that they are held to meet short-term cash commitments rather than for investment purposes. ASC 230 uses very similar wording and adds that the investment must be so near its maturity that changes in interest rates pose an insignificant risk to its value.
The three-month test is applied from the date the holder bought the instrument, not from its original issue date. A two-year Treasury note bought with two months left to run can be a cash equivalent; the same note bought three years earlier does not become one simply because it is now close to maturity. Equity investments are normally excluded because their value is not fixed.
What usually qualifies and what does not
- Usually included. Treasury bills and other Treasury securities bought within three months of maturity, short-dated commercial paper, bank deposits and certificates of deposit with original terms of three months or less, overnight repurchase agreements and most money market fund shares.
- Usually excluded. Shares, longer-dated bonds, fixed deposits with terms longer than three months, and cash that is legally restricted, for example held in escrow or pledged as collateral, which is normally shown separately.
- Bank overdrafts. Under IAS 7, overdrafts repayable on demand that form part of a company's cash management may be netted within cash and cash equivalents; under US GAAP they are generally shown as liabilities.
Each company must disclose its policy for deciding what it treats as a cash equivalent, and auditors test that the policy is applied consistently. Money market funds deserve care: the US reforms of 2014 introduced floating share prices for institutional prime funds, and the SEC said at the time that, under normal circumstances, such funds could still be treated as cash equivalents.
Why cash equivalents matter
Cash and cash equivalents are the starting and ending figures of the cash flow statement, so the definition directly shapes reported cash flow. Analysts use the figure to judge liquidity, for example in the cash ratio (cash and cash equivalents divided by current liabilities), and to calculate net debt. A company with 50 million of borrowings and 20 million of cash and cash equivalents has net debt of 30 million.
For corporate treasurers, holding cash equivalents is part of cash management: the goal is to earn something on spare money without risking the ability to pay staff, suppliers and lenders. The trade-off is that cash equivalents still carry some credit risk and, in a crisis, some liquidity risk. In September 2008 a large US money market fund "broke the buck", showing that even instruments treated as near-cash can lose value under stress. For investment funds, a large cash-equivalent position also dilutes returns in rising markets, which is why fund fact sheets report the cash weighting separately.
Holding cash equivalents is the conservative end of asset allocation and part of wider treasury management.