Definition

Cash equivalent refers to highly liquid assets readily convertible into cash with minimal risk of loss.

Description

Cash equivalents are short-term, highly liquid assets that can be converted into known amounts of cash within three months of their initial maturity. These assets are regarded as equivalent to cash because they may be changed into cash quickly and readily with little risk of loss of value.

Critical characteristics of cash equivalents include:

1. High Liquidity: Cash equivalents are highly liquid assets that can be changed into cash on short notice with minimal transaction expenses.
2. Low Risk: Cash equivalents are classified as low-risk assets since they are often issued by highly creditworthy entities, such as governments or financial institutions, and have short maturities, reducing the danger of default.
3. Original Maturity of Three Months or Less: Cash equivalents must have an original maturity of three months or less from the purchase date. This ensures they may be easily changed into cash, giving the investor greater freedom.
4. Stable Value: Cash equivalents are generally stable in value and are not subject to significant fluctuations in price, making them suitable for preserving capital and maintaining liquidity.
   
    

Importance of Cash Equivalent for startups

The importance of cash equivalents for startups:

• Security and Liquidity:  Cash equivalents provide a secure sanctuary for startup funding. They are more secure than keeping cash and can readily change into money when required, providing critical liquidity. This is critical for companies that face unforeseen costs or must exploit time-sensitive possibilities.
• Preserve Capital for Core Needs:  Startups avoid selling long-term investments (such as stocks) prematurely because they have easily convertible cash equivalents. Long-term investments may yield more significant returns but may be less liquid or subject to early withdrawal penalties. Cash equivalents act as a buffer, allowing companies to retain funds for critical business needs.
• Strategic Investment Opportunities:  Cash equivalents enable startups to respond swiftly when attractive financing possibilities materialise. A pool of immediately available capital allows them to invest in new initiatives, collaborations, or marketing efforts without liquidating existing assets.
• Negotiating Leverage:  Maintaining a good balance of cash equivalents improves a startup's negotiation position. Access to cash can help you negotiate better payment terms or discounts when dealing with merchants or suppliers.
• Investor Confidence:  Investors often value startups that demonstrate financial responsibility and preparedness. A strong showing of cash equivalents can improve investor confidence by showcasing the startup's ability to manage cash flow effectively and be ready for unforeseen circumstances.

How to calculate Cash Equivalent?
 

Calculating cash equivalents involves identifying and summing up the value of a company's short-term, highly liquid assets easy to convert into cash, typically within 90 days or less, with minimal risk of price fluctuation. 

Here's a step-by-step approach:

Step 1: Find the Balance Sheet:  Cash equivalents are listed on the balance sheet. Your financial statement provides a snapshot of a company's financial position at a specific time. Look for the current assets section, which details assets expected to be converted into cash within a year.

Step 2: Identify Cash Equivalents:  Not all current assets qualify as cash equivalents. Look for line items that specifically mention terms like:

* Cash equivalents

* Marketable securities

* Short-term investments

* Money market funds

* Treasury bills

Step 3: Exclude Specific Items: Some marketable securities might be listed under current assets but aren't necessarily cash equivalents. Generally, exclude:

* Stocks (due to potential price fluctuations)

* Bonds with maturities exceeding 90 days

Step 4: Add Up the Values: Once you've identified the relevant line items, simply add their values together. This total sum represents the company's cash equivalents.

Here's an example:

Imagine a company's balance sheet lists the following current asset items:

• Cash: Rs.10,000
• Marketable securities: Rs.20,000 (includes stocks and Treasury bills)
• Money market funds: Rs.15,000
• Accounts receivable: Rs. 25,000 (not a cash equivalent)

To calculate cash equivalents, you would add:

• Cash: Rs.10,000
• Money market funds: Rs. 15,000
• Treasury bills (assuming maturity within 90 days): (Portion of) Rs.20,000

Trends that can affect calculation of Cash Equivalent

Some of the trends that can affect calculation of cash equivalent:

• Rise of Alternative Investments:  The increasing popularity of alternative investment vehicles such as venture capital funds or private debt may blur the distinction between traditional cash equivalents and other short-term investments. 
• Some of these choices may provide better potential returns but have slightly less liquidity than money market funds or short-term government bonds. Companies must carefully assess the liquidity profile of these alternative investments before incorporating them as cash equivalents.
• Technological Advancements: The emergence of new financial instruments and investment platforms made possible by technology might make it difficult to categorise them for cash equivalent computations. 
• For example, certain online platforms may provide quick access to a part of invested funds, raising difficulties about whether they qualify as cash equivalents due to their ease of conversion. Companies and accounting professionals must be adaptable and interpret the applicable rules in the context of these new financial products.
•  Increased Focus on Risk Management:  With a greater emphasis on risk management, businesses may hold a more diverse pool of financial equivalents. 
• This may comprise a mix of assets with slightly different risk-reward profiles. While stressing safety, businesses may choose to invest a portion of their cash equivalents in assets that yield somewhat greater returns than typical options, even if it means foregoing a small amount of immediate liquidity. This might complicate the categorization of cash equivalents, necessitating careful assessment of liquidity and risk.

Example

As an example of a cash equivalent, you can consider "Vanguard Prime Money Market Fund." This is a mutual fund offered by Vanguard that invests in short-term, highly liquid securities such as treasury bills and commercial paper, making it a cash equivalent for investors seeking stability and liquidity.

FAQ

What are cash equivalents?

Cash equivalents are short-term, highly liquid assets with maturities of three months or less.

What are examples of cash equivalents?

Examples of cash equivalents include treasury bills, money market funds, commercial paper, and short-term government bonds.

What do you mean by cash and cash equivalents?

Cash and cash equivalents are assets that can be easily converted into known sums of cash and have a low risk of value fluctuations. This comprises real currency, bank deposits, and short-term, highly liquid assets with original maturities of three months or less. These assets are critical to a company's liquidity and financial health, as they allow it to meet short-term obligations while being operationally flexible.