A cash equivalent is an asset that a person or company can quickly convert to cash. These include certificates of deposit, checking and savings accounts, Treasury bills, short-term money market accounts, bonds, checks and money orders. These types of assets have disadvantages, but companies still use them for the advantages they offer.
Maturity and Ease of Conversion
By definition, a cash equivalent is any asset you can convert to cash quickly. Cash equivalents reach maturity in a shorter period than other forms of investments, usually in three months or less. This is advantageous from the business perspective because a company can use the cash equivalent to meet whatever short-term needs might arise. Should a company want to invest the funds elsewhere, it is easy for authorized personnel to tap the cash equivalent and redistribute company money. This is a significant consideration, given that sometimes the opportunity to invest passes very quickly.
In some instances, a business might have funds it has not yet allocated to a specific item. People consider cash equivalents very low-risk investments because of their quick maturity and ease of conversion. They maintain their dollar value well. This means a company can invest unallocated funds into one or more cash equivalents as a way to store the money until the business decides what to do with it.
Many cash equivalents such as checking accounts bear interest. However, the interest rate usually is low. The low rate of interest makes sense given that cash equivalents involve low risk, but it means that cash equivalents struggle to keep up with inflation. For this reason, companies often avoid investing great amounts in cash equivalents. Instead, they invest enough in cash equivalents to cover estimated short-term needs, and they put any additional monies into investment options that have better rates of return.
Loss of Revenue
Although cash equivalents allow a company to address short-term needs, it can be difficult to determine exactly what those short-term needs will be. Sometimes companies find that the amount set aside in cash equivalents far exceeds what was necessary to cover immediate liabilities, depending on market conditions. When this happens, the company loses out on potential revenue, as money that could have produced a higher return elsewhere was committed to the cash equivalent account. Careful analysis of the company's budget and current market might prevent this from happening.
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