Advantages & Disadvantages of Cash Equivalents

A cash equivalent is an investment security or current asset that an individual or company can quickly convert to cash. Examples of cash equivalents include bank accounts and marketable securities, such as:

• Certificates of deposit
• Checking and savings accounts
• U.S. government Treasury bills (T-bills)
• Short-term government bonds
• Money market accounts
• Checks
• Money orders
• Banker's acceptances
• Commercial paper

Cash equivalents have their disadvantages but are still used as highly liquid investments for the advantages they offer.

By definition, a cash equivalent is any asset you can quickly convert to cash. Cash equivalents reach maturity in a shorter period than other investments, usually in ‌three months‌ or less. This is advantageous from the business's perspective because a company can use the cash equivalent to meet short-term needs.

Should a company want to cash out or 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 the opportunity to invest sometimes passes very quickly.

Sometimes, a business might have funds 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 to store the money until the business decides what to do with it.

The short-term investment of cash equivalents helps to provide cash flow for individuals and businesses. When interest rates soar and inflation is on the rise, cash usually outperforms other asset classes, like stocks and bonds. This can help to provide a balance in volatile times.

Many cash equivalents, such as checking accounts, bear interest. However, the interest rates tend to be low. The Federal Deposit Insurance Corporation lists the national average interest rate for many cash equivalents.

For example, the national average was ‌0.3 percent‌ APY for savings and ‌0.05 percent‌ for checking accounts in December 2022. Certificates of deposit (CDs) for the same period ranged from ‌0.13 to 1.09 percent‌ depending on term length. In contrast, the composite rate for series I savings bonds issued by the U.S. Treasury between November 2022 and April 2023 is ‌6.89 percent‌.

The low interest rate makes sense given that cash equivalents involve low risk, but it also means that they will struggle to keep up with inflation. For this reason, companies often avoid investing significant amounts in cash equivalents and instead invest just enough to cover estimated short-term needs, putting any additional monies into investment options with better rates of return.

Although cash equivalents allow a company to address short-term needs, it can be challenging to determine precisely what those short-term needs will be. Sometimes, companies find that the amount set aside in cash equivalents far exceeds what is 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 the current market might prevent this from happening.

Fixed-income securities, stocks, equities and investment funds are not considered cash equivalents. However, some bonds, debt securities, mutual funds, money market funds and exchange-traded funds (ETFs) are liquid assets and can be converted to cash in a short period of time.

Depending on the particular financial instrument, the interest rate may bring the investor a higher return, whether through resale or by holding on to it to the maturity date.

A company's cash and cash equivalents are found on a financial statement in the current assets section of the balance sheet. They are part of a company's working capital, which is determined by taking total current assets minus current liabilities.

Portfolio composition should be discussed with a financial adviser and may vary according to an individual's financial goals, current situation and risk tolerance. Many advisers consider cash and cash equivalents as a component of a diversified portfolio, but there is no one-fits-all percentage. U.S. Bancorp suggests between ‌2 and 10 percent‌, while Charles Schwab recommends ‌5 to 30 percent‌ depending on age and investment style.

A business's accounts receivable isn't considered cash or a cash equivalent. It's a current asset because it represents an asset that can be turned into cash in less than a year.

PwC explains that the generally accepted accounting principles (GAAP) definition of cash equivalents includes those liquid investments that are short term and readily convertible to known amounts of cash and have little risk of their value being affected by a change in interest rates.

Similarly, inventory is a current asset that is not considered a cash equivalent because it isn't readily convertible and requires valuation before it can be turned into cash.