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A Complete Guide on Cash and Cash Equivalents

10 Mins 23 Jun 2023 0 COMMENT

All of us are familiar with the concept of cash as currency. Just like us, companies also use cash to run their operations. However, companies use cash in various ways, including liquid cash, coins, currency stored in bank accounts, notes, etc. Apart from cash in its traditional sense, companies also rely on the concept of cash equivalents. Cash equivalents are assets that can be immediately converted into cash. Continue reading to learn more about cash and cash equivalents (CCE) and how they are used by companies.

What are Cash and Cash Equivalents?

In India, we follow the system known as Ind-AS or Indian Accounting Standards. As per this system, cash and cash equivalents are defined in the following way:

Cash is defined as “cash on hand and demand deposits” whereas cash equivalents are defined 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.”

To help you understand the definition a bit better, you can consider these examples of cash equivalents:

Bank Cheques:

Bank cheques are a type of negotiable instrument issued by a bank on behalf of its customer. They are widely used in transactions such as large payments, purchases, and settlements. Bank cheques are guaranteed by the bank, which makes them a reliable form of payment.

Money Market Instruments:

In India, you can use three types of money market instruments:

  1. Commercial papers: This is a short-term debt instrument that a company will issue to raise money from the market for a short period of time, ranging from 15 days to one year.
  2. Treasury Bills: These are short-term borrowing instruments that have a maturity period of less than a year and are issued by the Reserve Bank of India (RBI) on behalf of the Government of India.
  3. Certificates of Deposit: Again, these are also short-term borrowing instruments that are issued by a bank. The tenure spans from three months to one year.

Traveller’s Cheques:

Traveller’s cheques are cheques that allow you to pay across currencies in foreign countries.

What are the Features of Cash Equivalents?

Here are some of the salient features of cash equivalents:

Convertible to Cash:

Cash equivalents are designed to meet the short-term requirements of a business. Thus, they are not used as long-term investment options. This means that are easily convertible to cash to facilitate easy use.

Convertible to Amount:

Apart from being convertible to cash, cash equivalents are convertible to specific amounts. Thus, either the price needs to be pre-determined or the market price should not be subject to various fluctuations.

Low Risk:

Since cash equivalents are short-term and not subject to too many market fluctuations, they are considered to be low risk.

Not Equity:

Most equity instruments are not considered to be cash equivalents. One of the few exceptions is preference shares since they have a short maturity period and a specific redemption date.

What is a Cash Flow Statement?

To understand the true meaning of cash and cash equivalents, you have to learn more about cash flow statements. All registered companies in India are mandated to prepare a cash flow statement that outlines how a company uses its cash. Such a statement tends to give us a clear picture of the inflow and outflows of cash across the company. This stands true regardless of the nature of the company or what cash looks like in that context.

A cash flow statement must be considered in tandem with other financial metrics if you want to get a good idea of how the company is using cash and where it stands when it comes to adapting to changing circumstances. Cash flow statements also give a fair idea of how the company is faring in terms of liquidity and what forms it is keeping its assets and cash in.

Basically, companies use cash to handle largely similar heads such as running operations, paying off debt, investments, paying off dividends, handing out salaries, etc. Thus, it is essential to analyse a company’s cash flow statement to understand how it is managing cash and its affairs to get a grip on its financial standing.

Why are Cash and Cash Equivalents Important?

Now that you know what cash and cash equivalents are, it is crucial to understand why they are so important. CCE is an important metric because cash and cash equivalents form a substantial portion of any company’s plan. Companies with higher CCE tend to find it easier to get through hard times than those in a cash crunch. On the other hand, it also helps you ensure that companies are not sitting with idle cash and cash equivalents and are putting them to good use with the aim to keep the company afloat. If a company is simply holding on to cash, it is missing out on the chance to use the cash to make returns.

Do remember, that while considering a company’s use of CCE, you must also consider other metrics to understand the company’s financial health. Make sure to do your research into a company and its practices before investing.

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