Cash Equivalents

Definition

Cash equivalents are securities used for short-term investments. They typically have high credit quality and high liquidity. As the name suggests, they are considered equivalent to cash because they can be quickly converted into actual cash. The term 'cash and cash equivalents' can be found in the current assets section of the balance sheet.

Origin

The concept of cash equivalents originated from the need for corporate financial management, particularly in the mid-20th century, as companies expanded and financial management became more complex. Companies needed assets that could be quickly converted into cash to meet short-term funding needs.

Categories and Features

Cash equivalents mainly include Treasury bills, commercial paper, and money market funds. These assets share the common characteristics of low risk and low return. Treasury bills are short-term debt instruments issued by the government and are considered one of the safest investments. Commercial paper is short-term unsecured debt issued by companies, typically used to meet short-term funding needs. Money market funds are mutual funds that invest in short-term, highly liquid securities, offering slightly higher yields than savings accounts.

Case Studies

During the 2008 financial crisis, many companies relied on cash equivalents to maintain liquidity. For example, Apple Inc. held a large amount of Treasury bills and commercial paper during the crisis to ensure its financial stability amid market turmoil. Another example is Microsoft Corporation, which has long maintained a substantial amount of cash and cash equivalents to quickly make strategic investments or acquisitions when needed.

Common Issues

Common issues investors face when using cash equivalents include low returns and inflation risk. Due to the low-risk nature of cash equivalents, their returns are typically low and may not offset the purchasing power decline caused by inflation. Additionally, investors might mistakenly believe that all cash equivalents are entirely risk-free, but in reality, some commercial paper may face credit risk.