Understanding Cash and Cash Equivalents in the Balance Sheet

Definition of Cash and Cash Equivalents

Cash and Cash Equivalents mainly refer to the line items on the Balance Sheet that represent the underlying value of the company’s assets that are in the form of cash or any other liquid form of cash.

They mainly include a couple of support, which have relative ease with converting them into cash.

Cash and Cash Equivalents allow the company to meet its day-to-day expenses using these liquid resources.

Cash and Cash Equivalents are the primary indicator of the extent to which the company is cash-rich. It represents the cash in the hand of the company, and hence, it is considered a vital decision-making tool for a lot of stakeholders.

Cash and Cash Equivalent in the Balance Sheet

Cash and Cash Equivalent is represented in the Balance Sheet under Current Assets. This is because they are readily usable.

These assets are used in day to day operations of the business, and therefore, they are regarded as one of the most critical asset classes of the businesses.

In the case where companies have numerous other asset classes, and on the other hand does not have a substantial amount for cash and cash equivalents, in that case, it is a red flag.

Ultimately, the company will need to sell out its other assets in order to arrange for cash so that it can continue its operations.

Therefore, this particular asset class tends to be extremely critical for businesses. Business survival is, in fact, directly linked with cash and cash equivalents, and it cannot be looked upon.

Importance of Cash and Cash Equivalents

From a stakeholder (and shareholders) perspective, it is essential to realize that cash and cash equivalents tend to be one of the most important factors that help them decide regarding its financial positioning.

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Cash-rich companies are given higher preference by creditors and by shareholders because cash-rich companies are highly likely to pay out dividends in time.

From creditor’s perspective, they would have an idea that the company is cash-rich, and therefore, they would not find it hard to meet their day-to-day expenses.

Consequently, they have a relatively lower risk profile, making it attractive for the investors to invest in the company.

From an organizational perspective, it can be seen that cash and cash equivalents are considered highly important because it reflects the ability of these companies to meet their day-to-day expenses.

This hints that there would be no operational issues faced by the company when settling their daily expenses and bills.

However, this does not mean that the more cash the company has, the better it will be. The best metric that can be used in this regard is the sufficiency of cash in terms of helping the company meet its day-to-day expenses.

In the case where the company has a lot of idle cash in the financial statements, that tends to be an indicator of improper utilization of assets.

If the company has resources to cover its expenses, then the remaining amount should ideally be invested in avenues to render a return for the company. Cash and Cash equivalents underutilization, therefore, involves an opportunity cost that cannot be ignored at any cost.

Types of Cash and Cash Equivalents

Cash to Cash Equivalents are important for companies because they are critical in ensuring that companies are able to meet their working capital needs.

This working capital need mainly includes resources that are required to pay off current liabilities. Current liabilities in a Balance Sheet are defined as short-term debts or obligations that need to be paid by the company to ensure that optimized results are obtained.

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Some examples of current liabilities include creditors, accrued utilities, and a portion of the long-term debt that is due in the current year. However, as far as Cash and Cash Equivalents are concerned, they can be of numerous different types.

However, they are clubbed together into several other heads and represented under cash and cash equivalents in the balance sheet. The different categories or types of cash and cash equivalents are given below:

  • Cash

Cash is the most basic form of Cash and Cash Equivalent. It is money in the form of currency. It includes bills, coins, as well as currency notes. It might also include demand deposits. They are referred to as checking accounts from which funds can be withdrawn at any point in time without informing the institution.

Therefore, all demand account balances on the date of financial statements are included in cash totals.  In cash and cash equivalents, cash is the form that is held in the company’s cash till or cash reserves. This amount can be used for several different purposes, and therefore, includes a wide variety of sources in this regard.

  • Foreign Currency

Companies might have multiple different currency-related options, primarily in the case where companies rely on exports. It might also exist with the company when companies invest in other foreign currency types to hedge against exchange rate risk.

Therefore, when companies have kept other currencies as their assets, they are then supposed to report it as cash and cash equivalents in the financial statements after translating the foreign currency to the local currency (in which financial statements are being prepared).

  • Cash Equivalent           

Cash Equivalents are referred to as liquid cash forms. In other words, they can easily be converted to cash. The investment in assets is primarily short-term, with a duration of three months or less.

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In the case where these investments have a maturity date of more than three months, in that case, it is reported under the account titled ‘Other Investments.’

Assets should only be included under cash and cash equivalents if they are highly liquid and can be easily sold in the market. The buyers of the given investments should also be easily accessible.

The respective dollar amount of all the cash equivalents should be known because they should have a given market price.

Furthermore, it is also essential that respective dollar amounts for all the cash equivalents are also known. The value of these cash equivalents should not be expected to change significantly before redemption or maturity.

What should not be included as Cash and Cash Equivalents?

Given the fact that cash and cash equivalents include liquid assets, yet a lot of accountants make the mistake of improperly classifying other investments or assets under cash and cash equivalents.

Here are a few examples of items that should not be included as cash or cash equivalents.

  • Credit Collateral

For short-term debt instruments, companies often utilize T-Bills, or other liquid assets to offer as collateral.

If companies have such a system in place, they mustn’t be classified as cash and cash equivalents. They should be mentioned separately under the heading of credit collaterals.

  • Inventory

Inventory that the company has present on hand should also never be classified as cash and cash equivalent because it cannot be readily converted to cash.

This implies that inventory should be classified separately, and regardless of the readiness of the inventory at hand, it should be classified under inventory as it is.