Cash is a form of money that a company can use to run its business. it can be in the form of liquid cash, coins, currency can be in bank accounts, notes etc. However, there is also a concept of cash equivalents. These are assets that a company has which can be liquified easily.
What are Cash and Cash Equivalents
We, in India, follow Ind-AS, which simply means Indian accounting standards. Here’s how the cash and cash equivalents definition has been prescribed and defined by the accounting standards in India.
Cash: “cash on hand and demand deposits.”
Cash equivalents: “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.”
These are a few examples of cash equivalents in India
- Traveler’s Cheques: Travellers’ cheques are cheques that allow payments across currencies in foreign countries.
- Bank Cheques: Bank cheques are pieces of paper that generally MICR codes that can be scanned by the bank. The banks obliged to give you the specified amount unless the account does not have the specified amount and the cheque bounces.
- Money market instruments.
Here are the types of money market instruments available in India:
- Commercial paper: CP is a short term debt instrument that a company issues to raise money from the market for a short period of time, 15 days to one year.
- Treasury Bills: T-Bills are short term borrowing instruments with a maturity period of less than one year and are issued by the RBI on behalf of the government of India
- Certificates of deposit: Also a short term borrowing instrument but issued by a bank. The tenure ranges from three months to one year.
- Short-term government bonds
- Short-term deposits due within 3 months from acquisition
- Short-term highly liquid debt instruments due within 3 months from acquisition
- Time deposits due within 3 months from acquisition ·
- Bank overdrafts repayable on demand
What is the Nature of Cash Equivalents?
Convertible to cash: Cash equivalents are meant to honour short term requirements of a business. Cash equivalents are not kept for long term or investment purposes.
Convertible to known amount: A cash equivalent just does not have to be convertible to cash It has to be convertible to a known amount. This means that either the price should be predetermined or the market price should be subject to many fluctuations.
Low risk: Cash equivalents, since are short term in nature and there should not be many fluctuations, the instruments should be of least to insignificant risk and should be readily convertible to cash. Hence, mostly all investments that qualify as cash equivalents have a maturity of less than three months.
Not equity investments: Equity investments are generally not included in the cash equivalents category unless in the case of preference shares which are bought in a short period from their maturity and have a specified redemption date.
Cash and cash equivalents show up in the balance sheet of a company on the asset side.
What is a Cash Flow Statement?
The cash and cash equivalents meaning, in its true sense, lies in the cash flow statement. This is all the information is, on a company’s cash and cash equivalents. All companies registered in India are required to prepare cash flow statements. All stakeholders will be interested in how a company uses its cash. Cash flow statements give us a snapshot of the inflows and outflows of the cash and cash equivalents. This is regardless of what is the nature of the company. Whether its a financial institution where cash is actually a product or a manufacturing company where cash only tenders transactional use.
What does a Cash Flow Statement Tell You?
Assessment of cash flows in association with other financial metrics and statements can give a good idea of the deployment of cash and the ability of the company to adjust its cash flows to adapt to the changing circumstances. It gives an idea of the liquidity that the company has at hand. It is also an indicator of how much the company is keeping its assets in cash and how much in other forms.
All companies need cash for similar purposes, to run their business operations, to pay off their debt obligations, to reinvest in the business, to reward shareholders, employee salaries, so on and so forth.
Now that it is clear what cash and cash equivalents are and what they mean, let’s understand the significance of these terms. It is a very important metric because it forms a huge portion of a company’s operating plan. It is easier for companies with higher cash and cash equivalents in the balance sheet to sail through hard times than those companies which are cash strapped.
A company should also not be sitting ideal with the money and use the various cash and cash equivalent examples and instruments in the best way possible so as to keep the company afloat.
Holding a lot of cash in hand at all times also means that the company is losing out on a high opportunity cost. The cost of the returns that it could have earned by rather investing the money in equity and other market-linked instruments. While analysing cash and cash equivalents is an important metric, it is always better to understand the financial performance of the company on the whole and look at all the metrics in conjunction with another.