Cash and Cash Equivalents

According to International Accounting Standard 7 (IAS 7), Cash “comprises cash on hand and demand deposits”. And cash equivalents “are 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”.

Cash

Cash is the money in the form of currency. Currency includes currency notes and coins. Any currency notes and coins held by an enterprise are part of the term “cash”.

Demand deposit is a type of an account from which funds can be withdrawn at any time without having to inform the bank or depository institution. Most of the checking and saving accounts are demand deposits.

Cash Equivalent

Cash equivalents are investments that can be readily converted to cash. Common examples of cash equivalents include commercial paper, treasury bills, short term government bonds, marketable securities, and money market holdings. An item should satisfy the following criteria to qualify for cash equivalent.

• The investment should be short term. They should typically mature in less than three months. If they mature in more than three months they most likely will be classified as other investments.
• They should be highly liquid. This means that they should be easily sold in the market. The buyers of these investments should be easily available.
• They should be convertible to known amounts of cash. This means that their market price should be available and this market price should not be subject to significant fluctuations.
• They should not be too risky. There should be very little risk of changes in their value. This means that equity shares cannot be classified as cash equivalents. But preferred shares purchased shortly before the redemption date can be classified as cash equivalents.

In short, cash and cash equivalents mean the cash and those assets which are immediately convertible to cash. Cash and cash equivalents are the most liquid assets of any business. Cash and cash equivalents are very important for the liquidity of a business. A company should have sufficient cash and cash equivalents to meet its urgent liabilities when they fall due.  

Cash and Cash Equivalents in the Balance Sheet

Cash and cash equivalents are typically reported as a separate line item in the statement of financial position, also known as the balance sheet. This line item represents the amount of cash or cash-like assets that a company has on hand, which can be used to meet short-term financial obligations.

Cash and cash equivalents are typically presented in the current assets section of the balance sheet. This section includes assets that are expected to be converted into cash within the next 12 months or within the normal operating cycle of the business, whichever is longer.

Cash and cash equivalents are considered to be highly liquid assets, meaning they can be easily and quickly converted into cash without significant loss of value. As such, they are typically reported at their fair market value and are included in the calculation of a company's working capital, which is an important measure of a company's short-term financial health.

Technically, it is possible for a company to have a negative balance in its cash and cash equivalents line item if it has an overdraft on its bank account. An overdraft occurs when a company withdraws more money from its bank account than it has available, resulting in a negative balance. In this case, the negative cash balance would be reported on the balance sheet as a liability, typically under the current liabilities section. This liability represents the amount of money that the company owes to the bank for the overdraft. It is important to note that while an overdraft may result in a negative cash balance, it is not a sustainable long-term financing strategy. Overdrafts typically come with high interest rates and fees, which can increase a company's financial expenses and reduce its profitability. Therefore, companies should aim to maintain a positive cash balance on their balance sheet by managing their cash flow effectively and avoiding excessive reliance on short-term financing sources.