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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Cash Equivalents

What it is:

Cash equivalents are company assets that are easily converted to cash.

How it works (Example):

Although there is some leeway for judgment in particular situations, examples of cash equivalents include marketable securities and Treasury bills. To be considered a "cash equivalent," a security must be so near maturity that there is little risk of change in its value if interest rates change (this typically translates to less than three months of remaining maturity). The Financial Accounting Standards Board requires companies to establish policies concerning which types of short-term, highly liquid investments are treated as cash equivalents.

The balance sheet shows the amount of cash and cash equivalents at a given point; the statement of cash flows explains the change in cash and cash equivalents over time.

Why it Matters:

The amount of cash and cash equivalents a company holds has implications for the company's overall operating strategy. For instance, companies with high amounts of cash or cash equivalents are better able to get through hard times when sales are low or expenses are particularly high. However, companies with a lot of cash or cash equivalents are often takeover targets because their excess cash essentially helps buyers finance their purchase.

High cash reserves could also indicate that management has not figured out how to best deploy the cash or cash equivalents, but for capital-intensive companies, high reserves could signal that the company is "saving up" to make some significant purchases.

It is important to note there is an opportunity cost to holding cash and cash equivalents; that cost is the return on equity that company could have earned by investing the cash in a new product or expanding business.

Many theories exist about how much cash and cash equivalents certain kinds of companies should hold, and the current ratio and the quick ratio help investors and analysts compare company cash levels in relation to certain expenses.

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