Understanding Cash Equivalents In Your Investment Portfolio

Cash equivalents are short-term investments that can be readily converted into cash. They are highly liquid and low-risk, with a maturity period of 90 days or less. Examples of cash equivalents include bank accounts, marketable securities, treasury bills, commercial paper, and short-term government bonds. These investments provide companies with flexibility in meeting short-term obligations and preserving capital. While they offer modest returns and limited growth potential, they are considered low-risk and provide a buffer against fluctuations in the value of more volatile assets.

Money market funds

A money market fund's share price is always $1 per share. Any excess earnings generated through interest on the portfolio holdings are distributed to the investors as dividend payments.

Short-term government bonds

However, when investing in short-term government bonds, it is important to carefully assess factors such as political risks, interest rate fluctuations, and inflation, as these can impact the value of the investment.

Overall, short-term government bonds are a relatively safe and stable investment option that provides investors with easy access to cash and the potential for modest returns.

Commercial paper

To be considered a cash equivalent, an investment must have a maturity of 90 days or less and be highly liquid and easily sold on the market. Cash equivalents are important for companies as they indicate their ability to meet short-term financial obligations. They are also used to build emergency funds and capitalise on future business opportunities.

Other examples of cash equivalents include Treasury bills, bank certificates of deposit, banker's acceptances, and money market instruments.

Marketable securities

Examples of marketable securities include T-Bills, CDs, bankers' acceptances, commercial paper, stocks, bonds, and exchange-traded funds (ETFs). They are often consolidated into the "Cash and Cash Equivalents" line item on a company's balance sheet.

• Available for Sale (AFS): Purchased intending to sell before maturity.
• Held-to-Trading: Bought to gain a short-term profit after sale and before full maturity.
• Held to Maturity (HTM): Purchased with the intent to hold until the maturity date.

Companies choose to invest in marketable securities to generate fixed, low-risk returns on their cash holdings rather than letting idle cash lose value due to inflation. These investments also provide a "cushion" for sudden cash needs or attractive acquisition opportunities.

Banker's acceptance

A banker's acceptance is a financial instrument that represents a promise of future payment from a bank. It is a short-term debt instrument, similar to a U.S. Treasury bill, that is traded at a discount to its face value in the money markets. Banker's acceptances are also known as bills of exchange and are used by companies as a safe form of payment for large transactions, especially in international trade.

The process of obtaining a banker's acceptance is similar to that of a short-term loan, with the bank assessing the creditworthiness of the borrower and conducting collateral checks. The borrower may or may not need to provide collateral, depending on the size of the acceptance. The bank charges the borrower a small percentage-based fee on the amount.

Once the bank accepts the banker's acceptance, the liability immediately transfers from the issuer to the bank. The bank is then obliged to make the payment on the specified date, regardless of whether the borrower defaults. This makes banker's acceptances a safe investment, similar to U.S. Treasury bills, and they are often used by importing and exporting businesses to facilitate transactions.

Frequently asked questions