Cash Equivalents: Definition & Examples

Instructor: Tammy Galloway

Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.

In this lesson, you'll learn the purpose of cash equivalents and their characteristics. We'll also define interest and discuss an example of a cash equivalent, time deposit.

Cash Equivalents

Let's say you just graduated with a degree in finance. You land your dream job as a financial analyst for a prestigious accounting firm. The first day on the job you meet with your supervisor and she explains your first project.

She tells you the company has an excessive amount of cash in checking and savings accounts and she would like for you to research and find cash equivalents because cash by itself is a bad investment! As you walk back to your office, you remember cash equivalents are short term investments that can be converted back to cash earning more interest than a checking or savings account.

For the rest of this lesson, we'll define interest rates, discuss the characteristics of cash equivalents, and explore an example of a cash equivalent, time deposits.

The Relationship Between Cash and Interest Rates

Companies must have immediate access to cash in case they don't make enough money to pay their bills, which can include salaries, rent, and cost of suppliers. The amount of cash to be kept on hand is dependent on the type and size of the business as well as economic and market factors. Cash deposited into a bank checking or savings account typically earns interest. For those of you who don't know, interest is a dollar amount paid to the account holder in return for depositing their money.

Checking and savings accounts pay a small amount of interest on deposits. Maintaining an excessive daily balance of cash could be considered a bad investment. There are other depository accounts that can earn more interest, such as cash equivalents.

Characteristics of Cash Equivalents

The process of investing in cash equivalents allows for a portion of the cash balance in an account to be invested at the end of the day, and then sold the next morning. Some cash equivalents must be invested for a longer time, such as 30 days.

For example, if a company has $1,000,000 in their checking account but typically have an immediate need for $500,000, they can invest the other $500,000 in a cash equivalent and earn more interest than offered by their checking or savings account. Cash equivalents are said to be highly liquid, because they're able to be converted from an investment to cash quickly.

Let's now look at an example of a cash equivalent.

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