Cash and Cash Equivalents, Explained

Cash and cash equivalents are highly liquid assets that may help offset risk in a financial plan or investing portfolio. Cash equivalents are generally low-risk, low-yield investments that can be converted to cash quickly and are thus considered relatively stable in value.

For companies, though, cash and cash equivalents refer to an accounting term. Cash and cash equivalents are listed at the top of a company’s balance sheet because they’re the most liquid of a company’s short-term assets. A company’s cash on hand can be considered one measure of its overall health.

It’s important for people to understand the role of cash and cash equivalents in their own asset allocation.

What Are Cash and Cash Equivalents?

People keep their money in a variety of accounts and investments. For example, you might keep your money on deposit at a financial institution in a checking account, savings account, or certificate of deposit (CD).

Investments, on the other hand, may include stocks, bonds, mutual funds, exchange-traded funds (ETFs), real estate holdings, and more. Many investments fluctuate in value, and some investments can be quite volatile. In addition, investments may be challenging to convert to cash in a short time period.

For that reason, people also tend to keep a portion of their portfolio in cash or cash equivalents, because while cash doesn’t typically grow in value, it also typically doesn’t fluctuate or lose value (although periods of inflation can take a bite out of the purchasing power of cash).

Cash refers to the funds in any account that are available for immediate use. Cash equivalents are short-term investment vehicles that can be converted to cash quickly, or even immediately.

Difference Between Cash and Cash Equivalents

The primary difference between cash and cash equivalents is that cash equivalents are investment vehicles with a specified maturity. These may include certificates of deposit (CDs), money market funds, U.S. Treasurys, and other low-risk, low-return investments.

If you’re considering opening a checking account, you wouldn’t be thinking about cash equivalents, but rather getting the best terms for the cash in your account. If you’re looking for added stability in an investment portfolio, you may want to consider cash equivalents.

How Do Cash Equivalents Work?

The idea behind a cash equivalent is that it can be converted to cash swiftly. So the maturity for cash equivalents is generally 90 days (three months) or less, whereas short-term investments may mature in up to 12 months, or sometimes longer.

Cash equivalents have a known dollar amount because the prices of cash equivalents are usually stable, and they should be easy to sell in the market.

Types of Cash Equivalents

There are a number of cash equivalents individuals may consider, with a wide variety of terms. Some may offer higher potential returns than others, often in exchange for trade-offs, such as maturity length or risk level.

Certificates of Deposit (CDs)

Investing in a certificate of deposit, or CD is like storing money in a savings account, but with more restrictions and potentially a higher yield. With most CDs, you agree to let a bank keep your money for a specified amount of time, from a few months to a few years. In exchange, the bank agrees to pay you a fixed rate of interest when the CD matures. (Variable CDs exist, but are not as common.)

The longer the term of the CD, the more interest it may pay, but terms vary by institution, so it can help to compare them. If you withdraw the money before the maturity date, you’ll usually owe a penalty.

CDs are similar to savings accounts in that you can deposit your money for a long period of time. Like savings accounts, these accounts are typically federally insured against bank failure up to applicable limits and they’re generally considered lower risk. But you can’t add or withdraw money, generally speaking, until the CD matures.

There are a few different kinds of CDs that offer different features. Some banks offer bump-up CDs, which allow you to move to a higher rate once during the term if the bank’s rate on that product rises. There are also brokered CDs, which are issued by banks and sold through brokerage firms rather than directly by the bank.

Owing to their lower-risk profile and modest but steady returns, allocating part of your portfolio to CDs can offer diversification that may help mitigate your risk exposure in other areas.

Note that a CD that does not permit withdrawals, even with the payment of a penalty, can be considered an unbreakable CD. As such, it wouldn’t be considered a cash equivalent because it cannot readily be converted to cash.

US Treasury Bills

U.S. Treasury securities are another type of conservative investment. They’re a type of bond or debt instrument, and they’re backed by the U.S. government.

Treasury bonds (T-bonds) usually mature in 20 or 30 years, but the standard terms for Treasury bills or T-bills are four, six, eight, 13, 17, 26, and 52 weeks.

Investors may trade Treasurys in a large and active secondary market, so they can generally be sold before maturity. Still, Treasurys are affected by other types of risk, including inflation and changing interest rates.

While Treasury securities are scheduled to pay interest and return principal at maturity, if investors attempt to sell the bond prior to maturity, they may receive more or less than the principal depending on current market conditions.

Other Government Bonds

Other government entities, including states and municipalities, may offer short-term bonds that could be considered cash equivalents. But investors may want to evaluate the creditworthiness of the entity offering the bond.

Money Market Funds

Money market funds and money market accounts are not the same product. While money market accounts are a type of deposit account, money market funds invest your money, then pay a portion of the earnings to you in the form of dividends.

Because the funds’ short-term investments generally mature in less than 13 months (397 days or less), they’re broadly considered very low risk. In addition, the overall dollar-weighted average maturity of a money market fund is 60 days or less.

Unlike a savings or money market deposit account, they’re not insured by the Federal Deposit Insurance Corporation (FDIC) in the event of a bank failure, though they’re typically insured by the Securities Investor Protection Corporation (SIPC). Money market funds could also potentially be subject to the loss of principal in a volatile market, as with other investments. However, they’re considered to be among the safest types of investments, given the nature of the short-term investments they hold.

Money Market Accounts

A money market account is a type of deposit account that may be opened with a bank. It’s not technically an investment account, similar to CDs, but is sometimes referred to as a cash equivalent since it may offer a higher interest rate than a traditional savings account in exchange for certain requirements, such as making a higher required minimum deposit or limiting the number of monthly transactions made.

As with savings and checking accounts, most money market accounts are insured by the Federal Deposit Insurance Corporation (FDIC). The FDIC insures money you deposit at a member bank up to at least $250,000 per depositor, per account ownership category, and per insured bank. You can make regular deposits and withdrawals without committing to a term length, though some banks set their own transfer and withdrawal limits.

Money market accounts often offer a higher interest rate than standard savings accounts. However, a high-yield savings account at an online bank or traditional bank may sometimes be competitive with money market accounts, and they, too, are typically FDIC-insured. However, in some cases, if your balance drops below a specified minimum, you might end up paying a monthly fee.

Commercial Paper

Commercial paper refers to short-term debt issued by a corporation. These notes carry different terms, maturity dates, and yields. Some can be considered cash equivalents.

Cash and Cash Equivalents vs Short-Term Investments

Investors might also consider including some short-term investments in their asset allocation as well, as these investments may offer higher returns vs. cash equivalents, though they may also come with higher risk. The goal of short-term investments is to generate some return on capital, without incurring too much risk.

Short-term investments are also sometimes called marketable securities or temporary investments. Some include longer-term versions of the cash equivalents listed above (e.g., CDs, money market funds, U.S. Treasurys), and are often meant to be redeemed within 12 months, but may extend up to five years.

The Takeaway

Cash and cash equivalents perform an important role in many investors’ portfolios. These assets are considered highly liquid and less likely to fluctuate in value, especially when compared with equities and other securities that offer more growth potential, but more exposure to risk.

If you’re looking for ways to add to your cash holdings, you may want to review your current banking partner.

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FAQ

What is a cash and cash equivalent example?

Cash equivalents are low-risk, low-yield investments that can be converted to cash quickly and are thus considered relatively stable in value. They may include bank accounts and securities, such as short-term government bonds.

What asset class are Treasurys?

Treasury bonds (T-bonds) are one of five types of debt that are issued by the U.S. Department of the Treasury. These securities are used to finance the U.S. government’s spending activities. The five types of debt are classified as Treasury bills, Treasury notes, Treasury bonds, Treasury Inflation-Protected Securities, and Floating Rate Notes.

How do you determine cash and cash equivalents?

Cash and cash equivalents may be identified by evaluating their liquidity and risk profile. While cash represents liquid money available for immediate use, cash equivalents are low-risk, short-term assets that can be quickly converted into cash with minimal risk of losing value. Cash may include money in hand and money in a savings account, while a cash equivalent could be a certificate of deposit (CD), short-term Treasury bill, or a money market fund, for example.

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