Cash and Cash Equivalents, Explained

For many people, cash and cash equivalents are highly liquid assets that can help offset risk in a financial plan or investing portfolio. Cash equivalents are 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 (CCE) refers 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 cash 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.

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 very 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 can include certificates of deposit (CDs), money market accounts, U.S. Treasuries, 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?

As noted above, 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 (3 months) or less, whereas short-term investments mature in up to 12 months.

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 investors can consider. Some offer higher or lower potential returns, and a wide variety of terms.

Certificates of Deposit (CDs)

Investing in a certificate of deposit, or CD is like 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 guaranteed rate of interest when the CD matures.

If you withdraw the money before the maturity date, you’ll typically owe a penalty.

The longer the term of the CD, the more interest it typically pays, but it’s important to do your research and find the best terms.

CDs are similar to savings accounts in that you can deposit your money for a long period of time, these accounts are federally insured, so they’re considered safe. 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 bank CDs have variable rates that allow you to change the rate once during the term. There are also brokerage CDs, which are marketed as securities and sometimes sold by banks to investment companies.

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 treasury bills or T-bills can be purchased with terms that range anywhere from a couple of days to a few weeks to a year.

Because Treasuries are popular, the market is active and they’re easy to sell if necessary. Still, Treasuries are affected by other types of risk, including inflation and changing interest rates.

While investors can expect to receive interest and principal payments as promised at maturity, if they 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 must evaluate the creditworthiness of the entity offering the bond.

Money Market Funds

Don’t confuse money market funds and money market accounts. 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, they’re generally considered very low risk. But unlike a savings or money market deposit account, they’re not federally insured. That means there’s no guarantee you’ll make back your investment, and it’s possible to lose money in a volatile market.

Savings and Money Market Accounts

A savings account has long been an essential money management tool. When you deposit your money in an FDIC-insured savings account, the Federal Deposit Insurance Corporation (FDIC) insures it up to the maximum amount allowed by law, so you can be sure your money is secure. Another bonus: You can make regular deposits and withdrawals (within federal limits) without committing to a term length or worrying about withdrawal penalties.

But a standard savings account could be a lower priority when you compare the interest rate offered to those of other bank products and cash equivalents. A high-yield savings account at an online bank or a money market account could also be FDIC-insured, so it’s safe, and pays more interest. 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 bonds 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 can offer higher returns vs. cash equivalents. 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. Treasuries), and are meant to be redeemed within five years, but often less.

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, it can also be wise to review your current banking partner.

Interested in opening an online bank account? When you sign up for a SoFi Checking and Savings account with direct deposit, you’ll get a competitive annual percentage yield (APY), pay zero account fees, and enjoy an array of rewards, such as access to the Allpoint Network of 55,000+ fee-free ATMs globally. Qualifying accounts can even access their paycheck up to two days early.

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 can include bank accounts and some securities, such as short-term government bonds.

What asset class are Treasuries?

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

How do you determine cash and cash equivalents?

To determine cash and cash equivalents, add up cash balances and short-term investments.

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