By George Boykin, eHow Contributing Writer
For accounting purposes, cash equivalents appear on the firm's balance sheet as a category of "current assets," which include cash, cash equivalents and those resources that are expected to be converted into cash during the normal course of the operating cycle of a firm, typically one year. Cash and cash equivalents make up the sub-category "cash on hand and demand deposits."
Cash equivalents have a 90-day conversion period. They are highly liquid, low-risk securities with a known market value that matures within no longer than 90 days. They include U.S. Treasury bills, bank certificates of deposit, corporate commercial paper and money market funds.
Cash Equivalents are Important in the Statement of Cash Flows
# Cash equivalents are particularly relevant in the "Statement of Cash Flows." The cash flow statement has been mandated by the Financial Accounting Standards Board as part of the firm's financial reports since 1987. It records the amounts of cash and cash equivalents entering and leaving a firm by presenting the details of the historical changes in cash and cash equivalents of a firm. In the process, the cash flow statement allows investors, trading partners, employees and other interested parties to understand the firm's viability based on how the firm's operations are running, where its money is coming from and how it is being spent.
Cash Flow From Operations
# Cash flow is determined by looking at three components by which cash enters and leaves a firm: the firm's operating activities, investing activities and financing activities.
Operating activities are the primary activities of the firm that generate revenue. Operating cash flows include cash received from customers and cash paid to suppliers and employees.
The change in cash from operations reflects how much cash was generated from a company's products or services. This change typically includes: changes made in cash, accounts receivable, depreciation, inventory and accounts payable. Excess cash not demanding immediate use is generally converted to a cash-equivalent, marketable security.
Cash Flow From Investing
# Cash equivalents usually represent the investment of cash available to the firm for current operations. This cash has been converted into short-term marketable securities until the cash is actually needed for current operations. Therefore, investing activities may impact cash equivalents.
Changes in cash from investing are usually a "cash out" item, because cash is used for such activities as purchasing new equipment, real estate or short-term assets such as marketable securities.
In the case of a short-term marketable security, the firm is exchanging cash (cash out) for a cash equivalent (cash in). Therefore, the transaction is essentially a wash. However, when a firm divests of an asset, the transaction is considered "cash in" for calculating cash from investing.
Cash Flow From Financing
# Financing activities involve actions that result in any changes in the equity capital and debt structure of the firm. Changes in cash from financing are "cash in" when, for example, capital is raised through the selling of stock to the public. On the other hand, they are "cash out" when dividends are paid. Therefore, if a firm sells a bond to the public, the company receives cash financing (cash in). When interest is paid to bondholders, the company is reducing its cash (cash out).
In the case of the firm selling stock to the public or engaging in debt financing through a bond issue the firm receives cash. Unless the firm has an immediate use for the cash, it will generally convert the cash to a short-term marketable security (a cash equivalent) until the cash is needed.
Financial Statements Require Careful Analysis
Through an analysis of earnings, revenues, assets, liabilities and cash flow, you can get a good depiction of a firm's viability and performance: how much cash it generates; what constitutes the components of cash and cash equivalents; and how much of that cash originates from the firm's core operations as opposed to from investing or financing.
From ehow published on May 20, 2010