Money-market holdings, short-term government bonds, treasury bills and savings bonds are examples of cash equivalents. Cash equivalents are short-term investments that can be immediately converted to cash and mature in three months or less.
A cash equivalent can be identified as short-term investment having little or no risk of a change in value. It is listed as a current asset on a company’s balance sheet. Maintaining adequate cash equivalents is critical to ensuring a company's liquidity. Cash equivalents can be converted to cash to pay dividends to shareholders or to navigate through difficult periods in a business cycle. When profitable businesses with strong cash reserves encounter tough economic conditions, they often use cash reserves to buy weaker competitors or to increase market share through expansion.
It is possible to have too much capital in the form of cash equivalents. Because of their liquidity, cash equivalents do not earn a high rate of return. Although having sizable cash and cash equivalents is generally positive, care must be taken to understand the source of the reserves. If these investments have been purchased through the use of borrowed capital, it does not indicate the same financial strength as if they had been generated through free cash flow.