Cash on hand and cash flow are key indicators of financial health for any company, especially for young companies which are vulnerable to cash shortages. Although it would seem to be a straight-forward balance to assess and interpret, the cash balance is frequently misinterpreted and manipulated.
The cash balance reported on the Balance Sheet is the cash in the bank adjusted for payments and receipts that have not yet cleared. Therefore, the cash balance on the bank statement will have cheques written by the firm but not yet cleared deducted and cheques received but not yet cleared added to the balance.
Cash Equivalents are frequently added to Cash on the Balance Sheet. Cash Equivalents are money market securities with maturities under 3 months such as Treasury Bills. If the maturities are over 3 months then they should be included in Short Term Investments.
Expanding the Definition
Cash and Cash Equivalents has a very tight definition under GAAP, however some firms attempt to artificially increase the cash balance by using a aggressive definitions for cash. Demand Media (DMD) accounting policies per the 2012 10-K define Cash and Cash Equivalents as :
.. all highly liquid investments with a maturity of 90 days or less at the time of purchase to be cash equivalents. The Company considers funds transferred from its credit card service providers but not yet deposited into its bank accounts at the balance sheet dates, as funds in transit and these amounts are recorded as unrestricted cash ….
Note the second sentence which includes funds in transit in the Cash balance. Funds in transit should not be included in Cash and should be left in other balances such as Accounts Receivable.
The Cash and Cash Equivalents details in the notes to the accounts should always be examined for details on the firm’s definition of Cash. Aggressive treatments include adding funds in transit, not deducting cheques written or including some accounts receivable. Inconveniently, a note on the firm’s definition of Cash is not a requirement and is not always available (Demand Media’s accounts filed in 2013 contain no Cash definition).
The Cash balance is sometimes viewed in isolation. For example, analysts will sometimes deduct cash from a company’s market capitalization prior to calculating a Price/Earnings ratio. This assumes that the Cash balance is essentially a permanent asset of the company with no encumbrances. However, in many circumstances the cash in owed to customers. Groupon for example collects payments directly from purchasers of its ‘Groupons’ , in then pays a portion of these payments to the provider of the service approximately 3 months later. Thus a large portion of Groupon’s cash balance is pledged to service providers and will only remain with Groupon for 3 months.
In Groupon’s 2012 10-K filing Cash and Cash Equivalents is $1.2bn and ‘Accrued Merchant and Supplier Payables’ is $670m. In addition Groupon includes refunds (ie amounts that must be repaid to purchasers when a merchant fails to fulfil its obligations) in Accrued Expenses. After deducting amounts payable Groupon’s cash balance is a mere $280m.