- Features of Marketable Securities
- #1 - Highly Liquid
- #2 - Easily Transferable
- Marketable Securities Examples
- Different types of risk associated with any security
- #1 - Commercial Paper
- #2 - Bills of exchange or bankers' acceptance
- #3 - Treasury bills (T Bills)
- #4 - Certificates of deposits
Features of Marketable Securities
There are many features of these securities, but the two most important ones that set them apart from the rest are highlighted below.
#1 - Highly Liquid
- It is perhaps the single most crucial feature that every financial instrument must have to classify as marketable security.
- These securities are highly liquid and can be easily converted into cash within a short time and at a reasonable price.
- What amounts to a short time has not to be defined anywhere, but as per the conventions and generally accepted principles, this duration should be less than one year.
- Some of the examples of instruments that exhibit the following features and hence classified as marketable securities are commercial paper, treasury bills, bills receivables, and other short term instruments.
Video Explanation of Marketable Securities
#2 - Easily Transferable
- To be highly liquid, these securities should be easily transferable.
- The highly liquid and easily transferable features of these securities complement one another.
- Such securities are instruments that can be easily transferable on a stock exchange or otherwise.
The above two features can be used to classify any security as marketable securities.
Let's understand how this is to be used as a classification tool with the help of a practical illustration.
Marketable Securities Examples
Company X Inc. invests in US Treasury bonds having a maturity duration of 30 years in the financial year 2016. The company's financial controller, Mr. Adam Smith, is in a dilemma as to whether those investments are to be classified as these securities or not.
Solution - As discussed above, the classification of securities as marketable securities has to be judged based on two crucial features – Highly liquid and easily transferable. Classification of such securities is not based on the time duration for which the investors hold it. Marketable securities on the Balance Sheet can be long term or short term. Government securities generally have a long maturity duration. E.g., U.S Treasury maturity can be as high as 30 years or as low as 28 days. Government security is one of the preferred modes of investment used by many fortune 500 Companies. Even though these securities don't promise to return the principal to the investor for 30 years, they can be sold relatively quickly in the bond market. Hence they are highly liquid and easily transferable. Thus, they are classified as marketable securities.
Also, see below examples of Microsoft. We note that investments with a maturity of fewer than 3 months are classified as cash equivalents, and those with a maturity greater than three months and less than one year are classified as short term investments.
#3 - Lower return
- Return on any security is directly proportional to a risk associated with it.
- Higher the risk, higher the return.
- Since these securities are highly liquid and easily transferable, inflation* and default risk* are very low compared to other types of securities.
- An investor has to make a trade-off between risk and return when choosing these securities.
Different types of risk associated with any security
- Default risk: Default risk is the probability that the issuer or borrower will not be able to make payments on their debt obligations on the due date.
- Interest rate risk: Interest rate risk is the risk associated with the fixed return instrument like bonds, debentures whose value decreases on account of rising in an interest rate.
- Inflation risk: Unlike interest rate risk, which affects only fixed income instruments. Inflation risk affects all types of securities. Though it affects every economy, it's an effect seen more in the high inflationary economy where the price level of commodities rises drastically every year. The rise in price level reduces the value of money, and the decreased value of money results in a decreased return on assets.
#4 - Marketability
- Marketable securities have an active marketplace where they can be bought and sold, e.g., London stock exchange, New York Stock exchange, etc.
- Marketability is similar to liquidity, except that liquidity means the time frame within which security can be converted into cash. In contrast, marketability implies the ease with which securities can be bought and sold.
Classification
Marketable securities on the balance sheet can be classified into two categories:
- Equity securities: Marketable equity securities are equity instruments that are traded on stock exchanges. The common type of equity securities is equity and preference shares. This instrument must be held for trading purposes or should be available for sale. If these equity securities are acquired for acquiring control, then these securities aren’t considered marketable equity securities but are classified as long term investment in the balance sheet.
- Debt securities: Marketable debt securities are those debt securities that are traded in the bond market. These instruments must be held for trading purposes or should be available for sale. Common types of debt securities are U.S Government bonds, Commercial papers, etc.
Marketable Securities Types
There are different types of Marketable Securities. Some of the common securities available in the market are discussed here.
#1 - Commercial Paper
- Commercial papers are short term debt instruments with a maturity of not more than 270 days.
- They are unsecured debt. I.e., they are not backed by collateral or, in other words, the borrower does not guarantee payment.
- They are used for short term financing, i.e., used for the purchase of inventory, current assets, and meeting short term liabilities.
- Since they are not secured, they are issued by large institutions and are purchased by big and wealthy corporates.
- Regulatory authorities do not regulate them, and this makes them a very cost-effective means of financing. They are always issued at a discount from the face value.
#2 - Bills of exchange or bankers' acceptance
- A bankers' acceptance is an amount that a borrower borrows, with a promise to pay in future, backed and guaranteed by the bank.
- The difference between commercial paper and bills of exchange is that bills of exchange, unlike commercial paper, is a secured debt.
- Like commercial paper, it is also a short term financial instrument that is generally used for the purchase of inventory, current assets, and meeting other short term liabilities.
- Bankers' acceptances specifies the amount of money, the due date, and the name of the person to whom payment is to be done.
#3 - Treasury bills (T Bills)
- These T-bills are short term securities with a maturity of less than one year.
- In the market, one can find different categories of T-bills with three-month, six-month, and one-year maturity.
- One of the features of T-Bills, which makes them popular with common investors, is that they are not issued in large denominations.
- They are issued in denominations of $1000, $5000, $10,000 and etc.
- Like commercial paper, they are issued at a discount, and investors get a face value on maturity.
In order to understand how discount and return are calculated, let us look at the illustration below.
U.S Government issues a T-Bill Face Value $10,000; maturity six months at $9,800.
- In this case, the Investor will have to shelve $9,800 for purchasing the T-Bill. At the end of six months, the Investor can sell back the T-bill to the Government at $10,000. Thus earning himself
- $200, which is a discount rate or the interest rate earned by holding the T-bill. Hence it is said that the T-bills are always issued at a discount.
#4 - Certificates of deposits
- These are similar to savings accounts.
- It is issued in place of the money deposited at a bank for a specified period.
- These are negotiable instruments and hence can be easily transferable.
- The maturity period of the certificate of deposits varies from seven days to one year in case of commercial banks, and from one year to three years, in case of financial institutions.
Why do Corporates Purchase Low Yielding Marketable Securities?
Before we answer that question, let us look at another marketable securities example. How much amount of marketable security Company Apple holds? Apple, the most valued company of wall street, maintains a massive pile of these securities.
On-Page 49 of the annual report of Apple Inc. for the year 2015, the following details are available about its Marketable securities.
Annual Report of Apple Inc. for the year ended 2015
Particulars Short term securities (Amount in 000' million) Long-term securities (Amount in 000' million) Mutual funds 1,628 - U.S. Treasury securities 3,498 31,584 U.S agency securities 767 4,270 Non- government securities 135 6,056 Certificates of deposit 1,405 877 Commercial paper 1,035 - Corporates Securities 11,948 104,214 Municipal securities 48 904 Mortgage and asset-backed securities 17 16,160 Total $20,481 $164,065 The total amount of these securities (Short term and long term) that Apple holds is in excess of $184 billion, whereas the Cash and Cash equivalents are at meager $21 billion. Some of the vital observation which one can derive by looking at the above data is as follows -:
- Apple holds far more amount of its wealth in marketable securities ($184 billion) than it holds in the form of Cash ($21 billion). The reason is obvious since cash does not give any return, it is better to hold funds in the form of such securities which offer return with minimum risk.
- It does not hold all of its securities in only one instrument. Still, it has distributed it in various types of marketable securities like mutual funds, U.S Treasury securities, Commercial papers, Corporate securities, etc. The reason for such distribution is to diversify the risk associated with holding such securities.
- Amongst the different types of marketable security, Apple has invested more than half of its funds in corporate securities (104 + 11 = 125 billion dollars). Marketable securities on the balance sheet vary significantly in their risk and return profile. Certificate deposits, U.S Government securities, and Commercial papers carry low risk with low returns. On the other hand, mutual funds and corporate securities offer higher returns with higher risk. The possible reason for Apple to hold more than half of its marketable security funds in Corporate deposits could be because of its higher risk appetite.
Why Invest in Marketable Securities?
Now let us come back to the question asked above. Almost every company will invest a certain amount of funds in marketable securities. Broad reasons for investing in marketable security as follows -:
- Substitute for hard cash – They are an excellent substitute for cash and bank balances. Idle cash does not grow since no return is received by holding it. On the other hand, bank balance offers only a meager return. Whereas, such securities not only offer an adequate return but also retains the benefits associated with holding money since they are highly liquid and easily transferable.
- Repayment of short term liabilities - Every company has liabilities that are further bifurcated into short term and long term liabilities. Long term liabilities are repaid over a more extended period, which generally is more than one year. In comparison, short term liabilities are to be paid within one year. Bonus expense, income tax expense, etc. are some of the examples of short term liability. These securities are the best mode of payment of short term liabilities since they are highly liquid and, in the meantime, also provide the company additional income in the form of interests and dividends.
- Regulatory requirement – In order to raise funds and loans from financial institutions, corporates have to follow specific guidelines and rules known as covenants that safeguard the interest of lenders. These covenants are agreed upon by the borrower and lender and are specified in every loan agreement. Debt Covenants are often in the form of ratios that the borrower has to maintain throughout the loan period. These ratios mostly deal with liquidity and long term solvency health of companies. Maintenance of these marketable securities helps in meeting out solvency ratios since most of the marketable securities are considered as current assets. Hence higher the number of such securities, the higher will be the current ratio and liquid ratio. (also, checkout Ratio Analysis)
Conclusion
All the above features and advantages of marketable securities on the balance sheet have made them quite popular means of the financial instrument. Almost every company holds some amount of marketable securities. The specific reason for holding these depends significantly on the solvency and financial condition of the company. Despite many advantages, there are some limitations like low return, default risk, and inflation risk associated with marketable securities. The company holds them for trading purposes or liquidity purposes. Generally, these are held up to their maturity period. Still, the company may sell them before their stated maturities for strategic reasons, including, but not limited to, the anticipation of credit deterioration and duration management.
Marketable Securities Video
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