When you own or manage a business, you soon learn the importance of maintaining cash reserves. A supply of ready cash allows you to meet unexpected expenses and insures that creditors are paid on time. However, a business exists to earn money. Cash that's doing nothing is earning nothing. Marketable securities are a way to keep funds available to respond rapidly to circumstances and generate some extra revenue at the same time. Marketable securities are calculated differently depending on the type of security in question. In addition, the marketable securities a company holds may be used to calculate several financial ratios that are helpful for analyzing the firm's condition.
Overview of Marketable Securities
A marketable security is a highly liquid financial instrument, such as publicly traded bonds or shares of stock. "Liquid" means the security can easily be converted into cash on short notice by the business that holds it. A marketable security is a short-term investment, meaning the business plans to hold it for less than one year. In general, market securities are traded on public stock or bond exchanges because these are markets where a buyer can be found quickly. The liquidity of marketable securities comes with a trade-off. Typically, they're very low-risk investments, but they tend to produce low rates of return.
Businesses invest in marketable securities for several reasons. They're considered current assets. A current asset is anything a business owns that a business expects to convert into cash in less than one year. Lenders like to see a strong position in current assets on a firm's balance sheet because it means the company is likely to be able to meet its short-term obligations. Holding reserve funds also means the company has money in reserve as a buffer against unexpected expenses or to take advantage of opportunities such as the acquisition of another business or real estate on favorable terms. Investing in marketable securities offers a modest amount of income from funds held in reserve, which is a better option than simply letting them sit idle.
Marketable Securities on the Balance Sheet
Marketable securities are always listed in the current assets part of a company's balance sheet, which is the financial statement that reports a firm's assets, liabilities and shareholders' or owners' equity. Publicly traded companies must publish a balance sheet periodically to comply with Securities and Exchange Commission regulations, but preparing them is routine for most companies. Current assets appear at the beginning of the assets section, which is the first section of the balance sheet.
Current asset types are listed in order of liquidity, with the most liquid appearing first. Cash and cash equivalents, such as money in checking or savings accounts, are the first items listed. Marketable securities come next. This is because it's very easy to convert them into cash. For example, a company can sell Treasury bonds it owns simply by placing the order with a broker. Accounts receivable due within one year are listed next. Inventory is considered the least liquid current asset type, so it comes last. For instance, some inventory may not be sold for months. In addition, the transaction may be made on credit. In this case, the sale is added to accounts receivable and doesn't produce any cash until payment arrives from the customer.
Types of Marketable Securities
There are two general categories of marketable securities. One is marketable equity securities. Essentially, this means common or preferred shares of a publicly traded company that the purchasing company intends to hold for less than one year. Companies may buy shares in other firms that they intend to hold for longer periods. This is the case if the acquiring company is attempting to gain control of another firm. In this situation, the shares should be listed as a long-term investment, not as a current asset.
Businesses also invest in short-term debt instruments of several types, collectively called marketable debt securities. Treasury bills with maturities of one year or less are one example, along with other money market securities. Commercial paper is another. The name refers to unsecured promissory notes sold by large corporations to raise cash for short-term needs. Commercial paper typically matures in about 30 days but may be issued for up to 270 days. Bankers' acceptances are similar to commercial paper, except these securities are guaranteed by commercial banks. As with equity instruments, marketable debt securities that may be held more than a year are generally listed on a balance sheet as long-term investments.
Calculating Marketable Securities
Different calculations are used to determine how marketable securities are valued on a balance sheet, depending on whether the security is equity or debt. As equities, stocks and bonds are always valued at either the cost of acquisition or the market price on the date of the balance sheet, whichever is less. Suppose a business buys 100 shares of XYZ Corporation at $150 per share to hold as a marketable security. The cost is $15,000. When the next balance sheet is prepared, the stock will be valued at $15,000 if the share price has increased or stayed the same. However, if the price per share has fallen to $145, you'd multiply $145 times 100 shares and use the result of $14,500 as the value of this marketable equity security on the balance sheet.
Marketable debt securities are always listed at cost. The cost depends on the par value of the security and its discount rate. These debt securities are sold at a discount and redeemed for the full par value when mature. The difference is the interest the security earns during its lifetime. Suppose a firm buys a $10,000 Treasury bill with a six-month maturity at 98 percent of par, or a discount of 2 percent. The cost is equal to 98 percent of $10,000. The result of $9,800 is reported as the Treasury bill's value on the balance sheet.
Financial Ratios Using Market Securities
The information on marketable securities and other current assets is used by business managers, creditors and investors to calculate several financial ratios. These ratios are used to assess how well a firm is prepared to cover its short-term obligations.
The current ratio evaluates a company's ability to meet short-term debts using only current assets. The formula is simply current assets, including marketable securities, divided by current liabilities. For example, if a business has $500,000 in current assets and $400,000 in current liabilities, the current ratio works out to 1.25.
A cash ratio is a more stringent version of the current ratio. This metric is computed by adding cash and the current market value of marketable securities together and dividing by current liabilities. Lenders use this ratio to asses how quickly a company can pay its short-term debts if they were to come due immediately. A cash ratio of 1 or higher is preferred. However, this means tying up a lot of capital in marketable securities that have low rates of return, so most companies maintain a lower cash ratio.
The quick ratio is a broad measure of a company's liquidity. It consists of cash, marketable securities and accounts receivable. These categories of current assets are sometimes referred to as quick assets. Inventory isn't included in the quick ratio because it's likely to take more time to liquidate. The quick ratio formula is cash plus marketable assets plus accounts receivable divided by current liabilities. For instance, the sum of quick assets might come to $240,000. If current liabilities are $400,000, you have $240,000 divided by $400,000. This works out to a quick ratio of 0.6.