Marketable Securities are a store of excess cash in an asset that can be quickly converted into cash and earns a return.
Marketable Securities are financial instruments used as securities for a financial emergency often be fulfilled by funds reserved in marketable securities.
In case of a financial emergency, you can quickly convert these securities into cash by selling them.
Marketable Securities are like emergency funds that will be available for you all the time.
These financial instruments are the best option for reserving excess cash. A firm invests funds in these securities to have a ready, liquid source of cash.
Models of cash management assume that managers stash cash they don’t need right away into these securities and convert them to cash as needed.
If cash flows of a firm are uneven—perhaps seasonal—the firm can deal with the uneven demands for cash by either borrowing for the short-term or selling these securities.
Aside from the uneven cash demands from operations, these securities may be a convenient way of storing funds for planned expenditures.
If a firm generates cash from operations or from the sale of securities for investment in the near future, the funds can be kept in marketable securities until needed.
1. Characteristics
In general, marketable securities are like money market securities which fulfill the requirements of safety and liquidity.
Marketable securities types are listed below. Some money market securities, such as government securities, have no default risk; the ones that do have very little default risk.
Due to the short maturity of money market securities and the fact that they are generally issued by large banks or corporations (who are not likely to get into deep financial trouble in a short time), their default risk is low.
Even so, a manager can look at the credit ratings by Moody’s, Standard & Poor’s, and Fitch for an evaluation of the default risk of any particular money market security.
Money market securities have relatively little interest rate risk. Because these securities are short-term, their values are not as affected by changes in interest rates as, say, a 10-year U.S. Treasury security.
Generally, the holdings of these marketable securities of a company can be divided into two categories:
(1) Operating short-term securities, generally a company holds these securities to prepare for liquidity and sell them as needed to provide funds for operations.
(2) Other short-term securities are the securities in which a company holds an excess amount of money that needed to support beyond normal operations.
Generally, bigger companies hold far more securities than that are required for liquidity purposes.
And then convert these securities into cash when required. These securities will be liquidated in order to pay a large one-time dividend, sometimes involve repurchasing stock, acquiring other firms, or financing major expansions.
But the breakdown of these two security types will not be reported on the balance sheet.
Although the financial managers keep a record of their securities and also the requirements for operating versus other purposes.
As I said earlier in the net working capital, the main target is on the securities held to provide operating liquidity.
When it comes to a perfect market setting, the level of cash becomes unimportant.
With perfect capital markets, a firm is able to raise new money instantly at a fair rate, so it can never be short of cash.
Similarly, the firm can invest excess cash at a fair rate to earn an NPV of zero. In the real world, of course, markets are not perfect.
Liquidity has a cost; for example, holding liquid assets may earn a below-market return, and a firm may face transaction costs if it needs to raise cash quickly.
Similarly, in some cases holding an excess of cash leads to tax disadvantage and the right approach for an organization is to hold cash in anticipation of seasonalities.
Generally, companies and firms with massive growth opportunities and rapid expansion hold a large volume of assets as cash.
Because of these tax disadvantages, small companies tend to hold less cash with easy access to capital markets (holding less cash means lower transaction costs).
In the next section, we will discuss the short-term securities in which companies invest and the aim of holding cash and tools required for managing cash.
The key is that the framework of finance process and practice serves to rearrange the cash flows of the underlying assets into different securities depending upon their difference in cash flow and risk characteristics.
Asset securitization is a prominent financing vehicle and the second-best alternative method for raising funds via borrowing.
With traditional secured bonds, it is necessary for the issuer to generate sufficient earnings to repay the debt obligation.
So, for example, if a manufacturer of farm equipment issues a bond in which the bondholders have a first mortgage lien on one of its plants, the ability of the manufacturer to generate cash flow from all of its operations is required to pay off the bondholders.
In contrast, in an asset securitization transaction, the burden of the source of repayment shifts from the cash flow of the issuer to the cash flow of a pool of financial assets or a third party that guarantees the payments if the pool of financial assets does not generate sufficient cash flow.
For example, if the manufacturer of farm equipment has receivables from installment sales contracts to customers (i.e., a financial asset for the farm equipment company) and uses these receivables in a structured financing as described below, payment to the buyers of the bonds backed by these receivables depends only on the ability to collect the receivables.
That is, it does not depend on the ability of the manufacturer of the farm equipment to generate cash flow from operations.
Firms need to forecast their cash flows. They have to prepare funds well in advance in case of additional cash requirements.
On the other hand, if they are likely to generate surplus cash, they should plan for their productive use.
2. Types of Marketable Securities
Certificates of Deposit
Debt issued by banks sold in large denominations. Most of these banks issued bonds with maturities ranging generally up to one year.
Because this debt is issued by banks but exceeds the amount for deposit guarantees by bank insurance, there is some default risk.
Deposits are playing a significant role in most businesses. These deposits are very important for transactions—labor payments and raw materials, purchasing fixed assets, paying taxes, servicing debt, paying dividends, and so forth.
But commercial demand deposits earn no interest, therefore companies make a balance between holdings and payments.
That means companies minimize their holdings depending upon their transactions. They make sure that they are able to pay suppliers promptly and advantage of bargain purchases.
For many corporates, bank deposit is the most popular route for handling short-term cash surpluses.
Deposits have a number of advantages. Among these is the ease with which they can be affected and the comparatively large size of deposits that can be made.
A company that has a forecast cash surplus of US$50 million for a month can deposit the surplus with two banks by making two telephone calls in the space of five minutes.
Generally, the companies have the freedom to deposit according to their needs it maybe six weeks or one month, rather than the investment period is partly dictated by the counterparty.
Bank deposits can suffer from a number of disadvantages, however. There are certain banks with higher credit quality that will offer interest rates below the market rate.
This is because their credit standing attracts such a high inflow of funds that they are usually ‘long’ of cash.
Furthermore, in some countries, domestic banks offer deposit rates below the market due to their regulatory capital reasons.
In addition, the surplus funds are ‘tied up’ for the period of deposit, and cannot be realized before maturity without suffering penalty charges.
Commercial Paper
Commercial paper is simply a short-term IOU issued by a company.
Commercial paper was introduced into the Euromarket (ECP) only in 1984 but it has been a source of short-term finance in the United States for a long time.
There is no direct supervision in the ECP market, but domestic markets are regulated by the relevant local authorities (for instance the Securities and Exchange Commission (SEC) regulates the CP market in the United States).
There are domestic CP markets in many countries around the world, each with their own rules and practices.
CP is typically used to meet short-term liquidity requirements. However, some larger companies with sound credit ratings may use CP as a near long-term source of funding.
CP can often provide the issuer with more attractively priced funds to manage liquidity shortages than those available by drawing on revolving facilities.
Drawings under revolving facilities will always carry a margin, which is not present in CP issuance.
Generally, large corporations issue debt with a large denomination and generally matures in 30 days.
While the debt is unsecured credit and is issued by corporations, there is some default risk, though this is minimized by the back-up lines of credit at commercial banks.
A large majority of the commercial paper outstanding has been issued by financial institutions.
Nonfinancial companies also issue a great deal of paper, but they generally rely more heavily on bank loans for short-term funding.
Treasury Bills
Treasury bills are short-term government securities issued in the government’s domestic currency and with maturities of up to one year.
The most frequent issuing periods are 91 and 182 days. Treasury bills are negotiable and can always be sold in the market before maturity.
Because treasury bills are government securities, in most developed economies they carry the highest rating.
However because it is the ‘risk-free’ debt security in such countries, it also provides the lowest return.
Few corporates purchase treasury bills, preferring to deposit funds or buy instruments with maturities that match more precisely their own cashflow forecasts or to obtain a higher yield by investing in safe but riskier instruments.
Securities issued by the U.S. Government that have maturities of one month, three months, and six months. These securities are readily marketable and considered as default-free.
Money Market Funds (MMFs)
Money market funds are the best option over the traditional overnight bank deposit and offer a number of advantages.
While there has been tremendous widespread use of money market funds in the United States for some time it is only comparatively recently that they have appeared in Europe.
Money market funds are more flexible. Funds can be deposited and withdrawn from MMFs on a daily basis.
Money market funds are a better option for higher returns than those available on the traditional bank deposit.
Most Money market funds have AAA ratings higher than that currently appreciated by virtually all banks and provide better security.
Money market funds are essentially diversified investment vehicles. So they invest in a broad range of liquid assets, including certificates of deposit, treasury bills, and short-dated commercial paper, they offer the advantage of a widely diversified portfolio of investments.
Since investors redeem their investments at different times, an MMF can invest further along the yield curve, and as a result, achieve higher returns than an overnight deposit.
To achieve a AAA rating, the profile of the MMFs investments needs, among other things, to meet the following broad criteria:
- A weighted average maturity not exceeding 60 days.
- No single security has a maturity of more than 13 months + 1 day.
- Exposure to any one counterparty cannot exceed 5 percent.
- At least 50 percent of investments must be with AAA-rated securities.