Marketable Securities Explained for Dummies

What are marketable securities?

Marketable securities refer to liquid financial instruments that can be easily and swiftly converted into cash at a fair price. In general, marketable goods are fit to be sold in a market because people or entities want to buy them.  

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Features of marketable securities

Marketable securities have the following distinctive features:

• Highly liquid

This is possibly the most important feature that a security must have to be categorised as a marketable security. Securities that are highly liquid can easily be converted into cash at a reasonable price and within a short period, meaning within a year or less.  

• Easily transferable

The easily transferable feature of a security goes hand in hand with its highly liquid feature. This means in order to be highly liquid, a security should be easily transferable. Marketable securities are easily transferable because they can be purchased and sold on secondary financial markets such as stock exchanges and bond markets.  

• Can be either debt instruments or equity instruments

Debt instruments include government and corporate bonds with a maturity period of one year or less. Equity instruments comprise securities such as ordinary and preference shares, also called preferred stock.  

• Lower risk, lower return

Regarding securities, the return is directly related to the risks associated with it. Hence, the lower the risk, the lower the return, and vice versa. Inflation risk and default risk associated with marketable securities are much lower compared to other types of securities, implying that the return on marketable securities is also lower than the return on other types of securities Inflation risk also called purchasing power risk, is the risk that inflation will reduce the real value (value after inflation) of an investment or asset. Default risk, also referred to as probability risk, refers to the probability that a borrower or issuer of a bond will fail to make timely and full payments regarding interest and principal amounts.  

Examples of marketable securities

Examples of marketable securities include, inter alia, the following financial instruments:

• Ordinary shares, also called common stock or common shares, of a public company.
• Bonds (government and corporate) with a maturity date of one year or less.
• Money market instruments such as:

Commercial papers (CPs) are short-term debt instruments issued by companies for a year or less with the object to obtain funds to finance new operational projects and to honour short-term financial obligations. A banker’s acceptance (BA), also called a bill of exchange, is a financial instrument that guarantees a promised future payment from a bank, making it a secured debt. Treasury bills, or T-Bills for short, are short-term financial instruments that are issued by the Treasury of the USA with maturity dates such as 4 weeks, 13 weeks, 26 weeks, up to a maximum of 52 weeks.  An exchange-traded fund (ETF) is a type of security that tracks an index of shares, a commodity, or other assets. ETFs are traded on a stock exchange. An ETF is classified as a marketable security because it has an associated price that enables traders and investors to buy and sell them the same way as ordinary shares.  

Types of marketable securities

Marketable securities are categorised into two categories:

• Equity securities

Marketable equity securities can be either ordinary shares (common stock) or preference shares (preferred stock) of a public company. They are bought and sold on stock exchanges such as the New York Stock Exchange (NYSE) and the Johannesburg Stock Exchange (JSE). To be considered marketable securities, the shares must be held for trading purposes or should be available for sale. When equity securities are acquired during an acquisition or merger, then they are not regarded as marketable equity. Instead, they are reported as a long-term investment on the balance sheet.

• Debt securities

Marketable debt securities are considered to be any short-term bond traded on a bond market. They are expected to be sold within a time period of one year.  

Reporting marketable securities on the balance sheet of a company

Marketable equity securities

In accounting, marketable securities are typically reported under ‘Current Assets’ on the balance sheet if they can be sold within a year. However, marketable equity securities will not be listed as part of ‘Cash and Cash Equivalents’ because they encompass equity securities and/or fixed income securities (debt securities) that mature in more than three months. Conversely, if a company expects to hold a marketable security for longer than one year, the security will be listed as a non-current asset. Both current and non-current marketable equity securities are reported at the lower value of cost or market value.  

Marketable debt securities

When expected to be sold within a year, marketable debt securities are reported at cost on the balance sheet of a company under ‘Current Assets’ until a loss or profit is realised upon the sale of the debt instrument. A debt security expected to be held for longer than one year is listed as a long-term investment on a company’s balance sheet.  

Marketable securities and liquidity ratios in accounting

As mentioned, marketable securities are reported as current assets on a company’s balance sheet. In addition, they are highly liquid. Due to the features mentioned above, marketable securities are used in various liquidity ratios in accounting. Express differently, marketable securities are assessed by investors and analysts when performing liquidity ratios on a company. A liquidity ratio is a financial ratio used in accounting to determine the ability of a business (such as a company) to meet its short-term financial obligations, also referred to as current liabilities, as they come due. In other words, a liquidity ratio determines whether a company is able to pay its short-term debts using its most liquid assets. The three key liquidity ratios are: the current ratio, the quick ratio, and the cash ratio.  

The current ratio

The current ratio measures whether a business is able to pay off its short-term debt (short-term liabilities) using all its current assets, including marketable securities, cash, inventory, and accounts receivable. The ratio is sometimes referred to as the working capital ratio. The formula to calculate the current ratio is: Current ratio = Current assets/Current liabilities Example of the current ratio: Let us say that company Almost There have R3 000 000 current assets and R1 200 000 current liabilities listed on its balance sheet. The company’s current ratio will be calculated as follows: Current ratio = R3 000 000/R1 200 000 = 2.5:1 The current ratio of 2.5:1 indicates that company Almost There has R2.50 of current assets for R1.00 of current liabilities. Express in other words, the company will be able to pay off its short-term debt obligations 2.5 times with its current assets available. The higher the current ratio, the better a business’s liquidity position, and vice versa. A current ratio of 1:1 is an indication that a company’s current assets equal its current liabilities. It is important to understand the type of industry in which a company operates when assessing its current ratio.  

The quick ratio

The quick ratio also called the acid test ratio, determines whether a business can satisfy its current liabilities with its most liquid current assets such as cash, cash equivalents, accounts receivable, and short-term marketable securities. Hence, the quick ratio is a stricter liquidity ratio than the current ratio, excluding less liquid current assets such as inventory and prepaid expenses. Formula to determine a business’s quick ratio: Quick ratio = Quick assets/Current liabilities Example of the quick ratio: Let us again take the information obtained from the balance sheet of company Almost There.

• Current liabilities of R1 200 000
• Current assets of R3 000 000, including inventory of R300 000 and prepaid expenses of R60 000

Quick ratio = (R3 000 000 - R300 000 - R60 000)/R1 200 000 = R2 640 000/R1 200 000 = 2.2:1 Almost There’s quick ratio (the stricter liquidity ratio) is lower than its current ratio - 2.2:1 compared to 2.5:1. The implication is that the company will only be able to repay its current liabilities 2.2 times (and not 2.5 times) with its quick assets available. In other words, instead of R2.50 of current assets available for R1.00 of current liabilities, the company has R2.20 of current assets available to cover R1.00 of current liabilities.  

The cash ratio

The cash ratio only includes the most liquid current assets of a business in the calculation, namely cash, cash equivalents, and highly liquid marketable securities. It is the most conservative ratio of the three liquidity ratios explained in this article. The formula to measure the cash ratio is: Cash ratio = (Cash + Cash equivalents + Marketable securities)/Current liabilities Example of the cash ratio: Figures from company Almost There are again used in this example. Current liabilities of R1 200 000 Current assets of R3 000 000, including the following assets:

• Cash - R600 000
• Cash equivalents - R350 000
• Highly liquid marketable securities - R250 000

Cash ratio = (R600 000 + R350 000 + R250 000)/R1 200 000 = R1 200 000/R1 200 000 = 1:1 The cash ratio shows that the company has R1.00 of current assets available for every R1.00 of current liabilities, meaning that the company will only just manage to pay off its short-term debt obligations.

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