What it means
Most businesses collect cash at one time and pay bills at another, which leaves spare money sitting in the bank for weeks or months. Rather than leave it earning little, the finance team places it in short-term investments that can be turned back into cash quickly.
The goal is to earn a modest return without taking much risk. Typical choices are government treasury bills, bank deposits with a fixed term, money market funds and high-quality commercial paper.
They are chosen because the price is stable and the investment can be sold or matures soon. Equities and other volatile assets can qualify if the company intends to sell them within a year, but they carry price risk.
On the balance sheet, short-term investments sit under current assets, usually after cash and cash equivalents. The accounting depends on the standard in use and on what the company intends to do with the investment.
Some are held at amortised cost, while others are shown at fair value, which is the current market price. Analysts add cash and short-term investments together to judge liquidity, meaning how easily a company can meet its immediate bills.
The quick ratio, which compares the most liquid assets to current liabilities, includes them. A company with a large pile of short-term investments has more room to manage shocks.
The main trade-off is return against safety and access. Longer maturities and riskier instruments pay more but can lose value or be hard to sell at short notice.
Most companies set a written treasury policy that lists approved instruments, limits per counterparty, and the maximum maturity allowed. The income earned is reported in the profit and loss account as interest or investment income, not as part of operating profit.
Any change in market value on securities held at fair value may also pass through the profit and loss account, which can add some volatility to reported results. Finance teams usually explain these items separately so that readers can see how the core business performed.
In practice
Real-world examples.
Example
A software company has just received $3,000,000 from annual subscriptions, and it will not need the money for payroll for three months. The treasurer puts $2,000,000 into a money market fund and $1,000,000 into a 90-day deposit. Both earn interest and can be accessed when the payroll date approaches.
Example
A retail chain keeps $500,000 in treasury bills to cover the gap between paying suppliers and collecting from customers after the holiday season. The bills mature just before the supplier invoices fall due. The chain makes a small return rather than letting the money sit in a current account.
Example
A university endowment holds a portion of its funds in certificates of deposit, laddered so that one matures each month. The ladder gives the finance office a steady stream of available cash. It also reduces the risk of reinvesting everything at a time when rates are low.
Formula
Calculation
Return over the holding period = (ending value - beginning value) / beginning value
Annualised return = return over the holding period x (365 / days held)
Suppose a company places $200,000 in a 91-day treasury bill and receives $202,000 at maturity. The return over the period is (202,000 - 200,000) / 200,000 = 2,000 / 200,000 = 0.01, which is 1%. The annualised return is 1% x (365 / 91) = 1% x 4.011 = about 4.01%. Annualising allows the investment to be compared with other options that have different maturities.Case study
Seen in the real world.
Peregrine Components is an illustrative, fictional electronics supplier that had $4,000,000 of idle cash after a large customer paid early. The financial controller wanted to earn a return without putting the money at risk.
She followed the company's treasury policy and split the cash between treasury bills and a government money market fund. Over the next four months the investments earned about $52,000, which was enough to cover the salary of a junior analyst for the year.
When an unexpected tooling cost of $1,200,000 appeared, the bills were sold in a day without a loss. The illustrative lesson is that the point of short-term investments is not to maximise return but to earn something while keeping the money available. The controller also presented the results to the board each quarter, showing the amount invested, the interest earned and the maturity dates, so that directors could see the policy working.
Watch out
Common mistakes.
- Chasing a higher yield by moving spare cash into long-dated or illiquid investments that cannot be sold quickly.
- Treating short-term investments and cash equivalents as the same thing, when cash equivalents have very short maturities, normally three months or less.
- Ignoring counterparty risk, which is the chance that the bank or issuer cannot repay, when placing large deposits with a single institution.
Questions
People also ask.
Are short-term investments the same as cash?
No, they are separate lines on the balance sheet, although they are both highly liquid and are often added together for liquidity analysis.
What is the usual maturity?
Within one year, with many treasurers favouring terms between one and six months.
Why do companies hold them?
They earn a return on spare cash while keeping the money available to pay bills or fund unexpected opportunities.
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