Investment of Surplus Funds

Principle & Practice of Management

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Investment of Surplus Funds

Components may have surplus funds (excess cash) on several occasions that are required after some time. Therefore, it would be an efficient decision, if the excess cash invested in some investment avenues that may be safe and liquid, and which may even earn some reasonable interest too, during the holding period. A number of marketable securities available to the firm, depending upon the varying degree of risks and liquidity and the matching income generation. The financial manager must decide the portfolio of marketable securities in which the firm’s excess cash (surplus funds) should be invested.

Surplus Funds

Selecting Investing (Avenues) Securities

A firm can invest surplus funds in any types of short-term marketable securities, but it has to take into considerations the prime criterion in security, liquidity and interest. Thus in selecting an investment avenue among available alternatives the firm has to examine four basic features of safety, marketability, yield and maturity.
1. Safety: Safety refers to the likelihood of getting back principle that is originally invested. Usually, a firm would be interested in receiving an as high return on investments, but the higher the return securities are relatively more risky and vice versa. For the safety of the investment, the firm should invest in safe securities.
2. Marketability: Marketability of securities refers to the owner’s ability to convert the securities into cash on short notice. The two important aspects of marketability are price and time. If the security can be sold within a short period without loss, it is the highly liquid asset. The firm has to invest its surplus funds only in marketable securities.
3. Yield: The yield or return, on a security, is related to the interest and appreciation of principle amount invested on a security. Some securities do not pay interest since they are sold at discount (Treasury bills). If the firm prefers return it may require bearing risk.
4. Maturity: Maturity refers to the time over which interest and principal amount are to paid. Almost all the short-term securities are having different maturity periods. Financial manager has to decide in which securities surplus funds cash should be invested.

Money Market Instruments or Marketable Securities

Money market refers to the market for short-term securities. It has no physical marketplace and it consists of a loose agglomeration of banks and dealers linked together by telex, telephones and computers. A huge volume of securities is regularly traded on the market and the competition is energetic. The following are most prominent short-term securities available for investment of surplus funds cash.
1. Units of Unit 1964 Scheme: This scheme is one of the units of Unit Trust of India (UTI), it is known as the Unit Scheme 1964 (in short US 64). It is the most popular mutual fund scheme in India, which comprises the following features: (i) it is an open ended scheme – as it can be purchased and sold back to the UTI itself on the continuous basis, (ii) the units have face value of Rs. 10 for sale and the purchase of units are not determined on the basis of the Net Asset Value (NAV) of the units, as should be the case for a truly open-ended scheme. It is instead, they are determined administratively by the UTI taking into account the element of accrued interest, from time to time, usually at monthly intervals. Thus the units of the US 64 scheme offer a convenient and attractive investment avenue for short-term funds for the following reasons: (i) Existence of active secondary market, (ii) Units appreciates over time in a fairly predictable manner as the UTI makes a gradual upward revision in its selling and repurchase price from July to June, each year.
2. Ready Forward (RFs or reports): In the ready forward deal, a commercial bank or some other organisation may enter into an arrangement with a company, intending to park its surplus funds for a short period, under which the bank may sell some securities to one company and repurchases the same securities at prices (i.e., both buying and selling prices) determined as mutually agreed. Hence, it is termed as ‘ready forward’. Ready forwards, are, however, permitted only in a limited number of specified securities. Ready forward does not provide any income to the company in the form interest, but the company’s income is the difference between the buying and selling prices. The income earned on the ready forward is taxable as usual. The rate of return on a ready forward deal is closely related to the market conditions prevailing in the money market, which is generally tight during the busy season, also at the time of the annual closing.
3. Treasury Bills: Treasury bills are the obligations of the government for a short-term period of less than one year, ranging from 91 days to its multiple like 182 days and 364 days. They are sold at a discount rate and redeemed at the face value and the difference between the rates constitutes to the income. In other words, they are not issued at any interest rate. The yield on treasury bills is low when compared to other gainful short-term investment avenues. But it has several attractive features, like First, they are issued in a bearer form, which makes them easily transferable mere by delivery of the documents, without any endorsement. Second, the secondary market for bills make them highly liquid, and also allows purchasing of bills with very short maturities. Third, they are risk-free since they are having the financial backing of the government.
4. Commercial Papers (CPs): Commercial paper is short-term, an unsecured promissory note issued by large companies. It was introduced in 1990 with a view to enabling the highly rated corporate borrowers to diversify the sources of their short-term borrowings, as also provide an additional instrument to the investors, to park their surplus funds for a short period. Eligibility, any firm which planning to issue of commercial papers has to fulfill the guidelines given by RBI, such as (i) the tangible net worth of the issuing company should not be less than Rs. 4 crore, as per latest balance sheet, (ii) the company should have been sanctioned a working capital limit by the bank(s) or all India Financial Institutions (IFIs), (iii) the company should have been classified as a Standard Asset by the financing bank(s) financial institutions, and (iv) a minimum credit rating of P-2 of CRISIL (Credit Rating Information Services of India Limited), or such equivalent rating by any other agency approved by RBI (like ICRA – Investment Information and Credit Rating Agency of India Limited, CARE – Credit Analysis and Research Limited).
Mode of Issue: Commercial papers can be directly (companies with high credit rating) issued or through dealers. These are generally sold at a discount (in bearer form) to the face value, as determined by the buyer, but sometimes they can be issued carrying interest and made payable to the order of the investor. The commercial paper should not be underwritten or co-accepted. They can be issued with a maturity of the minimum period of 15 days (reduced from 30 days) to a maximum period of up to one year. They are issued in the denomination of Rs. 5 lakh or multiples thereof. Any single investor has to invest a minimum amount of Rs. 5 lakh. The main attraction of CPs is the interest rate that is typically higher than that offered by the treasury bills or certificates of deposits. The only disadvantage is that it does not have an active secondary market.
5. Certificate of Deposit (CDs): Certificate of deposit represents the receipts of funds deposited with a bank specified period, like the bank term deposits, but the only difference is CDs are negotiable. CDs may be issued in registered form or bearer form. The latter form is more popular since it can be transacted more easily in the secondary market. Not like treasury bills (issued at discount) CDs are issued at an explicit rate of interest. On maturity, the investor gets the principal amount along with interest accumulated.
Certificate of deposits are popular form of short-term investment of surplus funds for companies due to the following reasons: (i) these can be issued by banks in the required denominations and maturities period suits to the needs of investors, (ii) CDs are fairly liquid, (iii) They are virtually risk-free and (iv) CDs generally offer higher rate of interest than the treasury bills and even bank term deposits.
6. Banker’s Acceptance: Banker’s acceptances are time drafts drawn on a bank by a firm (the drawer or exporter) in order to obtain payment for goods that he/she has shipped to a customer which maintains an account with that specific bank. In other words, it is a short-term promissory trade note for which a bank (by having ‘accepted’ them) promises to pay the
holder the face amount at maturity. The draft guarantees payment by the accepting bank at a specific point in time. Hence, the acceptance becomes a marketable security. The document is not issued in specialised denominations since one party uses acceptances to finance the acquisition of good. The size of bank acceptances is determined by the cost of goods being purchased. They serve a wide range of maturities and are sold on a discount basis, payable to the bearer. There is no secondary market for acceptances of large banks. Due to their greater financial risk and lesser liquidity, acceptances provide investors with a yield advantage over treasury bills of the same maturity. Acceptance of major banks is a safe investment.
7. Intercorporate Deposits (ICDs): This is a popular short-term investment avenue for companies in India. As the name itself suggests, an inter-corporate deposit is that deposit made by one corporate body (company) with another corporate company. The deposits are usually made for a maximum of six months.
There are three types inter-corporate deposits:
(a) Call Deposits: These types of deposits are expected to be paid on call, which is whenever its repayment is demanded. Generally, these deposits are called back giving a day’s notice. But in actual practice, the lender has to for at least three days.
(b) Three-month Deposits: These are more popular among the corporate bodies for parking the surplus funds correspondingly for tiding over the short-term financial crunch faced by some others.
(c) Six-month Deposits: Generally, inter-corporate deposits do not extend beyond six months period. This type of deposits is usually made with ‘A’ category companies only.
Inter-corporate deposits are in the nature of unsecured deposits. Hence, due care has to be taken to assess and ascertain the creditworthiness and willingness of the company concerned, with whom it is intended to be made. In addition, it must make sure that it adheres the following requirements, as stipulated by sections 370 and 372 of the Company’s Act, 1956 which states a company cannot lend more than 10 percent of its net worth without prior approval of the central government and a special resolution permitting such excess lending.
8. Bad Financing: A company providing badly financing is essentially lending money to a stock market operator who wishes to carry forward his/her transaction from one settlement period to another. Generally, such finance is provided through a broker and that too against the security of the shares already brought by the stock market operator. Badal has the single greatest advantage that it offers a very attractive rate of interest. But it is coupled with gain there are several risks like the stock market broker may not honour his commitment or the broker may become a defaulter. Soothe following precautionary and safety measures should bear in mind while providing badly financing: (i) provide finance only for reputed and financially strong stockbroker, (ii) select intrinsically sound shares, (iii) ask or keep adequate margin, if share is highly volatile, and (iv) secure possession of share certificates.
9. Bills Discounting: Generally bill arises out of trade transaction. Bill is drawn by the seller (drawer) on the buyer (drawee) for the value of goods delivered to him. During the pendency of the bill, if the seller needs finds he/she may get it discounted. On the maturity, the bill is presented to the drawee for payment. A bill of exchange is a self-liquidating instrument. Discounting is superior to the inter-corporate deposits. While participating in bill discounting a company should ensure that the bill is traded bill and not accommodation bill, try to go for bills backed by letters of credit rather than open bills as the former are more secure.