Introduction to Investments in Securities

Alright now let's discuss some of the investments a company can make to earn investment income, and how we classify those investments. Alright, let's do an introduction now. So a company may choose to invest for one of two main reasons. The first one would be if they have excess cash, right? They've been generating a lot of cash through their business and they have more cash than they can invest back into their business. Maybe they can't specifically grow their business. So they might buy some investments to earn a little extra money. So they're gonna earn some income off of these investments that they make. Or they can do it to uh to exercise influence over another company. If you buy enough stock in another company, you can say that you influence the company. Imagine if you owned all the stock in a company, well then you would be able to control that company, Right? So buying enough stock in another company allows you to affect its decision making. Okay? You can have you can have influence over the decision making. And we say that when you generally when you have more than 20% of the company, you're able to influence the company. Okay. So at this point we're gonna focus on less than 20% investment. So small investments that you make, maybe you buy 10 shares of Apple stock or some like that. Well, you're not gonna be able to control the company with just a few shares of the stock, but you might be able to make some income. So we're kind of focused more on this idea where you're just trying to make a little extra income off excess cash. Okay. We'll talk about influence in later videos. Um, but for now, let's discuss some of these securities that you might buy. So security. We use this word security for basically any kind of investment that you make. If you buy stock, if you buy bonds, right, any kind of financial instrument that holds monetary value, right? That's a security. Okay. So it's kind of a generic term and it could represent an ownership in the company or a creditor relationship. So creditor is like where they owe you money, right? So we have two types of securities. We, we talk about equity securities, which is an ownership interest, right? This is where you have an ownership interest in the company. So that's like buying common stock of the company or you might buy a special type of stock called preferred stock. Okay. It's similar to common stock, but it has special rules. Not, not too much to talk about it now, but it's basically just buying ownership interest in the company. Okay. So the way that you earn money off of an equity security is through the dividends that it pays. So we've talked about dividends before, but now we're on the receiving end, right? The company's gonna pay dividends and we're gonna receive a dividend that's income to us and through capital gains capital gains. Well, capital gains is when there's an increase in the value of the security. So you buy it at one price and the price goes up and you sell it at a higher price, right? Buy low, sell high. Those are capital gains there. So let's do a quick example about equity securities and uh income. So what do we got here? You purchased 10 shares of banana stock for $400. The company paid a dividend of $1 per share. You sell the banana stock when the price has increased to $55 per share. How much income did you earn on your investment? Okay, so there's two sources of income here, right? You earn income from the dividends you receive and you earn income from the capital gains. So let's check each of them separately 1st. Let's do the dividends. So the dividends, it says they paid $1 per share and you bought 10 shares, right? So if you bought 10 shares and you got $1 per share in dividends, 10 times $1 Well that's $10 in dividends that you received. Right? Not too nothing too crazy there. Let's think about the capital gains. Now You earned some money on the change in the price between when you bought it and you sold it. So let's see what you bought it for. You bought it, you bought 10 shares for $400, right? So there's two ways you can go about this, let's go about it. Two different ways you can think about the investment as a whole and think about how much you earned on the total investment. So if you if you bought 10 shares for 400, how much did you sell those shares for? $55 per share? And there were 10 shares. Right? So the selling price was $550 uh for the 10 shares, right? And you bought them for $400. So your earnings were $150 in capital gains, right? So you can think of it in total or you can do it on a per share basis But you're gonna get to the same answer right? So what you could do is you can find out, you sold each one for $55 per share. Let's find out how much you bought each one. So sorry, so you bought each one for $55 per share. How much did you purchase them for? Well you bought four, you spent 400 on 10 shares, so you paid $40 per share, right? So that means you earned 55 -40, you earned $15 per share was your earnings. And you you bought 10 shares, so you got 100 and $50 right. Either way you got 100 and $50 in capital gains and $10 from dividends. So how much income did you earn? Well you earned 160 right, you earned the sum of the 21 50 plus the 10 equals 1 60 total earnings. Right? The total of the two earnings would be your total investment income. So with equity securities, you can earn from two different places from dividends and from capital gains. Now, what about debt securities? These are the other type of security. We're gonna either have an equity security where we buy equity in a company, or debt security where we loan money to another company money. So in a debt security, it's money that is borrowed and it must be repaid with interest. So in this case, we're the ones lending out the money, right? So we're lending money to somebody and they're gonna pay us back with interest eventually. So this is usually bonds that we're gonna see as the investment will see. We will buy bonds in another company. Okay, So in that in that case we'll be dealing with how much interest that we earned, uh, nothing too crazy there. So let's go ahead and pause here and then we'll talk about the different classifications of securities, how we classify them on our books

So regardless of whether we bought a debt security or an equity security, we're going to classify them on our books, depending on what we plan to do with them. Okay, so the first one is a trading security, a trading security. And we usually are gonna use T. S. As an acronym for a trading security. And this is a security that an an investment that we make that we're expecting to sell within the near term and that we're going to be doing active trading with it. Okay. So generally when they when they talk about these classifications, they're gonna have to tell you which category it falls into. But sometimes they won't be so explicit and you'll have to be able to gauge based on what they tell you if you're trying to sell it quickly. Well then you're gonna have to assume it's a trading security compare that let's skip available for sale. And let's go to the last one held to maturity held to maturity. We'll call it H. T. M. As an acronym, held to maturity. Well these are going to have to be debt securities because if you think about an equity security, if you buy common stock in a company, you can't really hold it to maturity, right? A corporation has an unlimited life. It's gonna go on forever. So this is strictly for debt securities and that these are gonna be that the investor intends to hold until the maturity date. So if you think about a bond right, a bond might be a 10 year bond and in 10 years they're gonna repay the principal. Well, if you're expecting to hold it for the whole 10 years and receive all the interest payments, right, then you're gonna have this as a held to maturity investment. And they will have to tell you in the problem, the company intends to hold this investment until maturity, right? Something like that. Now let's look at the middle one here available for sale, which we call A. F. S. Available for sale securities. And this is somewhere in the middle. This is where we intend to sell them right there available for sale. But we're not doing any active trading, like we are with with the trading securities. Okay, So when we, when we have available for sale, it's like, yeah, we'll sell them if the right opportunity comes along, but we're not actively trying to trade them, we're not, you know, buying and selling quite a bit available for sale. So this is kind of a middle ground here. And they're gonna again have to tell you be pretty explicit when they're telling you which category it fits into. So let's learn a little bit more about these different securities, uh these different classifications. Um And when we talk about a trading security, this could be current. So when we talk about classification is where can it show up on the balance sheet? So I'll say Bs for balance sheet classification and those have to be current, right? Because we're actively trading them. Um So we're actively trying to get rid of it in the near term. So those are gonna be current investments available for sale. These could be current or long term as well as held to maturity. They can be current or long term depending on when the maturity date is, but they'll have to tell you in all of these examples and you'll be able to tell if it's current or long term. Right? If we're gonna have that one year threshold like we have always had on our balance sheet. Cool. So that's where we would classify it on the balance sheet. Now, the initial measurement, This is what happens when we initially by the investment. So we're gonna go and buy the shares of stock. How are we gonna make the journal entry and show it on our books? We're gonna show it at cost just like we've done with all other investments or all things that we've purchased, let's say we purchased a piece of machinery. How did we put it on our books at the cost? Right. Whatever we paid for it, it goes on the books about with inventory. When we purchased the inventory, How does it get on our books at the cost? Right. Whatever we paid for it, that's how it's going to get onto our books. However, as time passes, we're gonna change the value of these investments based on a few factors. So when it's a trading security or an available for sale security, we are going to use the fair value. Okay, we're gonna use the fair value of the of the investment. And what does that mean? The fair value. So if you think about, let's say you bought shares of apple and let's say hypothetically they were they were trading for $50 a share when you bought them. And then at the end of the year, when it's time to show your balance sheet, they're trading for $75 a share. Well, you're going to change the value in your book to show on your balance sheet that they have a value of $75 rather than the $50 you purchase them. But when you make that change from, from the cost of the fair value, Well, you're gonna have to take a gain or a loss. Right? And that's these unrealized gains or losses. We're gonna talk more about those once we get into the details of each of these securities, um but those unrealized gains or losses, those are the changes in fair value before you sold the investment. Okay. So when we're talking about a trading security, those unrealized gains or losses are gonna go on the income statement. Okay. But for an available for sale security, these are gonna go in other comprehensive income. We've talked about comprehensive income briefly, because it's not a big topic in this class. This is more for advanced level classes. But if you're gonna have to deal with other comprehensive income, this is probably the only situation you'll deal with it with available for sale securities. And I promise you it's gonna be very easy. Okay. The last one is here behind me, the held to maturity securities. So since you're holding these two maturity, you're going to be earning interest and you're gonna be doing what's called Amortization. So you're gonna keep them on your book at the advertised cost when you learn about bonds or if you've learned about bonds already at this point? Well, that is uh, we're basically going to use the same logic that we did when we do bonds for held to maturity securities. So if you haven't learned about bonds yet, then you're probably not gonna have to do held to maturity securities at this point. So you don't have to worry about it. Okay. And these unrealized gains or losses. Well, there are none when we're doing held to maturity investment because we're not changing the fair value. Remember these unrealized gains or losses? These are changes in fair value uh, since you purchase the investment. Okay. But from, so that's an entei behind me because it's not applicable there. But for health to maturity, that's not the case at all. We don't deal with that. So this is a little cheat sheet that you can keep. Um once we start going through, you'll, you'll kind of have this as a summary. Um but we're gonna go into a lot more details about each of these. So if you're still not feeling 100%, don't worry, we're gonna go into a lot more details coming up. Alright so let's go ahead and start that in the next video.