How secure are my investments?
Security means different things to different people. When we use that term here we are referring to a firm’s (such as an investment platform, investment provider or investment/fund manager) sustainability - will it be around for a long time? - and therefore in the main to a firm’s financial strength - its ability to generate profits and sufficient cash flow to pay bills and repay debt or investors. In general, the financial strength of a firm can be measured in three key areas: profitability, liquidity and solvency. There is a fourth critical factor and that is in having sound risk management practices.
What protection is there?
We are often asked by clients what happens if a firm they are invested with fails; or whether they can invest their money in such a way that it is 100% protected should this event occur. The good news is that there are protections in place for clients of authorised financial services firms if those firms are unable, or likely to be unable, to pay claims against it.
When we refer to authorised firms, these are UK firms that are authorised and regulated by the Financial Conduct Authority (FCA) and/or the Prudential Regulation Authority (PRA). Regulated firms offer consumers the highest levels of protection. However, these protections are multi-faceted and relatively complex to understand. How they work in reality is only really evidenced when these dramatic events occur (e.g. a firm’s insolvency).
We would never normally claim that an investor can fully secure 100% of their investments – although this is theoretically possible in certain scenarios, such as investing in insured funds. We will look at the various protections and how they apply to specific investment types in a subsequent article.
So while certain protections are in place in the event of an authorised firm failing, what we believe is of primary importance is ensuring, to the best of ones’ ability, that the firms used for savings and investments are unlikely to fail in the first place.
What is Profitability?
Profitability measures a company’s ability to generate profit or positive net income for a given level of sales or investment.
If a company is not profitable it eventually becomes insolvent and may require reorganisation or liquidation.
Operating profit serves as an indicator of a business’s potential profitability. Net profit is even better, as it is a robust profit measurement in showing the company’s profit net of interest payments and taxes - a company can show a positive operating profit but due to high debts have a negative net profit.
What is Liquidity?
Liquidity measures a company’s ability to utilise its resources available to meet its short-term commitments. If a company cannot meet its short-term commitments on time, it eventually becomes insolvent and may require reorganisation or liquidation.
The greater the ratio of resources available to short-term commitments, the stronger the company.
One example of a financial ratio that measures liquidity is the current ratio. The current ratio measures the size of a company’s current assets (i.e. assets that can be converted into cash in less than 12 months) to the size of its current liabilities (debts that have to be paid in less than 12 months).
What is Solvency?
Solvency measures a company’s ability to meet its interest and principal payments on long-term debt and similar obligations as they come due. If a company cannot make payments on time, it becomes insolvent and may require reorganisation or liquidation.
One example of a financial ratio which measures a firm’s long-term solvency is the debt ratio. This ratio measures the amount of long-term debt financing as a proportion of its overall capital structure. Credit ratings can help us to understand whether a company will be able to meet their obligations. Moody’s, Standard & Poor's, and Fitch are the three main ratings agencies for UK financial institutions.
In the UK, authorised investment firms must meet the FCA’s minimum capital requirements. Exceeding these regulatory requirements can demonstrate an additional level of prudence in the firm’s financial management.
Good Risk Management
One further element of assessing a firm’s sustainability is their approach to risk management. The FCA requires authorised firms to publish certain information to enable the market to assess a firm's risks, capital and risk management procedures - known as Pillar 3 disclosure. We believe that robust and evidenced risk management policies and procedures are of fundamental importance to the long-term sustainability of a firm.
What next?
If you would like us to assess how secure your investments are, get in touch for a free initial chat with one of our Chartered Financial Planners.
Please note this article offers information about financial planning and should not be taken as personal advice. The value of pensions and investments can go up and down in value, so you could get back less than you put in. Tax rules can change and the benefits depend on individual circumstances.