SEED Preparatory Kit - Finance

SEED REFERENCE GUIDE
2017 SIBM SEED REFERENCE GUIDE
TABLE OF CONTENTS
I. INTRODUCTION TO FINANCE ROLES.............................................................................5
Investment banking ..................................................................................................... 5

Asset management ...................................................................................................... 5
Equity research ............................................................................................................ 5
Project finance ............................................................................................................. 5
Wealth management ................................................................................................... 5
Corporate treasury ...................................................................................................... 5
Corporate finance ........................................................................................................ 6
Credit analyst ............................................................................................................... 6
II. ECONOMICS................................................................................................................6
Theory of demand ....................................................................................................... 6

Elasticity of demand .................................................................................................... 7
Theory of supply .......................................................................................................... 7
Inflation- CPI, WPI ........................................................................................................ 7
Fiscal policy .................................................................................................................. 8
Monetary policy ........................................................................................................... 9
Gross Domestic Product- GDP ..................................................................................... 9
III. ACCOUNTING............................................................................................................ 10
Basic Accounting principles ....................................................................................... 10

Golden Rules of Accounting ...................................................................................... 10
Cash vs. Accrual accounting ...................................................................................... 10
Financial Statements ................................................................................................. 10
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Linkages between the 3 financial statements ........................................................... 11
IV. GENERAL FINANCIAL CONCEPTS ................................................................................ 12
Ratio Analysis ............................................................................................................. 12

Cash conversion cycle ................................................................................................ 17
Working capital management ................................................................................... 17
Difference between Hedging, Speculation and Arbitrage......................................... 19
V. BANKING .................................................................................................................. 20
Measures to regulate banking in India ...................................................................... 20

Balance sheets of banks ............................................................................................ 23
Central Bank's Balance Sheet .................................................................................... 23
Why are cash flow statements not used in banking analysis? .................................. 24
How does a bank operate? ........................................................................................ 24
BASEL norms and type of capital (Tier 1 and 2) ........................................................ 25
Banking ratios ............................................................................................................ 27
CAMELS analysis ........................................................................................................ 28
Working of repo market ............................................................................................ 30
Open market operations by RBI ................................................................................ 31
SARFAESI Act .............................................................................................................. 32
NPAs ........................................................................................................................... 32
NBFCs ......................................................................................................................... 33
IV. CORPORATE FINANCE ............................................................................................... 34
Time Value of Money ................................................................................................ 34

Discount rate ............................................................................................................. 40
Capital Asset Pricing Model (CAPM) .......................................................................... 41
Valuation techniques overview ................................................................................. 42
Mutual funds ............................................................................................................. 44
Hedge funds ............................................................................................................... 44
Exchange Traded Funds (ETFs) .................................................................................. 45
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Differences between FII and FDI ............................................................................... 45
V. CAPITAL MARKETS AND FINANCIAL INSTRUMENTS .................................................... 46
Equity ......................................................................................................................... 46
Debt ........................................................................................................................... 51
Capital Markets.......................................................................................................... 53
Debt Instruments ....................................................................................................... 57
Capital structure ........................................................................................................ 62
Derivatives ................................................................................................................. 63
Efficient market hypothesis ....................................................................................... 64
Currencies .................................................................................................................. 66
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I. Introduction to finance roles
Investment banking
Investment banks aren't like your local branch office with ubiquitous ATMs (those are
commercial banks, like Citibank or Bank of America); instead, investment banks work with
corporations, governments, institutional investors and extraordinarily wealthy individuals to
raise capital, provide investment advice, and also assist companies involved in mergers and
acquisitions, and provide ancillary services such as market making, trading of derivatives, fixed
income instruments, foreign exchange, commodities, and equity securities.
Asset management
Investment management or asset management is professional management of various
securities (shares, bonds and other securities) and other assets (e.g., real estate) in order to
meet specified investment goals for the benefit of the investors. Investors may be institutions
(insurance companies, pension funds, corporations, charities, educational establishments
etc.) or private investors (both directly via investment contracts and more commonly via
collective investment schemes e.g. mutual funds or exchange-traded funds).
Equity research
Equity Research primarily means analysing company's financials, perform ratio analysis,
forecast the financials (financial modelling) and explore scenarios with an objective of making
Buy/Sell stock investment recommendation. Buy-side analysts work for hedge funds, mutual
funds and other institutional investors, where they produce the research that shapes these
organizations' investment strategies. Sell-side analysts work for independent research firms
or for investment banks, where salespeople advise individual and institutional clients on
investments.
Project finance
Project finance is the financing of long-term infrastructure, industrial projects and public
services based upon a non-recourse or limited recourse financial structure, in which project
debt and equity used to finance the project are paid back from the cash flow generated by the
project. Preparing a project finance report requires careful analysis of cost and revenue
drivers, market trends, interest rates, etc. and preparation of comprehensive financial models
for various projects to deliver cash flow forecast, scenario analysis, risk assessment and return
analysis.
Wealth management
Wealth management is an investment-advisory role that incorporates financial planning,
investment portfolio management and financial advice. High-net-worth individuals (HNWIs),
small-business owners and families who desire the assistance of a financial advisory specialist
call upon wealth managers to coordinate retail banking, estate planning, legal resources, tax
professionals and investment management. Private wealth management encompasses a wide
range of fields, such as financial planning, investment management.
Corporate treasury
Corporate treasurers undertake a range of risk, strategic and/or general financial
management activities that enable companies to maintain or improve/maximize their
financial position. For non-banking entities, the terms Treasury Management and Cash
Management are sometimes used interchangeably, while, in fact, the scope of treasury
management is larger and includes funding and investment activities. Corporate treasury
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professionals assess, review and protect company financial wellbeing and ensure that cash
flow is adequate.
Corporate finance
Corporate financiers are responsible for identifying and securing privatisation, merger and
acquisition deals, managing and investing large monetary funds, and buying and selling
financial products for their clients. They advise clients on how to meet targets and create
investment capital by assessing and predicting financial risks and returns. The Corporate
Finance Manager steers the financial direction of the business, and undertakes all strategic
financial planning and reporting to stakeholders.
Credit analyst
Credit analysts are tasked with assessing and evaluating the risk of companies making financial
loans proposals to retail and commercial customers. Employers include commercial,
investment and foreign banks, private equity firms, investment/asset management
companies, insurance companies and specialist credit rating agencies (for example: S&P
Global Ratings). Typical responsibilities include gathering information about clients; assessing,
analysing and interpreting complicated financial information and undertaking risk analysis by
developing statistical models.
II. Economics
Theory of demand
Demand is the quantity of a good or service that consumers are willing and able to buy at a
given price in a given time period.
Utility: Each of us has an individual demand for an object, which subjects the object to be
valued at a particular price. Utility is the usefulness we expect to derive by consumption of
the object.
Effective Demand: It is this, which draws a thin line between demand and desire. Effective
demand is when your desire to own something is backed by the ability to pay for it.
Latent Demand: It is when the consumers lack the purchasing power to be able to afford
something.
Law of Demand: There is an inverse relationship between

the price of a good and demand
1. As prices fall, we see an expansion of demand
2. If price rises, there will be a contraction of demand
There are two reasons for the inverse relationship

between price and demand:
Income Effect: There is an income effect when the price

of a good falls because the consumer can maintain the
same consumption for less expenditure. Provided that the good is normal, some of the
resulting increase in real income is used to buy more of this product.
Substitution Effect: There is a substitution effect when the price of a good falls because the
product is now relatively cheaper than an alternative item and some consumers switch their
spending from the alternative good or service.
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Elasticity of demand
Price elasticity of demand is a measure used in economics to show the responsiveness, or

elasticity, of the quantity demanded of a good or service to a change in its price. More
precisely, it gives the percentage change in quantity demanded in response to a one percent
change in price (ceteris paribus, i.e. holding constant all the other determinants of demand,
such as income). Some common uses of elasticity include:
Effect of changing price on firm revenue
Analysis of incidence of the tax burden and other government policies
Income elasticity of demand can be used as an indicator of industry health, future
consumption patterns and as a guide to firms investment decisions
Effect of international trade and terms of trade effects
Analysis of consumption and saving behaviour
Price elasticity of Demand= (% Change in Demand)/ (% Change in Price)
If a small change in price is accompanied by a large change in quantity demanded, the product
is said to be elastic (or responsive to price changes). Conversely, a product is inelastic if a large
change in price is accompanied by a small amount of change in quantity demanded.
Theory of supply
The law of supply states that ceteris paribus, a higher
price leads to a higher quantity supplied and that a
lower price leads to a lower quantity supplied. As the
price of an item goes up, suppliers will attempt to
maximize their profits by increasing the quantity
offered for sale. The law of supply summarizes the
effect price changes have on producer behaviour.
It works with the law of demand to explain how market economies allocate resources and
determine the prices of goods and services. The four basic laws of supply and demand are:
If demand increases (demand curve shifts to the
right) and supply remains unchanged, a shortage
occurs, leading to a higher equilibrium price
If demand decreases (demand curve shifts to the left)
supply remains unchanged, a surplus occurs, leading
to a lower equilibrium price
If demand remains unchanged and supply increases
(supply curve shifts to the right), a surplus occurs,
leading to a lower equilibrium price
If demand remains unchanged and supply decreases
(supply curve shifts to the left), a shortage occurs,
leading to a higher equilibrium price.
Inflation- CPI, WPI
Inflation is defined as a sustained increase in the general level of prices for goods and services.
Inflation directly affects interest rates. And hence, the RBI watches inflation closely as part of
its role of setting interest rates. At the same time, some amount of inflation (usually around 1
to 2 percent) is a sign of a healthy economy. If the economy is healthy and the stock market
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is growing, consumer spending increases. This means that people are buying more goods, and
by consequence, more goods are in demand. No inflation means that you do not have a robust
economy - that there is no competitive demand for goods.
CPI has been used for calculating Inflation in India since April 2014. Consumer prices in India
increased 2.18 percent year-on-year in May of 2017, slowing from a 2.99 percent rise in April
and well below market expectations of 2.6 percent. The inflation hit a new record low for the
second month as food prices fell for the first time ever led by pulses and vegetables. Inflation
Rate in India averaged 7.06 percent from 2012 until 2017, reaching an all-time high of 12.17
percent in November of 2013 and a record low of 2.18 percent in May of 2017.
There are several variations on inflation:

Deflation: is when the general level of prices is falling. This is the opposite of inflation.
Hyperinflation: It is unusually rapid inflation
Stagflation: It is the combination of high unemployment and economic stagnation with
inflation.
Consumer Price Index (CPI): A consumer price index (CPI) measures changes in the price level
of a market basket of consumer goods and services purchased by households.
Goods that are covered: Foods and Beverages, Housing, Apparel, Transportation, Medical,
Recreation, Education and communication & other goods and services.
Wholesale Price Index (WPI): It reflects the change in price of goods that are bought and sold
in the wholesale market. It is published by Ministry of Commerce and Industry in India to keep
a track of inflation. WPI eased to 2.17% in May 2017 after hitting 3.85% in April.
Goods included: Food articles (food grains, fruits, vegetables, meats, fish), non-food articles
(fiber, oil seeds), fuel, manufactured goods, and power.
Difference between CPI and WPI

WPI is the middle point of all the prices that the merchants pay for certain goods or services
from the manufacturers or traders. Whereas, CPI is the middle point of all the prices that the
consumers, homeowners and private sectors have paid for particular products and services.
The WPI is compiled and published by Office of the Economic Advisor on a weekly basis while
the CPI is compiled and published by the Labour Bureau on a monthly basis in India.
Fiscal policy
Government spending policies influence macroeconomic conditions. Through fiscal policy,

regulators attempt to improve unemployment rates, control inflation, stabilize business cycles
and influence interest rates in an effort to control the economy.
The government might lower tax rates to try to fuel economic growth in times of a recession.
If people are paying less in taxes, they have more money to spend or invest. Increased
consumer spending or investment could improve economic growth. Another possibility is that
the government might decide to increase its own spending say, by building more highways.
The idea is that the additional government spending creates jobs and lowers the
unemployment rate.
One of the many problems with fiscal policy is that it tends to affect particular groups
disproportionately. A tax decrease might not be applied to taxpayers at all income levels, or
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some groups might see larger decreases than others. Likewise, an increase in government
spending will have the biggest influence on the group that is receiving that spending.
Monetary policy
It relates to the actions of a central bank, currency board or other regulatory committee that
determine the size and rate of growth of the money supply, which in turn affects interest
rates.
Monetary policy is maintained through actions such as increasing the interest rate, or
changing the amount of money banks need to keep in the vault (bank reserves). In India, the
Reserve Bank of India (RBI) is in charge of monetary policy. Central banks have typically used
monetary policy to either stimulate an economy into faster growth or slow down growth over
fears of issues like inflation. The theory is that, by incentivizing individuals and businesses to
borrow and spend, monetary policy will cause the economy to grow faster than normal.
Conversely, by restricting spending and incentivizing savings, the economy will grow less
quickly than normal.
FISCAL POLICY MONETARY POLICY

Fiscal policy is the use of government Monetary policy is the process by which the
expenditure and revenue collection to monetary authority of a country controls the
influence the economy. supply of money, often targeting a rate of
interest to attain a set of objectives oriented
towards the growth and stability of the
economy.
Manipulating the level of aggregate demand Manipulating the supply of money to
in the economy to achieve economic influence outcomes like economic growth,
objectives of price stability, full employment inflation, exchange rates and
and economic growth. unemployment.
Government of India Reserve Bank of India
Taxes, amount of government spending Interest rates, reserve requirements,
currency peg, discount window, quantitative
easing
Gross Domestic Product- GDP
The monetary value of all the finished goods and services produced within a country's
borders in a specific time period, though GDP is usually calculated on an annual basis. It
includes all of private and public consumption, government outlays, investments and
exports less imports that occur within a defined territory.
GDP= C+G+I+NX
C is equal to all private consumption, or consumer spending, in a nation's economy G is

the sum of government spending I is the sum of all the country's businesses spending on
capital NX is the nation's total net exports, calculated as total exports minus total imports.
(NX = Exports Imports)
According to the World Bank, Gross Domestic Product (GDP) in India was worth 2088.80 billion
US dollars in 2015. The GDP value of India represents 3.37 percent of the world economy. GDP
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in India averaged 484.56 USD Billion from 1960 until 2015, reaching an all-time high of 2088.80
USD Billion in 2015 and a record low of 37.68 USD Billion in 1960.
III. Accounting
Basic Accounting principles
These are called Generally Accepted Accounting Principles, or GAAP. Key GAAPs are:
o Going concern concept: This principle assumes that a business will go on, that is, it will
continue in the foreseeable future it has no finite life. This principle is used to project
cash flows in the future.
o Legal entity concept: The business is an entity separate from owners; even if its a
small, one person business running out of home. Therefore the business accounts are
taken separate from the owners.
o Conservatism concept: It refers to the policy of 'playing safe'. As per this convention,
all prospective losses are taken into consideration but not all prospective profits.
o Matching concept: The business must match the expenses incurred for a period, to
the income earned during that period.
o Cost concept: All assets are recorded on the books at purchase price (historical cost),
not market price, with some exceptions.
Golden Rules of Accounting

Personal Account
Debit the Receiver, Credit the Giver
Real Account
Debit what comes In, Credit what goes out
Nominal Account
Debit all Expenses and Losses,
Credit all Incomes and Gains
Cash vs. Accrual accounting

The cash basis of accounting recognizes revenues when cash is received, and expenses when
they are paid. This method does not recognize accounts receivable or accounts payable.
Under the accrual basis, revenues and expenses are recorded when they are earned,
regardless of when the money is actually received or paid. This method is more commonly
used than the cash method. Accrual basis gives a more realistic idea of income and expenses
during a period of time, therefore providing a long-term picture of the business that cash
accounting cant provide.
Financial Statements
o Balance sheet: The Balance Sheet presents the financial position of a company at a given
point in time. It is comprised of three parts: Assets, Liabilities, and Shareholder's Equity.
Assets are the economic resources of a company. They are the resources that the
company uses to operate its business and include Cash, Inventory, and Equipment. A
company normally obtains the resources it uses to operate its business by incurring debt,
obtaining new investors, or through operating earnings. The Liabilities section of the
Balance Sheet presents the debts of the company. Liabilities are the claims that creditors
have on the company's resources. The Equity section of the Balance Sheet presents the
net worth of a company, which equals the assets that the company owns less the debts it
owes to creditors. In other words, equity is comprised of the claims that investors have
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on the company's resources after debt is paid off. The most important equation to
remember is that
Assets (A) = Liabilities (L) + Shareholder's Equity (SE)
To summarize, the Balance Sheet represents the economic resources of a business. One
side includes assets, the other includes liabilities (debt) and shareholder's equity, and
Assets = L+E. On the liability side, debts owed to creditors are more senior than the
investments of equity holders and are classified as Liabilities, while equity investments
are accounted for in the Equity section of the Balance Sheet.
o Profit and loss/ income Statement: The Income Statement presents the results of
operations of a business over a specified period of time (e.g., one year, one quarter, one
month) and is composed of Revenues, Expenses and Net Income.
Revenue is a source of income that normally arises from the sale of goods or services
and is recorded when it is earned.
Expenses are the costs incurred by a business over a specified period of time to
generate the revenues earned during that same period of time. For example, in order
for a manufacturing company to sell a product, it must buy the materials it needs to
make the product. In addition, that same company must pay people to both make and
sell the product. These are all types of expenses that a company can incur during the
normal operations of the business. When a company incurs an expense outside of its
normal operations, it is considered a loss. Losses are expenses incurred as a result of
one- time or incidental transactions.
Assets vs. expenses: A purchase is considered an asset if it provides future economic
benefit to the company, while expenses only relate to the current period. For
example, monthly salaries paid to employees for services they already provided to the
company would be considered expenses. On the other hand, the purchase of a piece
of manufacturing equipment would be classified as an asset, as it will probably be
used to manufacture a product for more than one accounting period.
Net income: The Revenue a company earns, less its Expenses over a specified period
of time, equals its Net Income. A positive Net Income number indicates a profit, while
a negative Net Income number indicates that a company suffered a loss (called a "net
loss").
o Cash flow statement: The Statement of Cash Flows presents a detailed summary of all of
the cash inflows and outflows during the period and is divided into three sections based
on three types of activity:
Cash flows from operating activities: Includes the cash effects of transactions involved
in calculating net income.
Cash flows from investing activities: Basically, cash from non-operating activities or
activities outside the normal scope of business. This involves items classified as assets
in the Balance Sheet and includes the purchase and sale of equipment and
investments.
Cash flows from financing activities: Involves items classified as liabilities and equity
in the Balance Sheet; it accounts for external activities that allow a firm to raise capital
and repay investors, such as issuing dividends, adding or changing loans or issuing
more stock.
Linkages between the 3 financial statements

Balance sheet and Income Statement: The main link between the two statements is that
profits generated in the Income Statement get added to shareholder's equity on the Balance
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Sheet as Retained Earnings. Also, debt on the Balance Sheet is used to calculate interest
expense in the Income Statement.
Balance sheet and Cash flow Statement: Cash balance in Balance Sheet is arrived through net
increase / decrease in cash, adjusted with beginning cash balance. Also, Cash from Operations
is derived using the changes in Balance Sheet accounts (such as Accounts Payable, Accounts
Receivable, etc.). The net increase in cash flow for the prior year goes back onto the next year's
Balance Sheet.
Income statement and Cash Flow Statement: The non-cash and non-operating items in the
Income Statement are adjusted to the net profit to arrive at the net cash flow from operations.
IV. General Financial Concepts

Ratio Analysis
Profitability ratios
Gross Profit Margin: The gross profit margin looks at cost of goods sold as a percentage of
sales. This ratio looks at how well a company controls the cost of its inventory and the
manufacturing of its products and subsequently pass on the costs to its customers. The larger
the gross profit margin, the better for the company. The calculation is: Gross Profit/Net Sales.
Both terms of the equation come from the company's income statement.
Operating Profit Margin: Operating profit is also known as EBIT and is found on the company's
income statement. EBIT is earnings before interest and taxes. The operating profit margin
looks at EBIT as a percentage of sales. The operating profit margin ratio is a measure of overall
operating efficiency, incorporating all of the expenses of ordinary, daily business activity. The
calculation is: EBIT/Net Sales. Both terms of the equation come from the company's income
statement.
Net Profit Margin: When doing a simple profitability ratio analysis, net profit margin is the
most often margin ratio used. The net profit margin shows how much of each sales dollar
shows up as net income after all expenses are paid. For example, if the net profit margin is 5
percent, which means that 5 cents of every dollar are profit. The net profit margin measures
profitability after consideration of all expenses including taxes, interest, and depreciation. The
calculation is: Net Income/Net Sales. Both terms of the equation come from the income
statement.
Return on Assets (also called Return on Investment): The Return on Assets ratio is an
important profitability ratio because it measures the efficiency with which the company is
managing its investment in assets and using them to generate profit. It measures the amount
of profit earned relative to the firm's level of investment in total assets. The return on assets
ratio is related to the asset management category of financial ratios. The calculation for the
return on assets ratio is: Net Income/Total Assets. Net Income is taken from the income
statement and total assets is taken from the balance sheet. The higher the percentage, the
better, because that means the company is doing a good job using its assets to generate sales.
Return on Equity: The Return on Equity ratio measures the return on the money the investors
have put into the company. This is the ratio potential investors look at when deciding whether
or not to invest in the company. The calculation is: Net Income/Stockholder's Equity. Net
income comes from the income statement and stockholder's equity comes from the balance
sheet. In general, the higher the percentage, the better, with some exceptions, as it shows
that the company is doing a good job using the investors' money.
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Leverage and capital structure ratios

In the financial world, leverage can be defined as the influence of fixed expenses over the
operating cash flow or earnings. Fixed expenses can be used as a lever to magnify the operating
cash flows and earnings. The term refers generally to circumstances, which brings about an
increase in income volatility. In business, leverage is the means of increasing profits. It may be
favourable or unfavourable. The leverage of a firm is essentially related to a profit measure, which
may be a return on investment or on earnings before taxes.
Types of leverage
Operating Leverage- It is defined as change in earnings before interest and taxes (EBIT) due to
change in sales. If all the costs of the product are variable, the expected percentage change in the
income before taxes will be equal to the percentage change in sales. Operating leverage is
concerned with the operation of any firm. The cost structure of any firm gives rise to operating
leverage because of the existence of fixed nature of costs. This leverage relates to the sales and
profit variations.
Operating leverage is the responsiveness of firms earnings before interest and taxes to the
changes in sales value. It refers to the sensitivity of operating profit before interest and tax to the
changes in quantity produced and sold. The firms operating leverage would be higher if the firm
has high quantum of fixed cost and low variable cost. The low operating leverage represents the
high variable cost and low fixed cost. If the operating leverage of the firm is higher, the more its
profits will vary with a given percentage in sales. The operating leverage is an attribute of the
firms business risk.
The operating leverage falls with the increase in sales beyond the firms break-even point. A
company with high proportion of fixed costs to total costs will have a high operating leverage. A
company with a high operating leverage will have higher break-even level. If contribution to sales
ratio of a firm is high, it can achieve higher profitability at maximum operating level. In times of
recession, the high operating leverage will act as a disadvantage to the firm for the reason that
lower level of operating profits due to higher fixed costs.
Degree of Operating Leverage

Degree of operating leverage is a relationship between the percentage changes in EBIT with 1%
change in sales. The ability of the firm to leverage the fixed costs to achieve more than
proportionate change in earnings is referred to as operating leverage. It is measured numerically
by the degree of operating leverage. (DOL), which is defined in the following equation:
The value of DOL is unique at each level of operation DOL is undefined at breakeven point.
Negative values of DOL signify that the firm is operating below breakeven point. They do not
signify the inverse relationship. While operating above the breakeven point, the value of DOL
declines and approaches 1 as the firm moves away from breakeven point. This is because the fixed
cost per unit decreases as the number of units increases.
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Financial Leverage- Financial leverage refers to the use of debt financing and the resultant
sensitivity of the earnings available to shareholders (EPS) by the substitution of their capital with
fixed charge finance. If the firm has no fixed financial charges, then any change in the levels of
EBIT will be transferred to shareholders as it is. The change in the shareholders wealth would be
identical to that of the change in EBIT. In such a case, all the business risk is borne by the
shareholders. However if some of the equity capital is substituted by fixed charge capital, changes
in earning per share will be larger as compared to all equity financing option. Replacing equity
with debt leaves the risk with the remaining equity shareholders. Financial leverage indicates the
effects on earnings by rise of fixed costs funds.
It refers to the use of debt in the capital structure. Financial leverage arises when a firm deploys
debt funds with fixed charge. The higher the ratio, the lower the cushion for paying interest on
borrowings. A low ratio indicates a low interest outflow and consequently lower borrowings. A
high ratio is risky and constitutes a strain on profits. This ratio is considered along with the
operating ratio, gives a fair and accurate idea about the firms earnings, its fixed costs and the
interest expenses on long-term borrowings. The financial leverage is an indicator of
responsiveness of firms EPS to the changes in its profit before interest and tax.
Degree of Financial Leverage (DFL)

Degree of Financial Leverage (DFL) is the percentage change in the Earning per share with 1%
change in the EBIT level. The minimum value of DFL is 1.00. Just as fixed cost leverage the EBIT for
changes in sales, as underlined under the section on operating leverage, the presence of a fixed
charge in the financing of the firm leverage the EPS for a given change in EBIT. This is called
financial leverage. Use of debt causes fixed charges on the capital by way of interest and since this
fixed capital replaces more expensive equity, the remaining equity earns a greater return. Degree
of financial leverage (DFL) is defined as highlighted in below.
DFL always has a value in excess of 1.0. The value of 1 signifies that entire funding is done through
equity. The firm has no interest burden. A DLF value less than 1 is possible when the firm is unable
to generate any income. The firm cannot meet its fixed operational cost and EBIT is negative.
Debt-Equity Ratio
This ratio indicates the relationship between loan funds and net worth of the company, which is
known as gearing. If the proportion of debt to equity is low, a company is said to be low-geared,
and vice versa. A debt-equity ratio of 2:1 is the norm accepted by financial institutions for
financing of projects. Higher debt-equity ratio of 3:1 may be permitted for highly capital intensive
industries like petrochemicals, fertilizers, power etc. The higher the gearing, the more is volatile
the return to the shareholders. The use of debt capital has direct implications for the profit
accruing to the ordinary shareholders, and expansion is often financed in this manner with the
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objective of increasing the shareholders rate of return. This objective is achieved only if the rate
of return earned on the additional funds raised exceeds that payable to the providers of the loan.
The shareholders of a highly geared company reap disproportionate benefits when earnings
before interest and tax increase. This is because interest payable on a large proportion of total
finance remains unchanged. The converse is also true, and a highly geared company is likely to
find itself in severe financial difficulties if it suffers a succession of trading losses. It is not possible
to specify an optimal level of gearing for companies but, as a general rule, gearing should be low
in those industries where demand is volatile and profits are subject to fluctuation. A debt-equity
ratio which shows a declining trend over the years is usually taken as a positive sign reflecting on
increasing cash accrual and debt repayment. The formula of the debt-equity ratio is highlighted in
below:
Shareholders Equity Ratio

It is assumed that larger the proportion of the shareholders equity, the stronger is the financial
position of the firm. This ratio will supplement the debt equity ratio. In this ratio, the relationship
is established between the shareholders fund and the total assets. Shareholders fund represent
equity and preference capital plus reserves and surplus less accumulated losses. A reduction in
shareholders equity signalling the over dependence on outside sources for long term financial
needs and this carries the risk of higher levels of gearing. This ratio indicates the degree to which
unsecured creditors are protected against loss in the event of liquidation. The ratio is calculated
as follows:
Long term Debt to Shareholders Net worth Ratio

The ratio compares long-term debt to the net worth of the firm i.e. the capital and free reserves
less intangible assets. This ratio is finer than the debt-equity ratio and includes capital which is
invested in fictitious assets like deferred expenditure and carried forward losses. This ratio would
be of more interest to the contributories of long term finance to the firm, as the ratio gives factual
idea of the assets available to meet the long-term liabilities. The ratio is calculated as follows:
Capital Gearing Ratio

The fixed interest bearing funds include debentures, long-term loans and preference share capital.
The equity shareholders funds include equity share capital, reserves and surplus. Capital gearing
ratio indicates the degree of vulnerability of earnings available for equity shareholders. This ratio
signals the firm which is operating on trading on equity. It also indicates the changes in benefits
accruing to equity shareholders by changing the levels of fixed interest bearing funds in the
organization. The ratio is calculated as follows:
Fixed Assets to Long Term Funds Ratio

This ratio indicates the proportion of long term funds deployed in fixed assets. Fixed assets
represent the gross fixed assets minus depreciation provided on this till the date of calculation.
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Long term funds include share capital, reserve and surplus and long-term loans. The higher the
ratio indicates the safer the funds available in case of liquidation. It also indicates the proportion
of long-term funds that is invested in working capital. The ratio is expressed in below:
Debt Service Coverage Ratio (DSCR)

The ratio is the key indicator to the lender to assess the extent of ability of the borrower to service
the loan in regard to timely payment of interest and repayment of loan instalment. It indicates
whether the business is earning sufficient profits to pay not only the interest charges, but also the
instalments due of the principal amount. A ratio of 2 is considered satisfactory by the financial
institution. The greater debt service coverage ratio indicates the better debt servicing capacity of
the organization. The ratio is calculated as:
Debt to Total Capital Ratio

The relationship between creditors fund and owners capital can also be expressed in terms of
another leverage ratio. This is the debt to total capital ratio. Here, the outsiders liabilities are
related to the total capitalization of the firm and not merely to the shareholders equity. It can be
measured in the following way. Here, permanent capital comprise of total debt capital, equity
capital, preference capital and free reserve.
Interest Coverage Ratio

This is also known as time- interest- earned ratio. This ratio measures the debt servicing capacity
of a firm in so far as fixed interest on long term loan is concerned. It is determined by dividing the
operating profits or earnings before interest and taxes by the fixed interest charges on loans. A
very high ratio indicates that the firm is conservative in using debt and a very low ratio indicates
excessive use of debt. Further, it indicates how many times a company can cover its current
interest payments out of current profits. It gives an indication of problem in servicing the debt. An
interest cover of more than 7 times is regarded as safe and more than 3 times is desirable. An
interest cover of 2 times is considered reasonable by financial institutions.
Dividend Coverage Ratio

It measures the ability of a firm to pay dividend on preference shares which carry a stated rate of
return. This ratio is the ratio of net profits after taxes (EAT) and the amount of preference
dividend. Thus it is seen that although preference dividend is a fixed obligation, the earnings taken
into account are after taxes. This is because, unlike debt on which interest is a charge on the profits
of the firm, the preference dividend is treated as an appropriation of profit. The ratio like the
interest coverage ratio reveals the safety margin available to the preference shareholders.
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Liquidity ratios
It is generally considered by analyst to determine the ability of firm to pay its short term liabilities.
Current Ratio= (Current assets)/ (Current Liabilities)

Higher the ratio the more likely is that company will be able to pay its short term bills. A current
ratio of less than one means that the company has negative capital and is facing a liquidity crisis.
Quick ratio= (Cash+ Marketable securities+ Receivables)/ (Current liabilities)

It is more stringent as it does not include the inventories and other such assets which might not
be liquid that easily. The higher the ratio, the more likely the company will be able to pay its short
term bills. Market securities are short term debt instruments typically liquid and of good credit
quality.
Cash Ratio = (Cash + Marketable securities)/ (Current liabilities)

It is the most conservative liquidity measure. These three just differentiate on basis of assumed
liquidity
Defensive interval ratio= (Cash+ Marketable securities+ Receivables)/ (Average daily

expenditure)
It tells about the average number of days cash expenditure the firm can pay with its current liquid
assets. Expenditure here includes cost of goods, Selling, general and administrative and R and D
cost.
Cash conversion cycle

Cash conversion cycle is the length of time it takes to turn the firms cash investment in
inventories back into cash, in form of collections from the sales of that inventory. High cash
conversion cycle is undesirable. A high cash conversion cycle means that company has an
excessive amount of capital investment in the sales process.
Cash conversion cycle= (Days sale outstanding) + (Days of inventory on hand) - (number of
Days payable)
Days sale outstanding= Number of days it takes a company to collect its account receivables.
Number of days payable= Average number of days a company takes to pay its supplier.
Working capital management

Working capital is what remains on the balance sheet after the current liabilities are
subtracted from the current assets. It can be defined as - net working capital (current assets -
current liabilities) or gross working capital (current assets).
Working capital management involves the relationship between a firm's short term assets and
its short-term liabilities. The goal of working capital management is to ensure that a firm is
able to continue its operations and that it has sufficient ability to satisfy both maturing short-
term debt and upcoming operational expenses (maximize short-term liquidity). The
management of working capital involves managing inventories, accounts receivable and
payable, and cash.
Composition of working capital

Working Capital = Current Assets - Current Liabilities
- Current assets are cash, accounts receivable, short-term investments, and inventory
- If most of the value of current assets is in A/R and inventory, that may make the working
capital number look good, but to actually get at that working capital the entity would have
to collect on some accounts and/or sell some inventory -both of which can take time.
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- Management of working capital means managing different components of current assets

and current liabilities.
o Management of Cash: Every enterprise irrespective of its scale requires certain amount of
cash to meet its day-to-day obligations. Hence, the enterprise needs to decide carefully
how much should be carried in cash. Management of cash aims at striking a fine balance
between two contradictory objectives of meeting the cash disbursement needs and
minimizing the amount locked up as cash balance. For this purpose, cash management
addresses to the following four problems:
Controlling the level of cash
Controlling inflows of cash
Controlling outflows of cash
Optimum use of surplus cash
o Management of Inventory: Inventories refer to raw material, work-in-progress and
finished goods. These constitute a major portion, about 60% of total current assets. There
are three major motives for holding inventories in a firm, namely, transaction motive,
precautionary motive and speculative motive. But, holding inventories involves costs, i.e.
ordering costs and carrying costs. Hence, inventories need to be maintained at an
optimum size. Inventory management is a trade-off between cost of acquiring and cost of
holding inventories. Among various models evolved for managing inventories, the
commonly used model is Economic Ordering Quantity (EOQ) Model based on Baumols
cash management model. The other model of inventory management is ABC Analysis also
known as CTE i.e., Control by Importance and Exception. This method controls expensive
inventory items more closely than less expensive items.
o Management of Accounts Receivable: The main objective of maintaining accounts
receivable are achieving growth in sales, increasing profits and meeting competition. Like
inventories, maintaining accounts receivable also involves certain costs such as capital
costs, administrative costs, collection costs and defaulting costs, i.e., bad debts. The size
of accounts receivable depends on the level of sales, credit policy, terms of trade,
efficiency of collection, etc. A larger size of accounts receivable increases profitability and
reduces liquidity and vice versa. Therefore, accounts receivable need to be maintained at
an optimum size. The optimum size of accounts receivable occurs at a point where there
is a trade-off between profitability and liquidity.
o Management of Accounts Payable: Accounts payable are just reverse to accounts
receivable. Accounts payable emerge due to credit purchase. This refers to a loaning of
goods and inventories to the buyer. This is also called buy-now, pay-later. The underlying
objective of accounts payable is to slow down the payments process as much as possible.
But, it should be noted that the saving of interest cost should be offset against loss of
credit standing of the enterprise. The enterprise has, therefore, to ensure that the
payments to the creditors are made at the stipulated time periods after obtaining the best
credit terms possible. The salient points to be noted on effective management of accounts
payable are:
Obtain most favourable credit terms with the prevailing credit practice
Make payments on maturity or due dates
Keep good track record of past dealings with the suppliers
Avoid tendency to divert payables
Provide full information to the suppliers
Keep a constant check on incidence of delinquency
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Negative working capital

Negative working capital is formed either when short term liabilities are used for long term
purposes or current assets faces a blow e.g. current liabilities or funds used for long term assets,
abnormal loss of inventory, bad debts, consistently selling goods at loss etc. For working capital
to go negative current assets must go below the current liabilities and it can happen in following
four situations.
1. Abnormal Loss in Inventory: If there is a loss in inventory due to wastage of material, fire
in the store, theft, etc. or any such reason which will diminish the value of inventory in
the balance sheet will result in negative working capital. If the goods are lying in store for
long and company is not able to sell, the value will deteriorate.
2. Bad Debts: If a company faces a lot of bad debts, it can lead to Negative Working Capital.
It may be because of bad selection of customers, credit extension to customers with bad
credit records, excessively aggressive selling approach etc.
3. Goods Sold at Loss Consistently: If we are selling at negative margin, it will take current
assets below the current liabilities
4. Cash Used for Investing in Fixed Assets: Using cash from Retained Earnings to invest in
fixed assets or long term investments.
Is Negative Working Capital Good or Bad?

It will depend upon the reason due to which it is going negative. If the reason for NWC going
negative is abnormal inventory loss or high level of bad debts or consistently selling goods at loss,
then, negative working capital is a bad sign and company has all the probabilities of facing financial
distress or even bankruptcy. If the reason is investment of extra available cash in Fixed Assets or
Long Term Investments without disturbing the operating cycle of the company, the negative
working capital is a sign of efficient management. Such situations appear for giant companies
having muscle power of bulk demand and who can command credit terms with the suppliers. Also,
companies having cash sales but credit purchase are able to create such a situation.
Difference between Hedging, Speculation and Arbitrage

Hedging is an act of protecting or guarding the investment against an undesired price
movement. Suppose a long term investor owns a portfolio of stocks worth Rs 10 lacs. The price
movement of a stock is dependent both on the micro (profitability of the company, its growth
potential, business model, management competency etc.) and the macro factors (GDP growth
of the country, interest rates, overall state of economy etc.). Such an investor can hedge his
portfolio by selling Index Futures (like Nifty future) and thereby removing the risk of macro
variables from his portfolio.
Arbitrage involves the simultaneous buying and selling of an asset in order to profit from small
differences in price. Often, arbitrageurs buy stock on one market (for example, a financial
market in the United States like the NYSE) while simultaneously selling the same stock on a
different market (such as the London Stock Exchange). Since arbitrage involves the
simultaneous buying and selling of an asset, it is essentially a type of hedge and involves
limited risk, when executed properly. Arbitrageurs typically enter large positions since they
are attempting to profit from very small differences in price.
Speculation, on the other hand, is a type of financial strategy that involves a significant
amount of risk. Financial speculation can involve the trading of instruments such as bonds,
commodities, currencies and derivatives. Speculators attempt to profit from rising and falling
prices. A trader, for example, may open a long (buy) position in a stock index futures contract
with the expectation of profiting from rising prices. If the value of the index rises, the trader
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may close the trade for a profit. Conversely, if the value of the index falls, the trade might be
closed for a loss.
V. Banking
Measures to regulate banking in India
o SDR
Under Strategic Debt Restructuring (SDR) Scheme, banks who have given loans to a
corporate borrower gets the right to convert the full or part of their loans into equity
shares in the loan taken company. The SDR scheme which was introduced by the RBI in
June 2015 thus helps banks recover their loans by taking control of the distressed listed
companies.
The SDR initiative can be taken by the group of banks or JLF that have given loans to the
particular defaulted entity. The Joint Lender Forum (JLF) is a committee comprised of the
entire bankers who have given loans to a potentially stressed or stressed borrower. At
present, banks can form a JLF if the account by a borrower is classified as Special Mention
Account 2 (not paid any money back during the last 60 days).
The JLF/Corporate Debt Restructuring Cell (CDR) may consider the following options when
a loan is restructured:
Possibility of transferring equity of the company by promoters to the lenders
Promoters infusing more equity into their companies
Transfer of the promoters holdings to a security trustee or an escrow arrangement
till turnaround of company.
.
At the time of initial restructuring, the JLF must incorporate an option to convert the
entire loan (including unpaid interest), or part thereof, into shares in the company in the
event the borrower is not able to achieve the critical conditions as stipulated in the
restructuring package.
The decision on invoking the SDR by converting the whole or part of the loan into equity
shares should be taken by the JLF. The decision should be documented and approved by
the majority of the JLF members (minimum of 75% of creditors by value and 60% of
creditors by number). In order to achieve the change in ownership, the lenders under the
JLF should collectively become the majority shareholder by conversion of their dues from
the borrower into equity. After the conversion, all lenders under the JLF must collectively
hold 51% or more of the equity shares issued by the company.
The basic purpose of SDR is to ensure more stake of promoters in reviving stressed
accounts and providing banks with enhanced capabilities to initiate change of ownership,
where necessary, in accounts which fail to achieve the agreed critical conditions and
viability milestones. SDR cannot be used for any other reason.
o S4A
Scheme for Sustainable Structuring of Stressed Assets (S4A) as announced by RBI is
outlined to tackle the problem loans of large projects at a sufficiently early stage and
protect the interest of lenders. The scheme is an optional framework under which the
liabilities of struggling companys debt will be bifurcated into sustainable and
unsustainable portions. The banks shall then convert the unsustainable debt into equity
and sell this stake to a new owner who will have the advantage of getting to run the
business with more manageable sustainable debts. Instead of the earlier system of leaving
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it to banks themselves, the entire exercise of credible resolution plan under S4A is
independently carried out by overseeing committee set up by Indian Banks Association
(IBA), in consultation with the RBI, in a transparent and prudent manner. By this exercise,
banks are put into a position to upgrade their loans with cleaning up of the large portion
of bad loans. Nevertheless, in this exercise, banks may have to take a haircut as the market
value of the stressed company might be less than the value of debt that is converted into
equity.
According to the guidelines, only the projects which have commenced commercial
operations are eligible for S4A scheme. The aggregate exposure of an enterprise like
Rupee loans, Foreign Currency loans, External Commercial Borrowings etc. (including
accrued interest) of all institutional lenders should be more than Rs.500 crore, to be
eligible for the scheme. The debt shall also meet the test of sustainability. The debt level
will be deemed as sustainable if an enterprise is in a position to service, its present
principal value of the funded and non- funded liabilities, over the same tenor as that of
the existing facilities, even if the future cash flows remain at their current level.
The sustainable debt cannot be less than 50 percent of current funded liabilities if an
enterprise is to be eligible for S4A. The assessment of debt will be done, through the
independent techno-economic viability (TEV) carried out by the experts of professional
agencies. The sustainable debt is referred as Part A and the remaining portion of the
aggregate debt is treated as unsustainable debt which is referred as part B. At individual
bank level, the bifurcation into Part A and part B will be made in the proportion of Part A
to Part B at the aggregate level. The resolution plan shall be agreed upon by a minimum
of 75 percent of lenders by value and 50 percent of lenders by number in the
JLF/consortium/bank for implementation.
The S4A resolution envisages the Part B portion of the debt to be converted into
equity/redeemable cumulative optionally convertible preference shares. In the cases
where the resolution plan does not involve the change in the promoter, banks may, at
their discretion, convert a portion of Part B into optionally convertible debentures which
will continue to be referred as Part B instruments. Further, the borrower is not eligible for
fresh moratorium on interest or principal repayment for servicing of Part A.
Management of the borrowing entity: The S4A post-resolution have two options to run
the management of the enterprise.
The existing promoters continue to hold the management if they hold the majority of
the shares required to have control.
If the existing promoter/s does not have the majority stake to have the control of the
enterprise; the existing promoter will be replaced with the new promoter/s. However,
in certain cases where the resolution does not contain a change in the promoter, the
lenders may allow the existing promoter to operate and manage the company as the
minority owner.
o Asset Quality review

In January 2016, Raghuram Rajan, then governor of the Reserve Bank of India (RBI) asked
banks to clean up their books by March 2017. The RBI had undertaken an asset quality
review (AQR) of the sector in the second half of 2015 and found that banks were under-
reporting stressed assets. What followed was an effort to get banks to classify loans
appropriately, provide for them and move towards resolving the pile of bad loans that had
been allowed to lurk in undeclared corners of bank books.
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Typically, Reserve Bank of India (RBI) inspectors check bank books every year as part of its
annual financial inspection (AFI) process. However, a special inspection was conducted in
2015-16 in the August-November period. This was named as Asset Quality Review (AQR).
In a routine AFI, a small sample of loans is inspected to check if asset classification was in
line with the loan repayment and if banks have made provisions adequately.
However, in the AQR, the sample size was much bigger and in fact, most of the large
borrower accounts were inspected to check if classification was in line with prudential
norms. Some reports suggest that a list of close to 200 accounts was identified, which the
banks were asked to treat as non-performing. Banks were given two quarters, October-
December and January-March of 2016 to complete the asset classification.
The AQR created havoc on banks profit & loss accounts as many large lenders slipped into
losses in both the said quarters, which resulted in some of them reporting losses for the
full financial year. Record losses were posted in Q4 of FY16 by many large lenders like
Bank of Baroda (Rs.3,230 crore), Punjab National Bank (Rs.5,367 crore), IDBI Bank
(Rs.1,376 crore) to name a few.
Almost all public sector banks were impacted, while the impact in the private sector was
limited to biggies such as ICICI Bank and Axis Bank. HDFC Bank the second-largest private
sector lender emerged unscathed from the crisis as its exposure to big-ticket
infrastructure projects was relatively small. Bad loans in the Indian banking system
jumped 80 per cent in FY16, according to RBI data, mainly on account of the AQR.
o Indradhanush plan
Mission Indradhanush is a 7 pronged plan launched by Government of India to resolve
issues faced by Public Sector banks. It aims to revamp their functioning to enable them to
compete with Private Sector banks. The 7 parts can be described as follows:
Appointments - separation of posts of CEO and MD to check excess concentration of
power and smoothen the functioning of banks; also induction of talent from private
sector ( recommendation of P J Nayak Committee)
Bank Boards Bureau - will replace the appointments board of PSBs. It will advise the
banks on how to raise funds and how to go ahead with mergers and acquisitions. It
will also hold bad assets of public sector banks and be a step into eventual transition
of the bureau into a bank holding company. The bureau will have three ex-officio
members and three expert members, in addition to the Chairman.
Capitalisation- Capitalisation of the banks by inducing Rs 70,000 crore into the banks
in the next 4 years. Banks are in need of capitalisation due to high NPAs and due to
need to meet the new BASEL- III norms
De-stressing - Solve issues in the infrastructure sector to check the problem of
stressed assets in banks
Empowerment- Greater autonomy for banks; more flexibility for hiring manpower
Framework of accountability- The banks will be assessed on the basis of new key
performance indicators. These quantitative parameters such as NPA management,
return on capital, growth and diversification of business and financial inclusion as well
as qualitative parameters such as human resource initiatives and strategic steps to
improve assets quality.
Governance Reforms- GyanSangam conferences between government officials and
bankers for resolving issues in banking sector and chalking out future policy.
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The Indian Government plans to come out with Indradhanush 2.0, a comprehensive plan
for recapitalisation of public sector lenders, with a view to make sure they remain solvent
and fully comply with the global capital adequacy norms, Basel-III.
Indradhanush 2.0 will be finalised after completion of the asset quality review (AQR) by
the Reserve Bank of India (RBI), which is likely to be completed by March-end. The RBI had
embarked on the AQR exercise from December 2015 and asked banks to recognise some
top defaulting accounts as non-performing assets (NPAs) and make adequate provisions
for them. It has had a debilitating impact on banks numbers and their stocks.
Under Indradhanush roadmap announced in 2015, the government had announced to

infuse Rs70,000 crore in state-run banks over four years while they will have to raise a
further Rs1.1 trillion from the markets to meet their capital requirement in line with global
risk norms, known as Basel-III.
In line with the plan, public sector banks were given Rs25,000 crore in 2015-16, and similar
amount has been earmarked for the current fiscal. Besides, Rs10,000 crore each would be
infused in 2017-18 and 2018-19. The government has already announced fund infusion of
Rs22,915 crore, out of the Rs25,000 crore earmarked for 13 PSBs for the current fiscal. Of
this, 75% has already been released to them.
Balance sheets of banks

Commercial bank's balance sheet has two main sides i.e. the liabilities and the assets.
Bank's Liabilities-
o Share capital: the contribution which shareholders have contributed for starting the
bank
o Reserve funds: the money, which the bank has accumulated over the years from its
undistributed profits
o Deposits are the money owned by customers and therefore it is a liability of a bank
o Borrowings from central banks or reserve banks
o Others
Banks Assets: cash, money at short notice, bills and securities discounted, bank's Investments,
loans sanctioned by the bank, etc.
o Bank's cash in hand, cash with other banks and cash with central bank (RBI)
o Money made available at short notice to other banks and financial institutions for a
very short period of 1-14 days
o loans and advances provided to its customers
Central Bank's Balance Sheet

Central bank assets:
o securities, mainly in the form of Treasuries
o foreign exchange reserves, which are mainly held in the form of foreign bonds
issued by foreign governments
o loans to commercial banks
Of these, the most important asset is securities, which the central bank uses to directly
control the supply of money in the country. In other countries, where exports are
important, such as China, federal exchange reserves may be the dominant asset.
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Central bank liabilities:

o currency, which is held by the public federal government's bank account, which
the central bank uses to deposit its revenues, mostly in the form of tax revenues,
into its account, and paying its bills, mostly in electronic format
o Commercial bank accounts, otherwise known as reserves, where commercial
banks keep their deposits with the Fed. Vault cash, which is cash held in the banks'
vaults, is also part of the commercial banks' reserves, because the cash is used to
service its customers.
Why are cash flow statements not used in banking analysis?

Cash flow statement is mandatory for all institutions according to Companies Act, 2013.
However, the banking regulations act (1949) decides banks final accounts- It specifies that
only balance sheet and income statement are mandatory for banks. Cash flows in banks are
useful for their own business decisions.
For an equity holder, cash flow statement is not needed for analysis as all the transactions are
made in terms of cash. Cash flows mainly consists of loans and deposits and those transactions
doesn't hold much value for banks itself.
The reason why bankers do not use the statements is that they do not consider the
information provided to be relevant. The results furthermore indicate that the cash flow
statements of banks are not used because the existing accounting standard does not consider
the credit creation function in banks. This is exemplified in the negative operative cash flow
during periods of lending growth.
Banks are different from other firms and hence, the reporting of banks cash flows functions
also differs because cash is their product and they create deposits on their balance sheet when
providing loans to their customers. The accounting transaction of lending does not involve any
prior funding or cash inflow, but occurs in the accounting system, creating deposit as a liability
and loan as an asset of the bank. These results contribute to the debate needed in accounting
and banking about useful cash flow statements for banks and provide an overview to prepare
new accounting regime.
How does a bank operate?

Banks take deposits from savers and pay interest on some of these accounts. They pass these
funds on to borrowers and receive interest on the loans. Their profits are derived from the
spread between the rate they pay for funds and the rate they receive from borrowers. This
ability to pool deposits from many sources that can be lent to many different borrowers
creates the flow of funds inherent in the banking system. By managing this flow of funds,
banks generate profits, acting as the intermediary of interest paid and interest received, and
taking on the risks of offering credit. Like any other company, banks also have an equity capital
but that is very small when compared to the operating margins and depositor money.
The main functions of commercial banks can be divided under the following heads:
1. Accepting deposits: The most important function of commercial banks is to accept
deposits from the public. Various sections of society, according to their needs and
economic condition, deposit their savings with the banks.
2. Giving loans: The second important function of commercial banks is to advance loans to
its customers. Banks charge interest from the borrowers and this is the main source of
their income.
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3. Overdraft: Banks advance loans to its customers up to a certain amount through over-
drafts, if there are no deposits in the current account. For this banks demand a security
from the customers and charge very high rate of interest.
4. Discounting of Bills of Exchange: This is the most prevalent and important method of
advancing loans to the traders for short-term purposes. Under this system, banks advance
loans to the traders and business firms by discounting their bills. In this way, businessmen
get loans on the basis of their bills of exchange before the time of their maturity.
5. Investment of Funds: The banks invest their surplus funds in three types of securities-
Government securities, other approved securities and other securities. Government
securities include both, central and state governments, such as treasury bills, national
savings certificate etc.
6. Agency Functions: Banks function in the form of agents and representatives of their
customers. Customers give their consent for performing such functions.
BASEL norms and type of capital (Tier 1 and 2)

BASEL norms are a set of international banking regulations put forth by the Basel Committee on
Bank Supervision, which set out the minimum capital requirements of financial institutions with
the goal of minimizing credit risk.
Tier I capital is core capital, this includes equity capital and disclosed reserves. Equity capital
includes instruments that can't be redeemed at the option of the holder.
Tier 2 capital is supplementary bank capital that includes items such as revaluation reserves,
undisclosed reserves, hybrid instruments and subordinated term debt. Components of Tier 2
Capital can be split into two levels: upper and lower. Upper Tier 2 maintains characteristics of
being perpetual, senior to preferred capital and equity; having deferrable and cumulative
coupons; and its interest and principal can be written down. Lower Tier 2 is relatively cheap for
banks to issue; has coupons not deferrable without triggering default; and has subordinated debt
with a maturity of a minimum of 10 years.
BASEL I
The first accord was the Basel I. It was issued in 1988 and focused mainly on credit risk by creating
a bank asset classification system. This classification system grouped a bank's assets into five risk
categories:
0% - cash, central bank and government debt and any OECD government debt
0%, 10%, 20% or 50% - public sector debt
20% - development bank debt, OECD bank debt, OECD securities firm debt, non-OECD bank debt
(under one year maturity) and non-OECD public sector debt, cash in collection
50% - residential mortgages
100% - private sector debt, non-OECD bank debt (maturity over a year), real estate, plant and
equipment, capital instruments issued at other banks
The bank must maintain capital (Tier 1 and Tier 2) equal to at least 8% of its risk-weighted assets.
For example, if a bank has risk-weighted assets of $100 million, it is required to maintain capital
of at least $8 million.
BASEL II
Basel II is the second of the Basel Committee on Bank Supervision's recommendations, and unlike
the first accord, Basel I, where focus was mainly on credit risk, the purpose of Basel II was to create
standards and regulations on how much capital financial institutions must have put aside. Banks
need to put aside capital to reduce the risks associated with its investing and lending practices.
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The guidelines were based on three parameters, which the committee calls it as pillars.
- Capital Adequacy Requirements: Banks should maintain a minimum capital adequacy
requirement of 8% of risk assets
- Supervisory Review: According to this, banks were needed to develop and use better risk
management techniques in monitoring and managing all the three types of risks that a bank faces,
viz. credit, market and operational risks
- Market Discipline: This need increased disclosure requirements. Banks need to mandatorily
disclose their CAR, risk exposure, etc.
BASEL III
Post crisis, with a view to improving the quality and quantity of regulatory capital, it has been
decided that the predominant form of Tier 1 capital must be Common Equity; since it is critical
that banks risk exposures are backed by high quality capital base. Non-equity Tier 1 and Tier 2
capital would continue to form part of regulatory capital subject to eligibility criteria as laid down
in Basel III. Accordingly, under revised guidelines (Basel III), total regulatory capital will consist of
the sum of the following categories:
1. Tier 1 Capital (going-concern capital)
a. Common Equity Tier 1
b. Additional Tier 1
2. Tier 2 Capital (gone-concern capital)
Limits and Minima

1. As a matter of prudence, it has been decided that scheduled commercial banks operating in
India shall maintain a minimum total capital (MTC) of 9% of total risk weighted assets (RWAs) as
against a MTC of 8% of RWAs as prescribed in Basel III
2. Common Equity Tier 1(CET1) capital must be at least 5.5% of risk weighted assets (RWAs) i.e.
for credit risk+ market risk + operational risk on an ongoing basis. Globally it is 4.5% as per Basel
III but RBI asks for an additional 1%.
3. Tier 1 capital must be at least 7% of RWAs on an ongoing basis. Thus, within the minimum Tier
1 capital, Additional Tier 1 capital can be admitted maximum at 1.5% of RWAs.
4. Total Capital (Tier 1 Capital plus Tier 2 Capital) must be at least 9% of RWAs on an ongoing
basis. Thus, within the minimum CRAR of 9%, Tier 2 capital can be admitted maximum up to 2%.
5. If a bank has complied with the minimum Common Equity Tier 1 and Tier 1 capital ratios, then
the excess Additional Tier 1 capital can be admitted for compliance with the minimum CRAR of
9% of RWAs
6. In addition to the minimum Common Equity Tier 1 capital of 5.5% of RWAs, banks are also
required to maintain a capital conservation buffer (CCB) of 2.5% of RWAs in the form of Common
Equity Tier 1 capital
7. For the purpose of reporting Tier 1 capital and CRAR, any excess Additional Tier 1 (AT1) capital
and Tier 2 (T2) capital will be recognised in the same proportion as that applicable towards
minimum capital requirements. This would mean that to admit any excess AT1 and T2 capital, the
bank should have excess CET1 over and above 8% (5.5%+2.5%)
8. In cases where the a bank does not have minimum Common Equity Tier 1 + capital
conservation buffer of 2.5% of RWAs as required but, has excess Additional Tier 1 and / or Tier 2
capital, no such excess capital can be reckoned towards computation and reporting of Tier 1
capital and Total Capital
9. For the purpose of all prudential exposure limits linked to capital funds, the capital funds will
exclude the applicable capital conservation buffer and countercyclical capital buffer as and when
activated, but include Additional Tier 1 capital and Tier 2 capital which are supported by
proportionate amount of Common Equity Tier 1 capital. Accordingly, capital funds will be defined
as [(Common Equity Tier 1 capital) + (Additional Tier 1 capital and Tier 2 capital eligible for
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computing and reporting CRAR of the bank)]. It may be noted that the term Common Equity Tier
1 capital does not include capital conservation buffer and countercyclical capital buffer.
Common Equity Tier 1 Capital

Elements of Common Equity Tier 1 Capital
(I) Common shares (paid-up equity capital) issued by the bank which meet the criteria for
classification as common shares for regulatory purposes
(ii) Stock surplus (share premium) resulting from the issue of common shares;
(iii) Statutory reserves;
(iv) Capital reserves representing surplus arising out of sale proceeds of assets
(v) Other disclosed free reserves, if any;
(vi) Balance in Profit & Loss Account at the end of the previous financial year.
Elements of Additional Tier 1 Capital

(i) Perpetual Non-Cumulative Preference Shares (PNCPS), which comply with the regulatory
requirements.
(ii) Stock surplus (share premium) resulting from the issue of instruments included in Additional
Tier 1 capital;
(iii) Debt capital instruments eligible for inclusion in Additional Tier 1 capital, which comply with
the regulatory requirements;
(iv) Any other type of instrument generally notified by the Reserve Bank from time to time for
inclusion in Additional Tier 1 capital;
(v) While calculating capital adequacy at the consolidated level, Additional Tier 1 instruments
issued by consolidated subsidiaries of the bank and held by third parties which meet the criteria
for inclusion in Additional Tier 1 capital; and
(vi) Less: Regulatory adjustments / deductions applied in the calculation of Additional Tier 1
capital
Elements of Tier 2 Capital

(i) General Provisions and Loss Reserves
(ii) Debt Capital Instruments issued by the banks;
(iii) Preference Share Capital Instruments [Perpetual Cumulative Preference Shares (PCPS) /
Redeemable Non-Cumulative Preference Shares (RNCPS) / Redeemable Cumulative
Preference Shares (RCPS)] issued by the banks;
(iv) Stock surplus (share premium) resulting from the issue of instruments included in Tier 2
capital;
(v) While calculating capital adequacy at the consolidated level, Tier 2 capital instruments
issued by consolidated subsidiaries of the bank and held by third parties which meet the
criteria for inclusion in Tier 2 capital;
(vi) Revaluation reserves at a discount of 55%;
Banking ratios
As banks have very different operating structures than regular industrial companies, investors
have a different set of fundamental factors to consider, when evaluating banks.
1. Loan/Deposit Ratio: helps assess a bank's liquidity, and by extension, the aggressiveness
of the bank's management. If the loan/deposit ratio is too high, the bank could be
vulnerable to any sudden adverse changes in its deposit base. Conversely, if the
Loan/deposit ratio is too low, the bank is holding on to unproductive capital and earning
less than it should.
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2. Efficiency Ratio: Equivalent to a company's operating margin, in that it measures how

much the bank pays on operating expenses, like marketing and salaries. A lower ratio is
preferable.
3. Capital Ratios: Ratios that bank regulators and investors use to assess how risky a bank's
balance sheet is, and the degree to which the bank is vulnerable to an unexpected
increase in bad loans. A bank's Tier 1 capital ratio takes a bank's equity capital and
disclosed reserves and divides it by the bank's risk-weighted assets, (assets whose value
is reduced by certain statutory amounts, based upon its perceived riskiness).
4. Capital Adequacy Ratio: A measure of a banks capital. It is expressed as a percentage of
a banks risk weighted credit exposures. Also known as Capital to Risk Weighted Assets
Ratio (CRAR). Although not an especially popular ratio prior to the 2007/2008 credit
crisis, it does offer a good measure of the degree of loss a bank can withstand, before
wiping out shareholder equity. Capital ratios can be thought of as proxies for a banks
margin of error. Nowadays, capital ratios also play a larger role in determining whether
regulators will sign off on acquisitions and dividend payments.
CAMELS analysis
Camels approach is used to analyse bank risk. It is an international bank-rating system where
bank supervisory authorities rate institutions according to six factors.
C - Capital adequacy
A - Asset quality
M - Management quality
E - Earnings
L - Liquidity
S - Sensitivity to Market Risk
o Capital Adequacy: How much capital a bank should set aside as a proportion of risky
Assets. It helps to reduce the risk of default. Capital adequacy is measured by the ratio
of capital to risk-weighted assets (CRAR). A sound capital base strengthens confidence
of depositors
o Asset Quality: One of the indicators for asset quality is the ratio of non-performing
loans to total loans (GNPA). The gross non-performing loans to gross advances ratio
is more indicative of the quality of credit decisions made by bankers. Higher GNPA is
indicative of poor credit decision-making. Hence management must follow four steps
1. Adopt effective policies before loans are made 2. Enforce those policies as the
loans are made 3. Monitor the portfolio after the loans are made 4. Maintain an
adequate Allowance for Loan and Lease Losses (ALLL)
o Management: To assess a banks management quality, it requires professional
judgment of a banks compliance to policies and procedures, aptitude for risk-taking,
development of strategic plans. The performance of the other five CAMELS
components will depend on the management quality. The ratio of non-interest
expenditures to total assets (MGNT) can be one of the measures to assess the working
of the management. This variable, which includes a variety of expenses, such as
payroll, workers compensation and training investment, reflects the management
policy stance. Another ratio helpful to judge management quality is Cost per unit of
money lent which is operating cost upon total money disbursed.
o Earnings: The quality and trend of earnings of an institution depend largely on how
well the management manages the assets and liabilities of the institution. An FI must
earn reasonable profit to support asset growth, build up adequate reserves and
enhance shareholders value. It can be measured as the return on asset ratio.
o Liquidity: An FI must always be liquid to meet depositors and creditors demand to
maintain public confidence. Cash maintained by the banks and balances with central
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bank, to total asset ratio (LQD) is an indicator of banks liquidity. In general, banks with
a larger volume of liquid assets are perceived safe, since these assets would allow
banks to meet unexpected withdrawals.
o Sensitivity to market risk: The main concern for FIs is risk management. Reflects the
degree to which changes in interest rates, foreign exchange rates, commodity prices,
or equity prices can adversely affect a financial institutions earnings. The major risks
to be examined include: (i) market risk; (ii) exchange risk; (iii) maturity risk; (iv)
contingent risk.
CRR, SLR, Repo and reverse repo

CASH RESERVE RATIO (CRR): It is the mandatory percentage of the amount of money in
deposits that the bank has to keep with the RBI. This Ratio secures solvency of the bank and
drains out the excessive money from the banks. The main purpose of CRR is to protect the risk
of the banks depositors to an extent and to ensure that a bank maintains some funds in liquid
form. It is used to meet the Net Demand and Time Liabilities. When a bank's deposits increase
by Rs100, and if the cash reserve ratio is 4%, the banks will have to hold Rs 4 with RBI and the
bank will be able to use only Rs 96 for investments and lending, credit purpose. Therefore,
higher the ratio, the lower is the amount that banks will be able to use for lending and
investment. This power of RBI to reduce the lendable amount by increasing the CRR, makes it
an instrument in the hands of a central bank through which it can control the amount that
banks lend. Thus, it is a tool used by RBI to control liquidity in the banking system. Its other
purpose is to adjust liquidity in the system, the supply of money circulating in the economy.
When there is excess money supply in the market, RBI will increase the CRR to drain out the
excess. Inversely if the economy is falling short of liquidity, then RBI will decrease the CRR to
release more funds in the market. This is thus one of the instruments that the central bank
uses to control inflation. Present value of CRR: 4%
STATUTORY LIQUIDITY RATIO (SLR): Banks are required to invest a certain percentage of their
time and demand deposits in assets specified by RBI, including gold, government bonds and
securities. In monetary jargon, SLR is that percentage of net demand and time liabilities
(NDTL); in other words, Bank deposits that must be used to buy specified assets. The SLR ratio
of 22.5% which means that for every Rs.100 deposited in a bank, it has to invest Rs.22.5 in any
of the asset classes approved by the RBI. RBI wants banks to hold a part of the money in near
cash so that they can meet any unexpected demand from depositors at short notice by selling
the bonds. Present value of SLR: 20.5%
REPO RATE: Repo rate is the rate at which the central bank of a country (Reserve Bank of India
in case of India) lends money to commercial banks in the event of any shortfall of funds. Repo
rate is used by monetary authorities to control inflation. In the event of inflation, central banks
increase repo rate as this acts as a disincentive for banks to borrow from the central bank.
This ultimately reduces the money supply in the economy and thus helps in arresting inflation.
The central bank takes the contrary position in the event of a fall in inflationary pressures.
Repo and reverse repo rates form a part of the liquidity adjustment facility. Present value of
Repo Rate: 6.25%
REVERSE REPO RATE: Reverse repo rate is the rate at which the central bank of a country (RBI
in case of India) borrows money from commercial banks within the country. Reverse repo rate
is the rate at which the central bank of a country (Reserve Bank of India in case of India)
borrows money from commercial banks within the country. It is a monetary policy instrument
which can be used to control the money supply in the country. An increase in the reverse repo
rate will decrease the money supply and vice-versa, other things remaining constant. An
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increase in reverse repo rate means that commercial banks will get more incentives to park
their funds with the RBI, thereby decreasing the supply of money in the market. Present value
of Reverse Repo Rate: 6%
Working of repo market

Repo (Repurchase Option) is a formal agreement between two counterparties where one
party sells securities to another party with the explicit intention of buying back the securities
at a later date. The Repo can be called a Sell-Buy transaction. The seller of the securities agrees
to buy back the securities from the buyer at a predetermined time and rate. The rate at which
the seller agrees to buy back the securities will include the interest rate charged by the buyer
for agreeing to buy the securities from the seller. Repo transactions take place between the
RBI and banks, RBI and primary dealers, banks to banks, banks to other counterparties,
primary dealers to primary dealers and primary dealers to other counterparties.
The reason a seller wants to sell and buy back securities and paying interest on the transaction
is that the seller requires funds. The seller of securities can be called as the Repo borrower as
he receives funds for selling the securities. The buyer of the securities is the Repo lender as
he pays for the securities purchased.
The Repo rate is the rate of interest charged by the buyer of the securities to the seller of
securities. A Repo transaction has two legs. The first leg is the sale of securities by the Repo
borrower to the Repo lender. The second leg is the purchase of securities by the Repo
borrower from the Repo lender.
Example 1. Repo transaction in the market

A Repo transaction is the actual sale of securities by the Repo borrower to the Repo lender.
The securities sold could be government bonds, corporate bonds, treasury bills and other
money market instruments. Let us take the example of a Repo borrower selling government
bonds to the Repo lender. The Repo period is one day and the Repo rate is 7.50%.
The government bond sold by the Repo Borrower to the Repo Lender is the benchmark ten
year government bond the 8.15% 2022 government bond. The first leg settlement date is 11th
of March 2013 and the second leg settlement date is 12th of March 2013.
Details of 8.15% 2022 Government Bond

The 8.15% 2022 Government Bond matures on the 11th of June 2022 and pays semi-annual
interest on the 11th of June and 11th of December. The bond is trading at a price of Rs 101.93
that translates into a semi-annual yield of 7.85%. The last interest payment date on the bond
was 11th of December 2012 and the next interest payment date is the 11th of June 2013.
The table below gives the first leg cash inflow and second leg cash outflow of the Repo
Borrower:
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The cash inflow to the Repo Borrower in the first leg is calculated by adding accrued interest
to the price of the bond. The interest outgo for the Repo rate borrower in the second leg is
calculated by the Repo interest rate on the cash inflow. The Repo borrower pays interest on
the full sum of money received by him from the Repo lender.
Repo transactions have also altered the policy toolbox of contemporary central banks. Repos
have overtaken the traditional outright sale and purchase of assets as monetary policy
instruments. Central banks use repos to meet banks demand for reserves and thus influence
interest rates on unsecured inter-bank money markets where they implement monetary
policy.
Open market operations by RBI

Open market operations are conducted by the RBI by way of sale or purchase of government
securities (g-secs) to adjust money supply conditions. The central bank sells g-secs to suck out
liquidity from the system and buys back g-secs to infuse liquidity into the system. These
operations are often conducted on a day-to-day basis in a manner that balances inflation while
helping banks continue to lend. The RBI uses OMO along with other monetary policy tools
such as repo rate, cash reserve ratio and statutory liquidity ratio to adjust the quantum and
price of money in the system.
In India, liquidity conditions usually tighten during the second half of the financial year (mid-
October onwards). This happens because the pace of government expenditure usually slows
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down, even as the onset of the festival season leads to a seasonal spike in currency demand.
Moreover, activities of foreign institutional investors, advance tax payments, etc. also cause
an ebb and flow of liquidity.
However, the RBI smoothens the availability of money through the year to make sure that
liquidity conditions dont impact the ideal level of interest rates it would like to maintain in
the economy. Liquidity management is also essential so that banks and their borrowers dont
face a cash crunch. The RBI buys g-secs if it thinks systemic liquidity needs a boost and offloads
them if it wants to mop up excess money.
The central banks signal that it will move to a neutral liquidity stance from a deficit stance,
hints at more liquidity in the system in future. This could arm banks with more funds for
lending, and lead to softer interest rates in the economy. This is good news for both businesses
as well as individuals.
However, large open market purchases by the RBI can give the government a helping hand in
its borrowing programme and are frowned upon for this reason. In April 2006, the RBI was
barred from subscribing to primary bond issues of the government. This was done to put an
end to the monetisation of debt by the Reserve Bank. However, that didnt stop the process.
With rising fiscal deficit, the RBI has been criticised for accommodating larger government
debt by way of OMO.
SARFAESI Act
SARFAESI stands for Securitization and Reconstruction of Financial Assets and Enforcement of
Security Interest Act. This Act covers the rights a lender has over the collateral, when a secured
loan defaults. Reconstruction of an asset, is banker-speak for reworking the terms of a loan
to ensure that the money is repaid.
The SARFAESI Act in case of default, covers features such as:

1. Securitization: Issuing securities financial instruments against the recovered
assets. It can be done only by specific registered entities called an asset reconstruction
company or securitization company.
2. Guidelines for Asset Reconstruction: It covers how a defaulting business should be
managed or controlled to ensure repayment. Payments can be rescheduled, and secured
collateral repossessed.
3. No court intervention needed: One of the main features of this Act is, the lender can
take over the collateral without court intervention, which was not possible earlier.
NPAs
The reported numbers show that gross NPAs across listed banks including the consolidated
bad bank loans declared by SBI stood at 7.7 lakh crore at the end of March 2017. Excluding
SBI associates for the purposes of comparison, gross NPAs stood at 7.11 lakh crore at the end
of FY 17, compared to 5.70 lakh crore at the end of FY 16, an increase of about 25% in
aggregate terms.
An NPA is a Non Performing Asset. Lenders must provision for NPAs, which means they
must keep aside a certain portion of their income to provide for the losses against these NPAs.
For a bank, a loan becomes an NPA after 90 days past due or overdue; for an NBFC, 180 days
after repayment is due and hasnt been made. A Non Performing asset (NPA) is a loan or an
advance where:
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o interest and/ or instalment of principal remain overdue for a period of more than 90 days in
respect of a term loan
o the account remains out of order , in respect of an Overdraft/Cash Credit (OD/CC)
o the bill remains overdue for a period of more than 90 days in the case of bills purchased and
discounted,
o the instalment of principal or interest thereon remains overdue for two crop seasons for
short duration crops,
o the instalment of principal or interest thereon remains overdue for one crop season for long
duration crops
The two ways in which NPAs can be removed are by Income recognition and Write off. Banks
are required to classify nonperforming assets further into the following three categories based
on the period for which the asset has remained nonperforming and the realisability of the
dues:
Substandard Assets- A substandard asset would be one, which has remained NPA for a
period less than or equal to 12 months. In such cases, the current net worth of the
borrower/ guarantor or the current market value of the security charged is not enough to
ensure recovery of the dues to the banks in full. In other words, such an asset will have
well defined credit weaknesses that jeopardise the liquidation of the debt and are
characterised by the distinct possibility that the banks will sustain some loss, if deficiencies
are not corrected.
Doubtful Assets- An asset would be classified as doubtful if it has remained in the
substandard category for a period of 12 months. A loan classified as doubtful has all the
weaknesses inherent in assets that were classified as substandard, with the added
characteristic that the weaknesses make collection or liquidation in full, on the basis of
currently known facts, conditions and values highly questionable and improbable.
Loss Assets- A loss asset is one where loss has been identified by the bank or internal or
external auditors or the RBI inspection but the amount has not been written off wholly.
In other words, such an asset is considered uncollectible and of such little value that its
continuance as a bankable asset is not warranted although there may be some salvage or
recovery value.
NBFCs
Non Banking Finance Companies (NBFCs) are financial institutions that provide services, similar to
banks, but they do not hold a banking license. The main difference is that NBFCs cannot accept
deposits repayable on demand. Classification if NBFCs:
1. Asset Finance Company (AFC): An AFC is an NBFC, whose principal business is the financing of
physical assets. This includes financing of automobiles, tractors, lathe machines, generator
sets, earth moving and material handling equipment and general purpose industrial machines.
Examples of AFCs are Infrastructure Finance Limited, Diganta Finance etc.
An AFC may be either
a. Giving loans to businesses for purchasing the physical assets tractors, machinery etc.
b. Leasing these assets to businesses
2. Investment Company (IC): This is an NBFC whose primary business is purchase and sale of
securities (financial instruments, such as stocks and bonds). A mutual fund would come under
this category. Examples of an Investment Company (IC) are Motilal Oswal, UTI Mutual Fund
etc.
3. Loan Company (LC): Loan Company (LC) means any NBFC whose principal business is that of
providing finance, by giving loans or advances. It does not include leasing or hire purchase.
Example of a Loan Company (LC) is Tata Capital Limited.
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NBFCs can be further classified into those taking deposits or those not taking deposits. Only those
NBFCs can take deposits, that
- Hold a valid certificate of registration with authorization to accept public deposits.
- Have minimum stipulated Net Owned Funds (NOF i.e. owners funds)
- Comply with RBI directions such as investing part of the funds in liquid assets, maintain
reserves, rating etc. issued by the bank.
The three key differences between a bank and NBFC are:

An NBFC cannot accept deposits which are repayable on demand. Some can accept fixed-term
deposits
Any deposits accepted by NBFCs (these will be of fixed maturity as explained above) are not
insured
Only banks can participate in the payment system; hence NBFCs cannot issue cheque books
to their customers
IV. Corporate Finance

Time Value of Money
The time value of money (TVM) is the idea that money available at the present time is worth
more than the same amount in the future due to its potential earning capacity. Conversely,
the sum of money received in future is less valuable that it is today. Since a rupee received
today has more value, rational investors would prefer current receipt to future receipts. The
time value of money can also be referred to as time preference for money. The main reason
for this is to be found in the reinvestment opportunities for funds which are received early.
The funds so invested will earn a rate of return; this would not be possible if the funds are
received at a later time.
Compounding techniques:
The most fundamental TVM formula takes into account the following variables:
FV = Future value of money
PV = Present value of money
i = interest rate
n = number of years
FV = PV x (1 + i)n
The term (1+i)n is called FVIF (Future Value Interest factor) whose values at different rates for
different time periods are provided in the FVIF Table.
For example, assume a sum of $10,000 is invested for one year at 10% interest. The future
value of that money is:
FV = $10,000 x (1 + (10% / 1) ^ (1 x 1) = $11,000
An Annuity is a stream of equal annual cash flows. Annuities involve calculations based upon
the regular periodic contribution or receipt of a fixed sum of money. Future Value of an
annuity is provided by the following formula:
Here, the annual amount is multiplied by the appropriate FVIFA (Future Value Interest factor
for Annuity), whose calculations are available in the FVIFA Table.
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Present Value or Discounting technique:

The concept of present value is the exact opposite of that of compound value. While in the
latter approach money invested now appreciates in value because compound interest is
added, in the former approach, money is received at some future date and will be worth less
because the corresponding interest is lost during the period. Present Value is the current value
of a future amount.
The formula for calculating the present value of a single sum is as follows:
PVIF (Present Value Interest Factor) is the multiplier used to calculate at a specified discount
rate the present value of an amount to be received in a future period. PVIF Tables give present
value of one rupee for various combinations of i and n.
Present Value of Annuity is calculated by the following formula:
PVIFA (Present Value Interest Factor for Annuity) is the multiplier to calculate the present
value of an annuity at a specified discount rate over a given period of time. PVIFA Table
provides annuity discount factor for Re. 1 for a wide range of i and n.
Capital Budgeting
The term capital budgeting is used to describe how managers plan significant outlays on
projects that have long-term implications such as the purchase of new equipment and the
introduction of new products. Managers must carefully select those projects that promise the
greatest future return. How well managers make these capital budgeting decisions is a critical
factor in the long run profitability of the company.
What types of business decisions require capital budgeting analysis?

Business decisions that require capital budgeting analysis are decisions that involve in outlay
now in order to obtain some return in the future. This return may be in the form of increased
revenue or reduced costs. Typical capital budgeting decisions include:
Cost reduction decisions- Should new equipment be purchased to reduce costs?
Expansion decisions- Should a new plan, warehouse, or other facility be acquired to
increase capacity and sales?
Equipment selection decision- Which of several available machines should be the most
cost effective to purchase?
Lease or buy decisions- Should new equipment be leased or purchased?
Equipment replacement decisions- Should old equipment be replaced now or later?
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In capital budgeting decisions, the focus is on cash flows and not on accounting net income.
The reason is that accounting net income is based on accruals that ignore the timing of cash
flows into and out of an organization. From a capital budgeting standpoint, the timing of cash
flows is important, since a dollar received today is more valuable than a dollar received in the
future. Therefore, even though accounting net income is useful for many things, it is not
ordinarily used in discounted cash flow analysis.
Typical cash out flows:

Most projects will have an immediate cash outflows in the form of an initial investment or
other assets. Any salvage value realized from the sale of the old equipment can be recognized
as a cash inflow or as a reduction in the required investment. In addition, some projects
require that a company expand its working capital. When a company takes on a new project,
the balances in the current assets will often increase. For example, opening a new
Nordstroms department store would require additional cash in sales registers, increased
accounts receivable for new customers, and more inventory to stock the shelves. These
additional working capital needs should be treated as part of the initial investment in a
project. Also, many projects require periodic outlays for repairs and maintenance and for
additional operating costs. These should all be treated as cash outflows for capital budgeting
purposes.
Typical cash inflows:

On the cash inflow side, a project will normally either increase revenues or reduce costs. Either
way, the amount involved should be treated as a cash inflow for capital budgeting purposes.
Notice that so far as cash flows are concerned, a reduction in costs is equivalent to an increase
in revenues. Cash inflows are also frequently realized from salvage of equipment when a
project ends, although the company may actually have to pay to dispose of some low value
or hazardous items. In addition, any working capital that was tied up in the project can be
released for use elsewhere at the end of the project and should be treated as a cash inflow at
that time.
Capital Budgeting techniques

Payback Period
The payback period is the length of time that it takes for a project to recoup its initial cost out
of the cash receipts that it generates. This period is also referred to as the time that it takes
for an investment to pay for itself. The basic premise of the payback method is that the more
quickly the cost of an investment can be recovered, the more desirable is the investment. The
payback period is expressed in years. When the net annual cash inflow is the same every year,
the following formula can be used to calculate the payback period.
Payback period = Investment required / Net annual cash inflow*
*If new equipment is replacing old equipment, this becomes incremental net annual cash
inflow.
To illustrate the payback method, consider the following example:

York Company needs a new milling machine. The company is considering two machines.
Machine A and machine B. Machine A costs $15,000 and will reduce operating cost by $5,000
per year. Machine B costs only $12,000 but will also reduce operating costs by $5,000 per
year. Calculate payback period and determine which machine should be purchased.
Machine A payback period = $15,000 / $5,000 = 3.0 years
Machine B payback period = $12,000 / $5,000 = 2.4 years
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According to payback calculations, York Company should purchase machine B, since it has
shorter payback period than machine A.
Evaluation of the payback period method:

The payback method is not a true measure of the profitability of an investment. Rather, it
simply tells the manager how many years will be required to recover the original investment.
Unfortunately, a shorter payback period does not always mean that one investment is more
desirable than another.
To illustrate, consider the two machines used in the example above. Since machine B has a
shorter payback period than machine A, it appears that machine B is more desirable than
machine A. But if we add one more piece of information, this illusion quickly disappears.
Machine A has a project 10-years life, and machine B has a projected 5 years life. It would take
two purchases of machine B to provide the same length of service as would be provided by a
single purchase of machine A. Under these circumstances, machine A would be a much better
investment than machine B, even though machine B has a shorter payback period.
Unfortunately, the payback method has no inherent mechanism for highlighting differences
in useful life between investments. Such differences can be very important, and relying on
payback alone may result in incorrect decisions.
Another criticism of payback method is that it does not consider the time value of money. A
cash inflow to be received several years in the future is weighed equally with a cash inflow to
be received right now. To illustrate, assume that for an investment of $8,000 you can purchase
either of the two following streams of cash inflows.
On the other hand, under certain conditions the payback method can be very useful. For one
thing, it can help identify which investment proposals are in the ballpark. That is, it can be
used as a screening tool to help answer the question, Should I consider this proposal
further? If a proposal does not provide a payback within some specified period, then there
may be no need to consider it further. In addition, the payback period is often of great
importance to new firms that are cash poor. When a firm is cash poor, a project with a short
payback period but a low rate of return might be preferred over another project with a high
rate of return but a long payback period. The reason is that the company may simply need a
faster return of its cash investment. And finally, the payback method is sometimes used in
industries where products become obsolete very rapidly such as consumer electronics. Since
products may last only a year or two, the payback period on investments must be very short.
Net Present Value (NPV)

Under the net present value method, the present value of a projects cash inflows is compared
to the present value of the projects cash outflows. The difference between the present value
of these cash flows is called the net present value. This net present value determines
whether or not the project is an acceptable investment.
A positive net present value indicates that the projected earnings generated by a project or
investment (in present dollars) exceeds the anticipated costs (also in present dollars).
Generally, an investment with a positive NPV will be a profitable one and one with a negative
NPV will result in a net loss. This concept is the basis for the Net Present Value Rule, which
dictates that the only investments that should be made are those with positive NPV values.
To illustrate, assume we are asked to use the NPV approach to choose between two projects,
and our company's weighted average cost of capital (WACC) is 8%. Project A costs $7 million
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in upfront costs, and will generate $3 million in annual income starting three years from now
and continuing for a five-year period (i.e. years 3 to 7). Project B costs $2.5 million upfront
and $2 million in each of the next three years (years 1 to 3). It generates no annual income
but will be sold six years from now for a sales price of $16 million.
For each project, find NPV = (PV inflows) - (PV outflows).
Project A: The present value of the outflows is equal to the current cost of $7 million. The
inflows can be viewed as an annuity with the first payment in three years, or an ordinary
annuity at t = 2 since ordinary annuities always start the first cash flow one period away.
PV annuity factor for r = .08, N = 5: (1 - (1/ (1 + r)N)/r = (1 - (1/(1.08)5)/.08 = (1 -

(1/(1.469328)/.08 = (1 - (1/(1.469328)/.08 = (0.319417)/.08 = 3.99271
Multiplying by the annuity payment of $3 million, the value of the inflows at t = 2 is ($3
million)*(3.99271) = $11.978 million.
Discounting back two periods, PV inflows = ($11.978)/(1.08)2 = $10.269 million.
NPV (Project A) = ($10.269 million) - ($7 million) = $3.269 million
Project B: The inflow is the present value of a lump sum, the sales price in six years discounted
to the present: $16 million/(1.08)6 = $10.083 million.
Cash outflow is the sum of the upfront cost and the discounted costs from years 1 to 3. We
first solve for the costs in years 1 to 3, which fit the definition of an annuity.
PV annuity factor for r = .08, N = 3: (1 - (1/(1.08)3)/.08 = (1 - (1/(1.259712)/.08 = (0.206168)/.08

= 2.577097. PV of the annuity = ($2 million)*(2.577097) = $5.154 million.
PV of outflows = ($2.5 million) + ($5.154 million) = $7.654 million.
NPV of Project B = ($10.083 million) - ($7.654 million) = $2.429 million

Applying the NPV rule, we choose Project A, which has the larger NPV: $3.269 million versus
$2.429 million.
One primary issue with gauging an investments profitability with NPV is that NPV relies
heavily upon multiple assumptions and estimates, so there can be substantial room for error.
Estimated factors include investment costs, discount rate and projected returns. A project
may often require unforeseen expenditures to get off the ground or may require additional
expenditure at the projects end.
Additionally, discount rates and cash inflow estimates may not inherently account for risk
associated with the project and may assume the maximum possible cash inflows over an
investment period. This may occur as a means of artificially increasing investor confidence. As
such, these factors may need to be adjusted to account for unexpected costs or losses or for
overly optimistic cash inflow projections.
Internal rate of Return (IRR)

The internal rate of return (IRR) is the rate of return promised by an investment project over
its useful life. It is some time referred to simply as yield on project. The internal rate of
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return is computed by finding the discount rate that equates the present value of a projects
cash out flow with the present value of its cash inflow In other words, the internal rate of
return is that discount rate that will cause the net present value of a project to be equal to
zero.
EXAMPLE:
A school is considering the purchase of a large tractor-pulled lawn mower. At present, the
lawn is moved using a small hand pushed gas mower. The large tractor-pulled mower will cost
$ 16,950 and will have a useful life of 10 years. It will have only a negligible scrap value, which
can be ignored. The tractor-pulled mower will do the job much more quickly than the old
mower and would result in a labour savings of $ 3,000 per year.
The simplest and most direct approach to compute the internal rate of return when the net
cash inflow is the same every year is to divide the investment in the project by the expected
net annual cash inflow. This computation will yield a factor from which the internal rate of
return can be determined.
The formula or equation is as follows:
[Factor of internal rate of return = Investment required / Net annual cash inflow] (1)
The factor derived from formula (1) is then located in the present value tables to see what
rate of return it represents. Using formula (1) and the data for schools proposed project:
Investment required / Net annual cash inflow

= $16,950 / $3,000
= 5.650
Thus, the discount factor that will equate a series of $ 3,000 cash inflows with a present
investment of $16,950. Now we need to find this factor in the table to see what rate of return
it represents. If we scan along the 10-period line, we find that a factor of 5.650 represents a
12% rate of return. We can verify this by computing the projects net present value using a
12% discount rate.
Notice that using a 12% discount rate equates the present value of the annual cash inflows
with the present value of the investment required in the project, leaving a zero net present
value. The 12% rate therefore represents the internal rate of return promised by the project.
Salvage value and other cash flows:

The technique just demonstrated works very well if a projects cash flow s are identical every
year. But what if they are not? For example, what if a project will have some salvage value at
the end of its life in addition to the annual cash inflows? Under these circumstances, a trial
and error process may be used to find the rate of return that will equate the cash inflow with
the cash outflows. The trial and error process can be carried out by hand; however, computer
software programs such as spreadsheets can perform the necessary computations in seconds.
In short, erratic or uneven cash flows should not prevent a manager from determining a
projects internal rate of return.
Once the internal rate of return has been computed it is compared to the companys required
rate of return. The required rate of return is the minimum rate of return that an investment
project must yield to be acceptable. If the internal rate of return is equal to or greater than
the required rate of return, than the project is acceptable. If it is less than the required rate of
return, then the project is rejected. Quite often the companys cost of capital is used as the
required rate of return. The reasoning is that if a project cannot provide a rate of return at
least as greater as the cost of the funds invested in it, then it is not profitable.
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Cost of capital as a screening tool:

The cost of capital often operates as a screening device, helping the manager screen out
undesirable investment projects. This screening is accomplished in different ways, depending
on whether the company is using the internal rate of return method or the net present value
method in its capital budgeting analysis.
When the internal rate of return method is used, the cost of capital is used as the hurdle rate
that a project must clear for acceptance. If the internal rate of return of a project is not great
enough to clear the cost of capital hurdle, then the project is ordinarily rejected.
When the net present value method is used, the cost of capital is the discount rate used to
compute the net present value of a proposed project. Any project yielding a negative net
present value is rejected unless other factors are significant enough to require its acceptance.
NPV vs. IRR

Each of the two rules used for making capital-budgeting decisions has its strengths and
weaknesses. The NPV rule chooses a project in terms of net dollars or net financial impact on
the company, so it can be easier to use when allocating capital.
However, it requires an assumed discount rate, and also assumes that this percentage rate
will be stable over the life of the project, and that cash inflows can be reinvested at the same
discount rate. In the real world, those assumptions can break down, particularly in periods
when interest rates are fluctuating. The appeal of the IRR rule is that a discount rate need not
be assumed, as the worthiness of the investment is purely a function of the internal inflows
and outflows of that particular investment. However, IRR does not assess the financial impact
on a firm; it only requires meeting a minimum return rate.
All other things being equal, using internal rate of return (IRR) and net present value (NPV)
measurements to evaluate projects often results in the same findings. However, there are a
number of projects for which using IRR is not as effective as using NPV to discount cash flows.
IRR's major limitation is also its greatest strength: it uses one single discount rate to evaluate
every investment.
Although using one discount rate simplifies matters, there are a number of situations that
cause problems for IRR. Without modification, IRR does not account for changing discount
rates, so it's just not adequate for longer-term projects with discount rates that are expected
to vary. Another type of project for which a basic IRR calculation is ineffective is a project with
a mixture of multiple positive and negative cash flows. If market conditions change over the
years, such projects can have two or more IRRs. The advantage to using the NPV method here
is that NPV can handle multiple discount rates without any problems. Each cash flow can be
discounted separately from the others. Another situation that causes problems for users of
the IRR method is when the discount rate of a project is not known.
Discount rate
In general, a dollar today is worth more than a dollar tomorrow for two simple reasons. First,
a dollar today can be invested at a risk-free interest rate (think savings account or U.S.
government bonds), and can earn a return. A dollar tomorrow is worth less because it has
missed out on the interest you would have earned on that dollar had you invested it today.
Second, inflation diminishes the buying power of future money.
A discount rate is the rate you choose to discount the future value of your money. A discount
rate can be understood as the expected return from a project that matches the risk profile of
the project in which you'd invest your money.
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Note: The discount rate is different than the opportunity cost of the money. Opportunity cost
is a measure of the opportunity lost. Discount rate is a measure of the risk. These are two
separate concepts.
Capital Asset Pricing Model (CAPM)

Capital Asset Pricing Model, or (CAPM) is a model used to calculate the expected return on
investment, also referred to as expected return on equity. It is a linear model with one
independent variable, Beta. Beta represents relative volatility of the given investment with
respect to the market. For example, if the Beta of an investment is I, the returns on the
investment (stock/bond/portfolio) vary identically with the market returns.
A Beta less than 1, like 0.5, means the investment is less volatile than the market. So if the
Dow Jones Industrial Average goes up or down 20 percent the next day, a less volatile stock
(i.e., Beta < 1) would be expected to go up or down 10 percent. A Beta of greater than 1, like
1.5, means the investment is more volatile than the market. A company in a volatile industry
(think Internet Company) would be expected to have a Beta greater than 1. A company whose
value does not vary much, like an electric utility, would be expected to have a Beta under 1.
Mathematically, CAPM is calculated as:
re = Discount rate for an all-equity firm

rf = Risk-free rate (The Treasury bill rate for the period the cash projections are being
considered. For example, if we are considering a 10-year period, then the risk-free rate is the
rate for the 10-year U.S. Treasury note.)
rm rf = Excess market return
= Equity Beta
Types of risk
The systematic risk is a result of external and uncontrollable variables, which are not industry
or security specific and affects the entire market leading to the fluctuation in prices of all the
securities. Systematic risk cannot be eliminated by diversification of portfolio. It is divided into
three categories that are explained as under:
Interest risk: Risk caused by the fluctuation in the rate or interest from time to time and
affects interest-bearing securities like bonds and debentures.
Inflation risk: Alternatively known as purchasing power risk as it adversely affects the
purchasing power of an individual. Such risk arises due to a rise in the cost of production,
the rise in wages, etc.
Market risk: The risk influences the prices of a share, i.e. the prices will rise or fall
consistently over a period along with other shares of the market.
On the other hand, unsystematic risk refers to the risk which emerges out of controlled and
known variables that are industry or security specific. Diversification proves helpful in avoiding
unsystematic risk. It has been divided into two category business risk and financial risk,
explained as under:
Business risk: Risk inherent to the securities, is the company may or may not perform well.
The risk when a company performs below average is known as a business risk. There are
some factors that cause business risks like changes in government policies, the rise in
competition, change in consumer taste and preferences, development of substitute
products, technological changes, etc.
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Financial risk: Alternatively known as leveraged risk. When there is a change in the capital
structure of the company, it amounts to a financial risk. The debt equity ratio is the
expression of such risk.
Valuation techniques overview

o Discounted Cash Flow (DCF)
Discounted cash flow (DCF) analysis is a method of valuing the intrinsic value of a company
(or asset). In simple terms, discounted cash flow tries to work out the value today, based on
projections of all of the cash that it could make available to investors in the future. It is
described as "discounted" cash flow because of the principle of "time value of money" (i.e.
cash in the future is worth less than cash today).
The advantage of DCF analysis is that it produces the closest thing to an intrinsic stock value -
relative valuation metrics such as price-earnings (P/E) or EV/EBITDA ratios aren't very useful
if an entire sector or market is overvalued. In addition, the DCF method is forward-looking and
depends more on future expectations than historical results. The method is also based on free
cash flow (FCF), which is less subject to manipulation than some other figures and ratios
calculated out of the income statement or balance sheet.
The steps involved are as follows:

A. Estimate Cash flows
Free Cash Flow to the Firm (FCFF) is the cash available to bond holders and stock holders after
all expense and investments have taken place.
B. Estimate Growth Profile (1 stage, 2 stage, etc.) & Growth Rates

C. Calculate Discount Rate
D. Calculate the Terminal Value
E. Calculate fair value of company and its equity
o Sum Of The Parts Analysis (SOTP)

Sum-of-the-parts ("SOTP") or "break-up" analysis provides a range of values for a company's
equity by summing the value of its individual business segments to arrive at the total
enterprise value (EV). Equity value is then calculated by deducting net debt and other non-
operating adjustments.
For a company with different business segments, each segment is valued using ranges of
trading and transaction multiples appropriate for that particular segment. Relevant multiples
used for valuation, depending on the individual segment's growth and profitability, may
include revenue, EBITDA, EBIT, and net income. A DCF analysis for certain segments may also
be a useful tool when forecasted segment results are available or estimable.
SOTP analysis is used to value a company with business segments in different industries that
have different valuation characteristics. Below are two situations in which a SOTP analysis
would be useful:
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Defending a company that is trading at a discount to the sum of its parts from a hostile
takeover
Restructuring a company to unlock the value of a business segment that is not getting
credit for its value through a spin-off, split-off, tracking stock, or equity (IPO) carve-out
o Asset Based Approach

An asset-based approach is a type of business valuation that focuses on a company's net
asset value (NAV), or the fair-market value of its total assets minus its total liabilities, to
determine what it would cost to recreate the business. Adjustments are made to the
companys historical balance sheet in order to present each asset and liability item at its
respective fair market value. Examples of potential normalizing adjustments include:
Adjusting fixed assets to their respective fair market values
Reducing accounts receivable for potential uncollectable balances if an allowance for
doubtful accounts has not been established or if it is not sufficient to cover the
potentially uncollectable amount
Reflecting any unrecorded liabilities such as potential legal settlements or judgments.
Consideration of the Adjusted Net Asset Method is typically most appropriate when:
Valuing a holding company or a capital-intensive company
Losses are continually generated by the business
Valuation methodologies based on a companys net income or cash flow levels
indicate a value lower than its adjusted net asset value
o Comparables approach
There are two primary comparable approaches. Trading comparables is the most common
and looks at market comparables for a firm and its peers. Common market multiples
include the following: enterprise value to sales (EV/S), enterprise multiple, price to
earnings (P/E), price to book (P/B) and price to free cash flow (P/FCF). The specific ratio to
be used depends on the objective of the valuation. The valuation could be designed to
estimate the value of the operation of the business or the value of the equity of the
business.
When calculating the value of the operation the most commonly used ratio is the EBITDA
multiple, which is the ratio of EBITDA (Earnings Before Interest Taxes Depreciation and
Amortization) to the Enterprise Value (equity value plus Net Debt). When valuing the
equity of a company, the most widely used multiple is the Price Earnings Ratio (PE) of
stocks in a similar industry, which is the ratio of Stock price to Earnings per Share of any
public company.
The second comparables approach; transaction comparables, looks at market

transactions where similar firms, or at least similar divisions, have been bought out or
acquired by other rivals, private equity firms or other classes of large, deep-pocketed
investors. Using this approach, an investor can get a feel for the value of the equity being
valued. Combined with using market statistics to compare a firm to key rivals, multiples
can be estimated to come to a reasonable estimate of the value for a firm.
It can be difficult to find truly comparable companies and transactions to value an equity.
Additionally, using trailing and forward multiples can make a big difference in an analysis.
If a firm is growing rapidly, a historical valuation will not be overly accurate. What matters
most in valuation is making a reasonable estimate of future market multiples. If profits
are projected to grow faster than rivals, the value should be higher.
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Mutual funds
A mutual fund is an investment vehicle made up of a pool of funds collected from many
investors for the purpose of investing in securities such as stocks, bonds, money market
instruments and similar assets. Mutual funds are operated by money managers, who invest
the fund's capital and attempt to produce capital gains and income for the fund's investors. A
mutual fund's portfolio is structured and maintained to match the investment objectives
stated in its prospectus. They give small investors access to professionally managed,
diversified portfolios of equities, bonds and other securities.
Investors typically earn a return from a mutual fund in three ways:

Income is earned from dividends on stocks and interest on bonds held in the funds portfolio.
A fund pays out nearly all of the income it receives over the year to fund owners in the form
of a distribution. Funds often give investors a choice either to receive a check for distributions
or to reinvest the earnings and get more shares
If the fund sells securities that have increased in price, the fund has a capital gain. Most funds
also pass on these gains to investors in a distribution.
If fund holdings increase in price but are not sold by the fund manager, the fund's shares
increase in price. The investor can then sell mutual fund shares for a profit in the market.
Advantages of mutual funds:

Professional Management The primary advantage of funds is not having to pick stocks and
manage investments. Instead, a professional investment manager takes care of all of this using
careful research and skilful trading.
Diversification- By owning shares in a mutual fund instead of owning individual stocks or
bonds, investors risk is spread out across many different holdings.
Economies of Scale Because a mutual fund buys and sells large amounts of securities at a
time, its transaction costs are lower than what an individual would pay for securities
transactions.
Variety- Mutual funds today exist with any number of various asset classes or strategies. This
allows investors to gain exposure to not only stocks and bonds but also commodities, foreign
assets, and real estate through specialized mutual funds.
Disadvantages of mutual funds:

Active Management- Actively managed funds incur higher fees, but increasingly passive index
funds have gained popularity. These funds track an index such as the S&P 500 and are much
less costly to hold.
Costs and fees- Since fees vary widely from fund to fund, failing to pay attention to the fees
can have negative long-term consequences. Actively managed funds incur transaction costs
that accumulate over each year.
Dilution- Because mutual funds can have small holdings in many different companies, high
returns from a few investments often don't make much difference on the overall return.
Dilution is also the result of a successful fund growing too big.
Hedge funds
Hedge funds are alternative investments using pooled funds that employ numerous different
strategies to earn active return, or alpha, for their investors. Hedge funds may be aggressively
managed or make use of derivatives and leverage in both domestic and international markets
with the goal of generating high returns. It is important to note that hedge funds are generally
only accessible to accredited investors as they require less SEC regulations than other funds.
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One aspect that has set the hedge fund industry apart is the fact that hedge funds face less
regulation than mutual funds and other investment vehicles.
Investors in hedge funds have to meet certain net worth requirements to invest in them - net
worth exceeding $1 million excluding their primary residence. Instead of charging an expense
ratio only, hedge funds charge both an expense ratio and a performance fee. This fee structure
is known as "Two and Twenty"a 2% asset management fee and then a 20% cut of any gains
generated.
Exchange Traded Funds (ETFs)

An ETF, or exchange traded fund, is a marketable security that tracks an index, a commodity,
bonds, or a basket of assets like an index fund. Unlike mutual funds, an ETF trades like a
common stock on a stock exchange. ETFs experience price changes throughout the day as they
are bought and sold. ETFs typically have higher daily liquidity and lower fees than mutual fund
shares, making them an attractive alternative for individual investors. Because it trades like a
stock, an ETF does not have its net asset value (NAV) calculated once at the end of every day
like a mutual fund does.
An ETF is a type of fund which owns the underlying assets (shares of stock, bonds, oil futures,
gold bars, foreign currency, etc.) and divides ownership of those assets into shares. The actual
investment vehicle structure (such as a corporation or investment trust) will vary by country,
and within one country there can be multiple structures that co-exist. Shareholders do not
directly own or have any direct claim to the underlying investments in the fund; rather they
indirectly own these assets. ETF shareholders are entitled to a proportion of the profits, such
as earned interest or dividends paid, and they may get a residual value in case the fund is
liquidated. The ownership of the fund can easily be bought, sold or transferred in much the
same was as shares of stock, since ETF shares are traded on public stock exchanges.
By owning an ETF, investors get the diversification of an index fund as well as the ability to sell
short, buy on margin and purchase as little as one share (there are no minimum deposit
requirements). Another advantage is that the expense ratios for most ETFs are lower than
those of the average mutual fund. When buying and selling ETFs, you have to pay the same
commission to your broker that you'd pay on any regular order.
Differences between FII and FDI

Both FDI and FII is related to investment in a foreign country. FDI or Foreign Direct
Investment is an investment that a parent company makes in a foreign country. On the
contrary, FII or Foreign Institutional Investor is an investment made by an investor in the
markets of a foreign nation.
In FII, the companies only need to get registered in the stock exchange to make
investments. But FDI is quite different from it as they invest in a foreign nation.
The Foreign Institutional Investor is also known as hot money as the investors have the
liberty to sell it and take it back. But in Foreign Direct Investment, this is not possible. In
simple words, FII can enter the stock market easily and also withdraw from it easily. But
FDI cannot enter and exit that easily. This difference is what makes nations to choose FDIs
more than then FIIs.
Foreign Direct Investment only targets a specific enterprise. It aims to increase the
enterprises capacity or productivity or change its management control. In an FDI, the
capital inflow is translated into additional production. The FII investment flows only into
the secondary market. It helps in increasing capital availability in general rather than
enhancing the capital of a specific enterprise.
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The Foreign Direct Investment is considered to be more stable than Foreign Institutional
Investor. FDI not only brings in capital but also helps in good governance practises and
better management skills and even technology transfer. Though the Foreign Institutional
Investor helps in promoting good governance and improving accounting, it does not come
out with any other benefits of the FDI.
While the FDI flows into the primary market, the FII flows into secondary market. While
FIIs are short-term investments, the FDIs are long term.
V. Capital Markets and Financial Instruments

Equity
Equity or Stock is a share in the ownership of a company, a claim on the company's assets and
earnings. As one acquires more stock, ones ownership stake in the company becomes
greater. Stockholders are entitled to a share of the company's earnings as well as any voting
rights attached. Shareholder are entitled to a portion of the company's profits and have a
claim on assets. Profits are sometimes paid out in the form of dividends. And there is no
obligation to pay out dividends even for those firms that have traditionally given them.
Without dividends, an investor can make money on a stock only through its appreciation in
the open market. A shareholders claim on assets is only relevant if a company goes bankrupt
i.e. they have a residual claim over the assets.
There are two main types of stocks: common stock and preferred stock.
Common Stock: When people talk about stocks they are usually referring to this type. In
fact, the majority of stock is issued is in this form. Common shares represent ownership
in a company and a claim (dividends) on a portion of profits. Investors get one vote per
share to elect the board members, who oversee the major decisions made by
management. Over the long term, common stock, by means of capital growth, yields
higher returns than almost every other investment. This higher return comes at a cost
since common stocks entail the most risk. If a company goes bankrupt and liquidates, the
common shareholders will not receive money until the creditors, bondholders and
preferred shareholders are paid.
Preferred Stock: Preferred stock represents some degree of ownership in a company but
usually doesn't come with the same voting rights. (This may vary depending on the
company.) With preferred shares, investors are usually guaranteed a fixed dividend
forever. This is different than common stock, which has variable dividends that are never
guaranteed. Another advantage is that in the event of liquidation, preferred shareholders
are paid off before the common shareholder (but still after debt holders). Preferred stock
may also be callable, meaning that the company has the option to purchase the shares
from shareholders at any time for any reason (usually for a premium). Some people
consider preferred stock to be more like debt than equity. A good way to think of these
kinds of shares is to see them as being in between bonds and common shares.
How do Stock Price Change

Stock prices change every day as a result of market forces. By this we mean that share prices
change because of supply and demand. If more people want to buy a stock (demand) than sell
it (supply), then the price moves up. Conversely, if more people wanted to sell a stock than
buy it, there would be greater supply than demand, and the price would fall.
Understanding supply and demand is easy. What is difficult to comprehend is what makes
people like a particular stock and dislike another stock. This comes down to figuring out what
news is positive for a company and what news is negative. The principal theory is that the
price movement of a stock indicates what investors feel a company is worth. Don't equate a
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company's value with the stock price. The value of a company is its market capitalization,
which is the stock price multiplied by the number of shares outstanding.
For example, a company that trades at Rs 100 per share and has 1 million shares outstanding
has a lesser value than a company that trades at Rs 50 that has 5 million shares outstanding
(Rs 100 x 1 million = Rs 100 million while Rs 50 x 5 million = Rs 250 million). To further
complicate things, the price of a stock doesn't only reflect a company's current value, it also
reflects the growth that investors expect in the future.
The important things to grasp about this subject are the following:
At the most fundamental level, supply and demand in the market determines stock price
Price times the number of shares outstanding (market capitalization) is the value of a
company. Comparing just the share price of two companies is meaningless
Theoretically, earnings are what affect investors' valuation of a company, but there are
other indicators that investors use to predict stock price. Remember, it is investors'
sentiments, attitudes and expectations that ultimately affect stock prices
There are many theories that try to explain the way stock prices move the way they do.
Unfortunately, there is no one theory that can explain everything .
Equity Markets
A bull market is when everything in the economy is great, people are finding jobs, Gross
Domestic Product (GDP) is growing, and stocks are rising. Picking stocks during a bull market
is easier because everything is going up. Bull markets cannot last forever though, and
sometimes they can lead to dangerous situations if stocks become overvalued. If a person is
optimistic and believes that stocks will go up, he or she is called a "bull" and is said to have a
"bullish outlook".
A bear market is when the economy is bad, recession is looming and stock prices are falling.
Bear markets make it tough for investors to pick profitable stocks. One solution to this is to
make money when stocks are falling using a technique called short selling. Another strategy
is to wait on the sidelines until you feel that the bear market is nearing its end, only starting
to buy in anticipation of a bull market. If a person is pessimistic, believing that stocks are going
to drop, he or she is called a "bear" and said to have a "bearish outlook".
Active and passive investing

Active investing, as its name implies, takes a hands-on approach and requires that someone act in
the role of portfolio manager. The goal of active money management is to beat the stock markets
average returns and take full advantage of short-term price fluctuations. It involves a much deeper
analysis and the expertise to know when to pivot into or out of a particular stock, bond or any
asset.
Advantages to active investing:

Flexibility Active managers aren't required to follow a specific index. They can buy those
"diamond in the rough" stocks they believe they've found.
Hedging Active managers can also hedge their bets using various techniques such as short sales
or put options, and they're able to exit specific stocks or sectors when the risks become
too big.
Tax management Even though this strategy could trigger a capital gains tax, advisors can tailor
tax management strategies to individual investors, such as by selling investments that are
losing money to offset the taxes on the big winners.
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But active strategies have these shortcomings:

Very expensive Thomson Reuters Lipper pegs the average expense ratio at 1.4% for an actively
managed equity fund, compared to only 0.6% for the average passive equity fund. All
those fees over decades of investing can kill returns.
Active risk Active managers are free to buy any investment they think would bring high returns,
which is great when the analysts are right but terrible when they're wrong.
Passive investors limit the amount of buying and selling within their portfolios, making this a very
cost-effective way to invest. The strategy requires a buy and hold mentality. That means resisting
the temptation to react or anticipate the stock markets every next move. The prime example of
a passive approach is to buy an index fund that follows one of the major indices like the S&P 500
or Dow Jones. Whenever these indices switch up their constituents, the index funds that follow
them automatically switch up their holdings by selling the stock thats leaving and buying the stock
thats becoming part of the index.
Some of the key benefits of passive investing are:

Ultra-low fees There's nobody picking stocks, so oversight is much less expensive. Passive funds
simply follow the index they use as their benchmark.
Transparency It's always clear which assets are in an index fund.
Tax efficiency Their buy and hold strategy doesn't typically result in a massive capital gains tax
for the year.
Proponents of active investing would say that passive strategies have these weaknesses:
Too limited Passive funds are limited to a specific index or predetermined set of investments
with little to no variance; thus, investors are locked into those holdings, no matter what
happens in the market.
Small returns By definition, passive funds will pretty much never beat the market, even during
times of turmoil, as their core holdings are locked in to track the market.
Technical and fundamental analysis

Technical analysis involves looking at charts and patterns associated with a stock's historical price
movements to try to profit from predictable patterns, regardless of fundamentals such as revenue
growth or expense trends. While many on Wall Street look down upon technical analysis (and it is
rarely taught at business schools), some Wall Street traders still rely on it or use it in conjunction
with fundamental analysis to decide whether and when to buy and sell.
In contrast, fundamental analysis of a stock (or other security) involves using financial analysis to
analyse the company's underlying business, such as sales growth, its balance sheet, etc. (its
"fundamentals") to decide whether and when to buy and sell.
Indicators to pick a stock

P E ratio= Market price per share/Earnings per share
This ratio is used to know if the stock price is overvalued or undervalued. High ratio indicates that
the stock is expensive. This is generally used to compare companies in the same industry.
Dividend yield= Dividend/Share price
This is a financial ratio that indicates how much the shareholders are paid in the form of dividend
for a specific amount invested.
EPS- Earnings per share= (Profit-dividend on preferred stock)/No of shares outstanding
Earnings per share is a measurement of companys profit per outstanding share. EBIT - EPS analysis
is considered very important to determine the firms capital structure that maximises earnings per
share over the expected range of earnings before interest and tax.
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Valuation of shares
Zero growth model
The zero-growth model assumes that the dividend always stays the same, the stock price would
be equal to the annual dividends divided by the required rate of return. This is basically the same
formula used to calculate the value of a perpetuity, which is a bond that never matures, and can
be used to price preferred stock, which pays a dividend that is a specified percentage of its par
value. A stock based on the zero-growth model can still change in price if the capitalization rate
changes.
Gordon model
The constant-growth DDM (aka Gordon Growth model) assumes that dividends grow by a specific
percentage each year, and is usually denoted as g, and the capitalization rate is denoted by k.
The constant-growth model is often used to value stocks of mature companies that have increased
the dividend steadily over the years. Although the annual increase is not always the same, the
constant-growth model can be used to approximate an intrinsic value of the stock using the
average of the dividend growth and projecting that average to future dividend increases.
Note that if both the capitalization rate and dividend growth rate remains the same every year,
then the denominator doesn't change, so the stock's intrinsic value will increase annually by the
percentage of the dividend increase. In other words, both the stock price and the dividend amount
will increase by the constant-growth factor, g.
Multi stage growth model

Variable-growth rate models (aka multi-stage growth models) can take many forms, even
assuming the growth rate is different for every year. However, the most common form is one that
assumes 2 different rates of growth: an initial high rate of growth and a sustainable, steady rate
of growth. Basically, the constant-growth rate model is extended, with each phase of growth
calculated using the constant-growth method, but using 2 different growth rates of the 2 phrases.
The present values of each stage are added together to derive the intrinsic value of the stock.
Sometimes, even the capitalization rate, or the required rate of return, may be varied if changes
in the rate are projected.
Minority interest
A minority interest, which is also referred to as non-controlling interest (NCI), is ownership of less
than 50% of a company's equity by an investor or another company. Minority interest shows up
as a noncurrent liability on the balance sheet of companies with a majority interest in a company,
representing the proportion of its subsidiaries owned by minority shareholders.
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Dividends
Dividends are paid to many shareholders of common stock (and preferred stock). However, the
directors cannot pay any dividends to the common stock shareholders until they have paid all
outstanding dividends to the preferred stockholders. The incentive for company directors to issue
dividends is that companies in industries that are particularly dividend sensitive have better
market valuations if they regularly issue dividends. Issuing regular dividends is a signal to the
market that the company is doing well.
Stock splits
As a company grows in value, it sometimes splits its stock so that the price does not become
absurdly high. This enables the company to maintain the liquidity of the stock. If The Coca-Cola
Company had never split its stock, the price of one share bought when the company's stock was
first offered would be worth millions of dollars. If that were the case, buying and selling one share
would be a very crucial decision. This would adversely affect a stock's liquidity (that is, its ability
to be freely traded on the market). In theory, splitting the stock neither creates nor destroys value.
However, splitting the stock is generally received as a positive signal to the market; therefore, the
share price typically rises when a stock split is announced.
Stock buybacks
Often when a company has announced that it will buy back its own stock, it is usually followed by
an increase in the stock price. The reason behind the price increase is fairly complex, and involves
three major reasons.
The first has to do with the influence of earnings per share on market valuation. Many investors
believe that if a company buys back shares, and the number of outstanding shares decreases, the
company's earnings per share goes up. If the P/E (price to earnings-per-share ratio) stays stable,
investors reason, the price should go up. Thus investors drive the stock price up in anticipation of
increased earnings per share.
The second reason has to do with the signalling effect. This reason is simple to understand, and
largely explains why a company buys back stock. No one understands the health of the company
better than its senior managers. No one is in a better position to judge what will happen to the
future performance of the company. So if a company decides to buy back stock (i.e., decides to
invest in its own stock), these managers must believe that the stock price is undervalued and will
rise. This is the signal company management sends to the market, and the market pushes the
stock up in anticipation.
The third reason the stock price goes up after a buyback can be understood in terms of the debt
tax shield (a concept used in valuation methods). When a company buys back stock, its net debt
goes up (net debt = debt - cash). Thus the debt tax shield associated with the company goes up
and the valuation rises.
Basic and diluted EPS

Earnings per share (EPS) and diluted EPS are profitability measures used in fundamental analysis
of companies. EPS only takes into account a company's common shares, whereas diluted EPS take
into account all convertible securities.
EPS measures the amount of a company's profit on a per share basis. Unlike diluted EPS, basic EPS
does not take into account any dilutive effects that convertible securities have on its EPS. The
formula to calculate a company's basic EPS is its net income less any preferred dividends divided
by the weighted average number of common shares outstanding.
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Conversely, diluted EPS is a metric used in fundamental analysis to gauge a company's quality of
earnings per share, assuming all convertible securities are exercised. Convertible securities
includes all outstanding convertible preferred shares, convertible debt, equity options, mainly
employee-based options, and warrants.
The formula used to calculate a company's diluted EPS is a company's net income less preferred
dividends divided by the weighted average number of shares outstanding plus impact of
convertible preferred shares, impact of options, warrants and other dilutive securities. Generally,
if a company has convertible securities, the diluted EPS is less than its basic EPS.
Debt
Bonds - A debt investment in which an investor loans money to an entity (corporate or

governmental) that borrows the funds for a defined period of time at a fixed interest rate.
Features of Bonds
Principal - Nominal, principal, par or face amount the amount on which the issuer pays
interest, and which, most commonly, has to be repaid at the end of the term. Some structured
bonds can have a redemption amount which is different from the face amount and can be
linked to performance of particular assets such as a stock or commodity index, foreign
exchange rate or a fund. This can result in an investor receiving less or more than his original
investment at maturity.
Maturity - The issuer has to repay the nominal amount on the Maturity date. The maturity can
be any length of time, some bonds have been issued with maturities of up to one hundred
years, and some do not mature at all. In the market for U.S. Treasury securities, there are
three groups of bond maturities:
Bills - debt securities maturing in less than one year.
Notes - debt securities maturing in one to 10 years.
Bonds - debt securities maturing in more than 10 years.
Coupon - The coupon is the interest rate that the issuer pays to the bond holders. Usually this
rate is fixed throughout the life of the bond. It can also vary with a money market index, such
as LIBOR, or it can be even more exotic.
Types of Coupon
1. Fixed rate bond- It is a type of debt instrument bond with a fixed coupon (interest)
rate, payable at specified dates before bond maturity.
2. Zero coupon bond- Zero coupon bonds are bonds that do not pay interest during
the life of the bonds. Instead, investors buy zero coupon bonds at a deep discount
from their face value, which is the amount a bond will be worth when it "matures"
or becomes due. When a zero coupon bond matures, the investor will receive one
lump sum equal to the initial investment plus the imputed interest.
3. Floating rate notes (FRNs) - FRNs are a medium-term instrument similar in
structure to straight bonds but for the interest base and interest rate calculations.
The coupon rate is reset at specified regular intervals, normally 3 months, 6
months, or one year. The coupon comprises a money market rate (e.g. The
London Interbank Offered Rate for 6-month deposits, or LIBOR) plus a margin,
which reflects the creditworthiness of the issuer. FRNs usually carry a prepayment
option for the issuer. Issuers like FRNs because they combine the lower pricing of
a bank loan and larger maturities than the straight bond market. Investors are
attracted to FRNs because the periodic resetting of the coupon offers the
strongest protection of capital.
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4. Reverse Floating Rate -A bond or other debt security with a variable coupon rate
that changes in inverse proportion to some benchmark rate. For example, an
inverse floating- rate note may be linked to LIBOR; as the LIBOR decreases, the
coupon rate increases and vice versa. An inverse floating-rate note allows a
bondholder to benefit from declining interest rates. It is also called an inverse
floater.
Types of Bonds
1. Government Bonds (Treasuries) - Treasuries are different from all other types of bonds,
because they are issued by the government, and are therefore considered stable in value and
virtually free of credit risk. For this reason, the yields of all other types of bonds are compared
to the yield on a treasury bond with the same maturity.
2. Agency Bonds (Agencies) - Agency bonds are bonds issued by institutions that were originally
created by the US Government to perform important functions such as fostering home
ownership, and providing student loans. The primary government agencies are Fannie Mae,
Freddie Mac, Ginnie Mae and Sallie Mae. While these agencies technically operate in a similar
manner to a corporation, they are thought to be implicitly backed by the US government.
3. Municipal Bonds (Munis) State and local governments often borrow money by issuing bonds,
similar to the US Government, but on a smaller scale. Municipal bonds fund a wide variety of
projects and government functions ranging from police and fire departments to bridges and
toll roads. Municipal bonds are popular among individual investors because they provide tax
advantages that other types of bonds do not.
4. Corporate Bonds (Corporates) - And last but certainly not least are corporations, who often
choose the bond market as a way of raising capital to fund improvement in their businesses.
A corporation can issue bonds for many reasons, including paying dividends to shareholders,
purchasing another company, funding an operating loss, or expansion.
5. High-yield bonds (junk bonds) are bonds that are rated below investment grade by the credit
rating agencies. As these bonds are more risky than investment grade bonds, investors expect
to earn a higher yield.
6. Convertible bonds let a bondholder exchange a bond to a number of shares of the issuer's
common stock. These are known as hybrid securities, because they combine equity and debt
features.
7. Inflation-indexed bonds (linkers) (US) or Index-linked bond (UK), in which the principal amount
and the interest payments are indexed to inflation.
8. Asset-backed securities are bonds whose interest and principal payments are backed by
underlying cash flows from other assets. Examples of asset-backed securities are mortgage-
backed securities (MBS's), collateralized mortgage obligations (CMOs) and collateralized debt
obligations (CDOs).
Yield to Maturity
The yield to maturity (YTM), book yield or redemption yield of a bond or other fixed-interest
security, such as gilts, is the internal rate of return (IRR, overall interest rate) earned by an investor
who buys the bond today at the market price, assuming that the bond will be held until maturity,
and that all coupon and principal payments will be made on schedule. Yield to maturity is the
discount rate at which the sum of all future cash flows from the bond (coupons and principal) is
equal to the price of the bond. As some bonds have different characteristics, there are some
variants of YTM:
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Yield to call (YTC): when a bond is callable (can be repurchased by the issuer before the maturity),
the market looks also to the Yield to call, which is the same calculation of the YTM, but assumes
that the bond will be called, so the cash flow is shortened.
Yield to put (YTP): same as yield to call, but when the bond holder has the option to sell the bond
back to the issuer at a fixed price on specified date.
Coupon Rate vs. YTM

If a bond's coupon rate is less than its YTM, then the bond is selling at a discount
If a bond's coupon rate is more than its YTM, then the bond is selling at a premium
If a bond's coupon rate is equal to its YTM, then the bond is selling at par
Pricing of debentures/bonds
The price of a bond is the net present value of all future cash flows expected from that bond.
The bond price depends on the interest rate. If the interest rate is higher, the bond price is lower
and vice versa.
Here:
r = Discount rate
t= Interval (for example, 6 months)
T = Total payments
Relation between Price, yields and prevailing interest rates

Bond price and yield are inversely related. That is, if a bond's price rises, it's yield falls, and vice
versa. Simply put, current yield = interest paid annually / market price * 100%.
When inflation does up, interest rates rise. And when interest rates rise, bond prices fall.
Therefore, when inflation goes up, bond prices fall.
In general, a positive economic event (such as a decrease in unemployment, greater consumer
confidence, higher personal income, etc.) drives up inflation over the long term (because there
are more people working, there is more money to be spent), which drives up interest rates, which
causes a decrease in bond prices.
The following table summarizes this relationship with a variety of economic events:
Capital Markets
Primary Markets
A primary market issues new securities on an exchange for companies, governments and
other groups to obtain financing through debt-based or equity-based securities. Primary
markets are facilitated by underwriting groups consisting of investment banks that set a
beginning price range for a given security and oversee its sale to investors. Once the initial
sale is complete, further trading is conducted on the secondary market, where the bulk of
exchange trading occurs each day.
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Companies and government entities sell new issues of common and preferred stock,
corporate bonds, and government bonds, notes, and bills on the primary market to fund
business improvements or expand operations. Although an investment bank may set the
securities' initial price and receive a fee for facilitating sales, most of the funding goes to the
issuer. Investors typically pay less for securities on the primary market than on the secondary
market.
Public Offer
An Initial Public Offering (IPO) is the first time that the stock of a private company is offered
to the public. IPOs are often issued by smaller, younger companies seeking capital to expand,
but they can also be done by large privately owned companies looking to become publicly
traded. In an IPO, the issuer obtains the assistance of an underwriting firm, which helps
determine what type of security to issue, the best offering price, the amount of shares to be
issued and the time to bring it to market.
A Follow-on Public Offer (FPO) is an issuing of shares to investors by a public company that is
already listed on an exchange. An FPO is essentially a stock issue of supplementary shares
made by a company that is already publicly listed and has gone through the IPO process. FPOs
are popular methods for companies to raise additional equity capital in the capital markets
through a stock issue.
There are two main types of follow-on public offers. The first type is dilutive to investors, as
the companys Board of Directors agrees to increase the share float level. This type of follow-
on public offering seeks to raise money to pay debt or expand the business. This increases the
number of shares outstanding.
The other type of follow-on public offer is non-dilutive. This approach is used when directors
or large shareholders sell privately held shares. This is non-dilutive, as no additional shares are
sold. This method is commonly referred to as a secondary market offering. There is no benefit
to this method for the company or current shareholders.
Private Placement
A private placement is the sale of securities to a relatively small number of select investors as
a way of raising capital. Investors involved in private placements are usually large banks,
mutual funds, insurance companies and pension funds. A private placement is different from
a public issue, in which securities are made available for sale on the open market to any type
of investor. A formal prospectus is not necessary for a private placement, and the participants
in a private placement are usually large, sophisticated investors such as investment banks,
investment funds and insurance companies.
Secondary markets
A market where investors purchase securities or assets from other investors, rather than from
issuing companies themselves. The national exchanges - such as the Bombay Stock Exchange
and the National Stock Exchange are secondary markets. Diverse roles played by stock
exchanges include, generation of initial capital required for starting a business, channelizing
savings for further investment, facilitating growth of a company, redistributing funds of the
company and creating investment opportunities for small investors.
A newly issued IPO will be considered a primary market trade when the shares are first
purchased by investors directly from the underwriting investment bank; after that any shares
traded will be on the secondary market, between investors themselves. In the primary market
prices are often set beforehand, whereas in the secondary market only basic forces like supply
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and demand determine the price of the security. Most stocks are traded on exchanges, which
are places where buyers and sellers meet and decide on a price. Some exchanges are physical
locations where transactions are carried out on a trading floor. The other type of exchange is
virtual, composed of a network of computers where trades are made electronically.
A private investor needs to use a stock broker to buy and sell shares on the Stock market.
There are three types of services offered by a stockbroker:
Discretionary services
This gives the broker or investment manager complete authority to buy and sell shares
for you without obtaining your prior approval. This will be in the context of a carefully-
designed brief, a clear framework for your portfolio manager to use when making
transactions on your behalf. The advantage is that your manager can therefore act
instantly on changes in the market, rather than spending valuable time trying to
contact you. You will receive a contract note every time a transaction is made and
detailed reports will be sent to you regularly.
Advisory services
Instead of managing the portfolio without consulting you, your investment manager
will suggest courses of action which you may or may not choose to take. As well as
verbal or written advice, you may receive regular newsletters which review the
market. A second kind of advisory service gives you access to this advice, but still
allows you to control your own portfolio and manage your own bargains. Essentially
you simply call your professional and ask whether he or she shares your view on
whether you should buy or sell a particular share.
Execution only
Execution only services are generally the cheapest as they do not require advice or
management - you simply tell your stockbroker to buy and sell shares for you. Because
of the increasing knowledge of investors and the wider access to these services the
use of execution only stockbrokers has increased dramatically over recent years. Most
execution only brokers allow trading over the telephone or over the internet.
Over-The-Counter (OTC)
A security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX,
etc. The phrase "Over-The-Counter" can be used to refer to stocks that trade via a dealer network
as opposed to on a centralized exchange. It also refers to debt securities and other financial
instruments such as derivatives, which are traded through a dealer network.
Over-The-Counter (OTC) or off-exchange trading is done directly between two parties, without
any supervision of an exchange. It is contrasted with exchange trading, which occurs via
exchanges. A stock exchange has the benefit of facilitating liquidity, mitigates all credit risk
concerning the default of one party in the transaction, provides transparency, and maintains the
current market price. In an OTC trade, the price is not necessarily published for the public.
OTC trading, as well as exchange trading, occurs with commodities, financial instruments
(including stocks), and derivatives of such. Products traded on the exchange must be well
standardized. This means that exchanged deliverables match a narrow range of quantity, quality,
and identity which is defined by the exchange and identical to all transactions of that product. This
is necessary for there to be transparency in trading. The OTC market does not have this limitation.
In general, the reason for which a stock is traded over-the-counter is usually because the company
is small, making it unable to meet exchange listing requirements. Also known as "unlisted stock",
these securities are traded by broker-dealers who negotiate directly with one another over
computer networks and by phone.
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GDR, ADR, IDR

A Global Depositary Receipt (GDR) is a bank certificate issued in more than one country for shares
in a foreign company. The shares are held by a foreign branch of an international bank. The shares
trade as domestic shares but are offered for sale globally through the various bank branches. A
GDR is a financial instrument used by private markets to raise capital denominated in either U.S.
dollars or euros. GDRs may be traded in multiple markets, generally referred to as capital markets,
as they are considered to be negotiable certificates. Capital markets are used to facilitate the trade
of long-term debt instruments, primarily for the purpose of generating capital. GDR transactions
in the international market tend to have lower associated costs than some other mechanisms that
can be used to trade in foreign securities.
Introduced to the financial markets in 1927, an American Depositary Receipt (ADR) is a stock that
trades in the United States but represents a specified number of shares in a foreign corporation.
ADRs are bought and sold on American markets just like regular stocks, and are issued/sponsored
in the U.S. by a bank or brokerage. ADRs were introduced as a result of the complexities involved
in buying shares in foreign countries and the difficulties associated with trading at different prices
and currency values. For this reason, U.S. banks simply purchase a bulk lot of shares from the
company, bundle the shares into groups, and reissues them on either the New York Stock
Exchange (NYSE), American Stock Exchange (AMEX) or the Nasdaq. In return, the foreign company
must provide detailed financial information to the sponsor bank. The depositary bank sets the
ratio of U.S. ADRs per home-country share. This ratio can be anything less than or greater than 1.
This is done because the banks wish to price an ADR high enough to show substantial value, yet
low enough to make it affordable for individual investors.
Indian Depository Receipt (IDR) is a financial instrument denominated in Indian Rupees in the form
of a depository receipt. The IDR is a specific Indian version of the similar global depository receipts.
It is created by a Domestic Depository (custodian of securities registered with the Securities and
Exchange Board of India) against the underlying equity of issuing company to enable foreign
companies to raise funds from the Indian securities Markets. The foreign company IDRs will
deposit shares to an Indian depository. The depository would issue receipts to investors in India
against these shares. The benefit of the underlying shares (like bonus, dividends etc.) would accrue
to the depository receipt holders in India.
Market Participants
Issuer: Any corporate or government entity that issues a fixed income security is termed as an
issuer. While selecting a debt instrument, the investor should primarily consider the stability of
the issuer, since this assures repayment of the principal. In the Indian context, instruments issued
by the Central or State governments are far more stable than those issued by any corporate. E.g.
- RBI
Investor: The investor in the market is one who buys the debt that is being issued in the market.
They basically include every group or organization as well as any type of investor, including the
individual. Governments play one of the largest roles in the market because they borrow and lend
money to other governments and banks.
Intermediaries: There are two types of transactions in the market:

Direct transactions between wholesale market participants. This does not include any
intermediary; and Broker intermediated transactions i.e. where brokers undertake dealings for
banks, institutions or other entities.
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An intermediary is an entity that acts as the middleman between two parties in a financial
transaction. While a commercial bank is a typical financial intermediary, this category also includes
other financial institutions such as investment banks, insurance companies, broker-dealers,
mutual funds and pension fund.
Regulators: The debt market is regulated by either central bank or government exchange board.
The issue & trade of securities in India are regulated by either RBI or SEBI. Government securities
and bonds, instruments issued by banks and financial institutions are regulated by RBI while issues
of non-government securities (i.e. issue by corporates) are regulated by SEBI.
Credit rating agency: A credit rating agency is a company that assigns credit ratings, which rate a
debtor's ability to pay back debt by making timely interest payments and the likelihood of default.
An agency may rate the creditworthiness of issuers of debt obligations, of debt instruments, and
in some cases, of the servicers of the underlying debt, but not of individual consumers. The debt
instruments rated by CRAs include government bonds, corporate bonds, CDs, municipal bonds,
preferred stock, and collateralized securities, such as mortgage-backed securities and
collateralized debt obligations.
A credit rating facilitates the trading of securities on a secondary market. It affects the interest
rate that a security pays out, with higher ratings leading to lower interest rates. Individual
consumers are rated for creditworthiness not by credit rating agencies but by credit bureaus (also
called consumer reporting agencies or credit reference agencies), which issue credit scores.
Debt Instruments
o Government Securities
A Government Security is a bond (or debt obligation) issued by a government
authority, with a promise of repayment upon maturity that is backed by said
government. A government security may be issued by the government itself or by one
of the government agencies. These securities are considered low-risk, since they are
backed by the taxing power of the government. Government securities are usually
used to raise funds that pay for the government's various expenses, including those
related to infrastructure development projects.
Such securities are short term (usually called treasury bills, with original maturities of
less than one year) or long term (usually called Government bonds or dated securities
with original maturity of one year or more). In India, the Central Government issues
both, treasury bills and bonds or dated securities while the State Governments issue
only bonds or dated securities, which are called the State Development Loans (SDLs).
Government securities carry practically no risk of default and, hence, are called risk-
free gilt-edged instruments. Government of India also issues savings instruments
(Savings Bonds, National Saving Certificates (NSCs), etc.) or special securities (oil
bonds, Food Corporation of India bonds, fertiliser bonds, power bonds, etc.). They are,
usually not fully tradable and are, therefore, not eligible to be SLR securities.
1. Treasury bills: Treasury bills or T-bills, which are money market instruments, are
short term debt instruments issued by the Government of India and are presently
issued in three tenors, namely, 91 day, 182 day and 364 day. Treasury bills are
zero coupon securities and pay no interest. They are issued at a discount and
redeemed at the face value at maturity. For example, a 91 day Treasury bill of
Rs.100/-(face value) may be issued at say Rs. 98.20, that is, at a discount of say,
Rs.1.80 and would be redeemed at the face value of Rs.100/-. The return to the
investors is the difference between the maturity value or the face value and the
issue price. The Reserve Bank of India conducts auctions usually every Wednesday
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to issue T-bills. Payments for the T-bills purchased are made on the following
Friday. The Reserve Bank releases an annual calendar of T-bill issuances for a
financial year in the last week of March of the previous financial year. The Reserve
Bank of India announces the issue details of T-bills through a press release every
week.
2. Cash Management Bills (CMBs): Government of India, in consultation with the

Reserve Bank of India, has decided to issue a new short-term instrument, known
as Cash Management Bills (CMBs), to meet the temporary mismatches in the cash
flow of the Government. The CMBs have the generic character of T-bills but are
issued for maturities less than 91 days. Like T-bills, they are also issued at a
discount and redeemed at face value at maturity. The tenure, notified amount
and date of issue of the CMBs depends upon the temporary cash requirement of
the Government. The announcement of their auction is made by Reserve Bank of
India through a Press Release which will be issued one day prior to the date of
auction. The settlement of the auction is on T+1 basis. The non-competitive
bidding scheme has not been extended to the CMBs. However, these instruments
are tradable and qualify for ready forward facility. Investment in CMBs is also
reckoned as an eligible investment in Government securities by banks for SLR
purpose. First set of CMBs were issued on May 12, 2010.
3. State Development Loans (SDLs): State Governments also raise loans from the
market. SDLs are dated securities issued through an auction similar to the
auctions conducted for dated securities issued by the Central Government (see
question 3 below). Interest is serviced at half-yearly intervals and the principal is
repaid on the maturity date. Like dated securities issued by the Central
Government, SDLs issued by the State Governments qualify for SLR. They are also
eligible as collaterals for borrowing through market repo as well as borrowing by
eligible entities from the RBI under the Liquidity Adjustment Facility (LAF).
4. Commercial Mortgage Backed Securities (CMBS): They are a type of mortgage-

backed security backed by commercial mortgages rather than residential real
estate. CMBS tend to be more complex and volatile than residential mortgage-
backed securities due to the unique nature of the underlying property assets.
A commercial mortgage-backed security (CMBS) is a type of fixed-income security
that is collateralized by commercial real estate loans. In essence, CMBS are
created when a bank takes a group of loans on its books, bundles them together,
and sells them in securitized form as a series of bonds. Each series will typically
be organized in "tranches" from the senior - or highest-rated, lowest-risk issue -
to the highest-risk, lowest-rated issue. The senior issue is first in line to receive
principal and interest payments, while the most junior issues will be the first to
take a loss if a borrower defaults. Investors choose which issue they invest in
based on their desired yield and capacity for risk.
This process of loan securitization is useful in many ways: it enables banks to make
more loans, it provides institutional investors with a higher-yielding alternative to
government bonds, and it makes it easier for commercial borrowers to gain access
to funds.
The risk of individual issues can vary based on the strength of the property market
in the specific area where the loans were originated, as well as by the date of
issuance. For instance, commercial mortgage-backed securities issued during a
market peak or a time in which underwriting standards were more relaxed would
58 | P a g e
be seen as having higher risk. CMBS can also be negatively affected by weakness
in the real estate market, which was the case during 2009. CMBS lending dried up
in the wake of the financial crisis of 2008, but it gradually came back as market
conditions improved. Post-crisis CMBS tend to be larger and characterized by
more stringent underwriting standards.
5. Dated Government securities: Dated Government securities are long term

securities and carry a fixed or floating coupon (interest rate) which is paid on the
face value, payable at fixed time periods (usually half-yearly). The tenor of dated
securities can be up to 30 years. The Public Debt Office (PDO) of the RBI acts as
the registry/ depository of government securities and deals with the issue,
interest payment and repayment of principal at maturity. The details of all the
dated securities issued by the Government of India are available on the RBI
website at http://www.rbi.org.in/Scripts/financialmarketswatch.aspx. Just as in
the case of Treasury Bills, dated securities of both, Government of India and State
Governments, are issued by Reserve Bank through auctions. The Reserve Bank
announces the auctions a week in advance through press releases. Government
Security auctions are also announced through advertisements in major dailies.
Instruments:
Fixed Rate Bonds These are bonds on which the coupon rate is fixed for the
entire life of the bond. Most Government bonds are issued as fixed rate
bonds.
Floating Rate Bonds Floating Rate Bonds are securities which do not have a
fixed coupon rate. The coupon is re-set at pre-announced intervals (say, every
six months or one year) by adding a spread over a base rate. In the case of
most floating rate bonds issued by the Government of India so far, the base
rate is the weighted average cut-off yield of the last three 364- day Treasury
Bill auctions preceding the coupon re-set date and the spread is decided
through the auction.
Zero Coupon Bonds Zero coupon bonds are bonds with no coupon
payments. Like Treasury Bills, they are issued at a discount to the face value.
The Government of India issued such securities in the nineties, it has not
issued zero coupon bond after that.
Capital Indexed Bonds These are bonds, the principal of which is linked to
an accepted index of inflation with a view to protecting the holder from
inflation. The government is currently working on a fresh issuance of Inflation
Indexed Bonds wherein payment of both, the coupon and the principal on the
bonds, will be linked to an Inflation Index (Wholesale Price Index). In the
proposed structure, the principal will be indexed and the coupon will be
calculated on the indexed principal. In order to provide the holders protection
against actual inflation, the final WPI will be used for indexation.
Bonds with Call/ Put Options Bonds can also be issued with features of
optionality wherein the issuer can have the option to buy-back (call option)
or the investor can have the option to sell the bond (put option) to the issuer
during the currency of the bond.
Special Securities - In addition to Treasury Bills and dated securities issued by
the Government of India under the market borrowing programme, the
Government of India also issues, from time to time, special securities to
entities like Oil Marketing Companies, Fertilizer Companies, the Food
59 | P a g e
Corporation of India, etc. as compensation to these companies in lieu of cash

subsidies. These securities are usually long dated securities carrying coupon
with a spread of about 20-25 basis points over the yield of the dated securities
of comparable maturity. These securities are, however, not eligible SLR
securities but are eligible as collateral for market repo transactions. The
beneficiary oil marketing companies may divest these securities in the
secondary market to banks, insurance companies / Primary Dealers, etc., for
raising cash.
Steps are being taken to introduce new types of instruments like STRIPS (Separate
Trading of Registered Interest and Principal of Securities). Accordingly, guidelines for
stripping and reconstitution of Government securities have been issued. STRIPS are
instruments wherein each cash flow of the fixed coupon security is converted into a
separate tradable Zero Coupon Bond and traded. For example, when Rs.100 of the
8.24%GS2018 is stripped, each cash flow of coupon (Rs.4.12 each half year) will
become coupon STRIP and the principal payment (Rs.100 at maturity) will become a
principal STRIP. These cash flows are traded separately as independent securities in
the secondary market. STRIPS in Government securities will ensure availability of
sovereign zero coupon bonds, which will facilitate the development of a market
determined zero coupon yield curve (ZCYC). STRIPS will also provide institutional
investors with an additional instrument for their asset- liability management. Further,
as STRIPS have zero reinvestment risk, being zero coupon bonds, they can be
attractive to retail/non-institutional investors. The process of stripping/reconstitution
of Government securities is carried out at RBI, Public Debt Office (PDO) in the PDO-
NDS (Negotiated Dealing System) at the option of the holder at any time from the
date of issuance of a Government security till its maturity. Minimum amount of
securities that needs to be submitted for stripping/reconstitution will be Rs. 1 crore
(Face Value) and multiples thereof.
o Corporate Debt Instruments

1. Certificate of Deposit: A certificate of deposit is a promissory note issued by a bank. It
is a time deposit that restricts holders from withdrawing funds on demand. Although
it is still possible to withdraw the money, this action will often incur a penalty. CDs are
generally issued by commercial banks. The term of a CD generally ranges from one
month to five years.
2. Inter- Corporate Deposits: Inter-company deposit is the deposit made by a company

that has surplus funds, to another company for a maximum of 6 months. It is a
source of short-term financing. Such deposits are of three types:
Call Deposit: Such a type of deposit is withdrawn by the lender by giving a notice
of one day. However, in practice, a lender has to wait for at least 3 days.
Three-month Deposit: As the name suggests, such type of a deposit provides
funds for three months to meet up short-term cash inadequacy
Six-month Deposit: The lending company provides funds to another company for
a period of six months
Advantages of Inter-company deposits:
Surplus funds can be effectively utilized by the lender company
Such deposits are secured in nature
Inter-corporate deposits can be easily procured
Disadvantages of Inter-company Deposits:
60 | P a g e
A company cannot lend more than 10 per cent of its net worth to a single company
and cannot lend beyond 30 per cent of its net worth in total
The market for such source of financing is not structured
3. Call Money: Call money is short-term finance repayable on demand, with a maturity
period of one to fifteen days, used for inter-bank transactions. The money that is lent
for one day in this market is known as "call money" and, if it exceeds one day, is
referred to as "notice money." Commercial banks have to maintain a minimum cash
balance known as the cash reserve ratio. The Reserve Bank of India changes the cash
ratio from time to time.
Call money is a method by which banks lend to each other to be able to maintain the
cash reserve ratio. The interest rate paid on call money is known as the call rate. It is
a highly volatile rate that varies from day to day and sometimes even from hour to
hour. There is an inverse relationship between call rates and other short-term money
market instruments such as certificates of deposit and commercial paper. A rise in call
money rates makes other sources of finance, such as commercial paper and
certificates of deposit, cheaper in comparison for banks to raise funds from these
sources.
4. CBLO: It was in the year 2002-03 that the RBI first time came up with the term CBLO
(Collateralized Borrowing & Lending Obligation). Similar to Repo, an organization with
surplus funds can lend out its money in the market to other organizations in need of
funds with collateral in place. While call money market caters to the need of banks
and primary dealers, CBLO lends out to mutual funds, insurance & financial companies
etc. in addition to primary dealers and banks mostly. The only difference is that CBLO
involves collateral. Interested parties are required to open Constituent SGL (CSGL)
Account with Clearing Corporation of India Limited (CCIL) for depositing securities as
collateral.
Types of CBLO:
CBLO Normal Market: It facilitates borrowing and lending by members on an
online basis
CBLO Auction Market: It facilitates borrowing and lending by members through
submission of bids and offers
Features:
This RBI approved Money Market instrument is backed by Gilts as collateral
It creates an obligation to repay the borrowed money along with interest on a
fixed date. Also it provides a right to the lender to receive money lent with interest
on a fixed future date
CBLO is tradable and CCIL acts counterparty to transaction
It is traded on screen that provides right amount of anonymity to a trade for
counter parties
CBLO membership is usually extended to REPO eligible entities as per the
guidelines laid down by the RBI. CBLO Membership is granted to Negotiated
Dealing System (NDS) Members and non NDS Members
61 | P a g e
Capital structure
Refers to the percentage of capital (money) at work in a business by type or the composition
of debt and equity capital that comprise a firms financing its assets. The capital structure
decision affects financial risk and, hence, the value of the company.
Equity Capital: Refers to money put up and owned by the shareholders (owners). Typically,
equity capital consists of two types:
Contributed capital: Money that was originally invested in the business in exchange for
shares of stock or ownership
Retained earnings: Represents accumulated profits from past years
Debt Capital: Refers to borrowed money that is at work in the business. Different types of
debt capital include short term bonds, long term bonds, commercial paper, etc.
Optimal Capital Structure

The best debt-to-equity ratio for a firm that maximizes its value. The optimal capital structure
for a company is one which offers a balance between the ideal debt-to-equity range and
minimizes the firm's cost of capital. The optimal capital structure of a company cannot be
determined as it depends on the following:
The business risk of the company
The tax situation of the company
The degree to which the companys assets are tangible
The companys corporate governance
The transparency of the financial information
Debt vs. Equity

Advantages to equity financing:
Less risky than a loan as it doesnt have to be paid back
Investors take a long-term view, and most don't expect a return on their investment
immediately
Disadvantages to equity financing:

It may require returns that could be higher than the rates of interest on bank loans
Investors may interfere in big (or even routine) decision making
In the case of irreconcilable disagreements with investors, may need to cash in
portion of the business and allow the investors to run the company
Advantages to debt financing:

The bank or lending institution has no ownership in the business
The business relationship ends once the money is paid back
The interest on the loan is tax deductible
Loans can be short term or long term
Principal and interest are known figures you can plan in a budget
Disadvantages to debt financing:

Money must paid back within a fixed amount of time
May have trouble paying back loan in case of problems with cash flow
Too much debt is seen as high risk by potential investors which may limit ability to
raise capital by equity financing in the future
Assets of the business can be held as collateral to the lender. And the owner of the
company is often required to personally guarantee repayment of the loan
62 | P a g e
Derivatives
A derivative is an instrument whose value is derived from the value of one or more underlying,
which can be commodities, precious metals, currency, bonds, stocks, stocks indices, etc. The
various types of derivatives are described below:
o Forwards
A forward contract is a customized contract between two parties, where settlement
takes place on a specific date in future at a price agreed today. The main features of
forward contracts are
They are bilateral contracts and hence exposed to counter-party risk
Each contract is custom designed, and hence is unique in terms of contract size,
expiration date and the asset type and quality
The contract price is generally not available in public domain
The contract has to be settled by delivery of the asset on expiration date
In case the party wishes to reverse the contract, it has to compulsorily go to the
same counter party, which being in a monopoly situation can command the price it
wants
o Futures
Futures are exchange-traded contracts to sell or buy financial instruments or physical
commodities for a future delivery at an agreed price. There is an agreement to buy or
sell a specified quantity of financial instrument commodity in a designated future
month at a price agreed upon by the buyer and seller. To make trading possible, BSE
specifies certain standardized features of the contract.
A margin in the futures market is the amount of cash an investor must put up to open
an account to start trading. This cash amount is the initial margin requirement. It acts
as a down payment on the underlying asset and helps ensure that both parties fulfil
their obligations. Both buyers and sellers must put up payments.
Initial Margin- This is the initial amount of cash that must be deposited in the account
to start trading contracts. It acts as a down payment for the delivery of the contract
and ensures that the parties honour their obligations.
Maintenance Margin- This is the balance a trader must maintain in his or her account
as the balance changes due to price fluctuations. It is some fraction - perhaps 75% -
of initial margin for a position. If the balance in the trader's account drops below this
margin, the trader is required to deposit enough funds or securities to bring the
account back up to the initial margin requirement. Such a demand is referred to as a
margin call.
Basis Futures Forwards

Nature Traded on organised Over the Counter
exchange
Contract Standardised Customised
Liquidity More liquid Less liquid
Margin payments Required margin payments Not required
Settlement Follows daily settlement At the end of the period
Squaring off Can be reversed with any Contract can be reversed only
member of the exchange with the same counter party
with whom it was entered into
63 | P a g e
o Options
Options are basically the financial instruments that give the buyers the right to buy or
sell the underlying security within a point of time in the future for a price, which is
fixed at the time when the option is bought. The stock option buyers are called the
holders and sellers are called writers in option trading terminology.
The call in option trading gives the owner of option a right but not an obligation to
buy an underlying security within the specified time while the put gives the owner a
right but not the obligation to sell the underlying asset within the specified time at a
pre-fixed price.
The value of a stock option contract is determined by five factors the strike price,
price of the stock, the expiration date, the cumulative cost that is required to hold a
position in the stock and the estimated future volatility of the stock price. The strike
price is referred to the price for which an option stock can be bought or sold. For calls,
the stock price must go above the strike price while for puts the stock price should be
below the strike price.
o Swaps
Swap is a derivative where the two parties agree to exchange one stream of cash flow
with another while the streams are called the legs of the swap. The two commonly
used swaps are INTEREST RATE SWAPS and CURRENCY SWAPS. Interest rate swaps
entail swapping only the interest between the parties and currency swaps entail
swapping both the principal and interest between the parties.
Efficient market hypothesis

In the early 1960s, Nobel Prize winning economist Eugene Fama put forth the theory of
efficient markets, which continues to garner acceptance throughout the field of finance.
Fundamental to Famas theory are inherently efficient markets, rational expectations and
security prices reflecting all available information. The logic behind this is characterized by a
random walk, where all subsequent price changes reflect a random departure from previous
prices. According to the EMH, stocks always trade at their fair value on stock exchanges,
making it impossible for investors to either purchase undervalued stocks or sell stocks for
inflated prices. As such, it should be impossible to outperform the overall market through
expert stock selection or market timing, and the only way an investor can possibly obtain
higher returns is by purchasing riskier investments.
Strong form efficiency is where all information, public, personal and confidential, is reflected
in share prices. Therefore investors are unable to achieve a competitive advantage and deters
insider trading. This degree of market efficiency implies that above average return cannot be
achieved regardless of an investors access to information.
To a lesser degree, semi-strong efficiency proposes that share prices are a reflection of publicly
available information. Since market prices already reflect public information, investors are
unable to gain abnormal returns.
In its last degree, weak form efficiency claims all previous stock prices are a reflection of
todays price. Therefore, technical analysis is not a practical tool to predict future price
movements.
If all the assumptions about efficient markets had held, then the housing bubble and
subsequent crash would not have occurred. Yet, efficiency failed to explain market anomalies,
including speculative bubbles and excess volatility. As the housing bubble reached its peak
64 | P a g e
and investors continued to pour funds into subprime mortgages, irrational behaviour began
to precede the markets. Contrary to rational expectations, investors acted irrationally in
favour of potential arbitrage opportunities. Yet an efficient market would have automatically
adjusted asset prices to rational levels.
Besides its failure to address financial downturns, the theory itself has often been contested.
In theory, each individual is able to access and analyse information at the same pace.
However, with the growing number of information channels, including social media and the
internet, even the most involved investors are unable to monitor every piece of information.
With that being said, investment decisions tend to be influenced more so by emotions rather
than rationality.
Regulators, Clearing Corporation and Depositories

RBI Reserve Banks of India:
Reserve Bank of India is the apex monetary Institution of India. It was established on April 1,
1935 in accordance with the provisions of the Reserve Bank of India Act, 1934. Though
originally privately owned, since nationalization in 1949, the Reserve Bank is fully owned by
the Government of India. RBI is the financial regulator of all the financial institutions like public
sector banks, private sector banks, RRBs, Cooperative banks and all type of NBFCs etc. RBI is
the banker to the banks and banker to the government of India. It decides the policy rates
which influence the growth and inflation in the country.
SEBI Securities and Exchange Board of India:

Apart from RBI, SEBI also forms a major part under the financial body of India. It is a regulator
associated with the security markets in Indian Territory. Established in the year 1988, the SEBI
Act came into power in the year 1992, 12th April. There are three groups, which fall under its
supervision; investors, the security issuers and market intermediaries. It directs the capital
market and money market to work in the interest of general public. SEBI also regulates the
foreign investments in Indian firms and businesses.
IRDA- Insurance Regulatory and Development Authority

The Insurance Regulatory and Development Authority (IRDA) is a national agency of the
Government of India and is based in Hyderabad (Andhra Pradesh). It was formed by an Act of
Indian Parliament known as IRDA Act 1999, which was amended in 2002 to incorporate some
emerging requirements. Mission of IRDA as stated in the act is "to protect the interests of the
policyholders, to regulate, promote and ensure orderly growth of the insurance industry and
for matters connected therewith or incidental thereto."
CCIL- Clearing Corporation of India

The Clearing Corporation of India Ltd. (CCIL) was set up in April, 2001 to provide guaranteed
clearing and settlement functions for transactions in Money, G-Secs, Foreign Exchange and
Derivative markets. The introduction of guaranteed clearing and settlement led to significant
improvement in the market efficiency, transparency, liquidity and risk
management/measurement practices in these market along with added benefits like reduced
settlement and operational risk, savings on settlement costs, etc. CCIL also provides non-
guaranteed settlement for Rupee interest rate derivatives and cross currency transactions
through the CLS Bank.
FIMMDA- Fixed Income Money Market and Derivatives

The Fixed Income Money Market and Derivatives Association of India (FIMMDA), an
association of Scheduled Commercial Banks, Public Financial Institutions, Primary Dealers and
65 | P a g e
Insurance Companies was incorporated as a Company under section 25 of the Companies Act,
1956 on June 3rd, 1998. FIMMDA is a voluntary market body for the bond, money and
derivatives markets. FIMMDA has members representing all major institutional segments of
the market. The membership includes Nationalized Banks such as State Bank of India, its
associate banks and other nationalized banks; Private sector banks, Foreign Banks, Financial
institutions, Insurance Companies and all Primary Dealers.
NSDL- National Securities Depositories Ltd

NSDL, the first and largest depository in India was established in August 1996. Using innovative
and flexible technology systems, NSDL works to support the investors and brokers in the
capital market of the country. NSDL aims at ensuring the safety and soundness of Indian
marketplaces by developing settlement solutions that increase efficiency, minimise risk and
reduce costs. In the depository system, securities are held in depository accounts, which is
more or less similar to holding funds in bank accounts. Transfer of ownership of securities is
done through simple account transfers. This method does away with all the risks and hassles
normally associated with paperwork. Consequently, the cost of transacting in a depository
environment is considerably lower as compared to transacting in certificates.
CDSL- Central Depository Services Ltd.

CDSL was initially promoted by BSE Ltd. which has thereafter divested its stake to leading
banks as "Sponsors" of CDSL. CDSL was set up with the objective of providing convenient,
dependable and secure depository services at affordable cost to all market participants. CDSL
facilitates holding of securities in electronic form and enables security transactions, off market
transfer and pledge through book entry. It also offers other online services such as e-voting,
e-locker etc. All leading stock exchanges like the BSE Ltd, National Stock Exchange and
Metropolitan Stock Exchange of India have established connectivity with CDSL.
Currencies
These three factors - interest rates, inflation, and the principle of capital market equilibrium -
govern the valuation of various currencies. Because the U.S. dollar is generally considered the
world's most stable currency, it is the widely accepted basis for foreign exchange valuation.
Other currencies that are considered stable are the Japanese yen and the Euro. The relative
movements of these currencies, as well as others, are monitored daily.
Influence of inflation on Foreign exchange

If the inflation in the foreign country goes up relative to the home currency, the foreign currency
devalues or weakens relative to the home currency.
Influence of interest rates on foreign exchange

The higher interest rates that can be earned tend to attract foreign investment, increasing the
demand for and value of the country's currency. Conversely, lower interest rates tend to be
unattractive for foreign investment and decrease the currency's relative value. When interest
rates in a country rise, investments held in that country's currency (for example, bank deposits,
bonds, CDs, etc.) will earn a higher rate of return. Therefore, when a country's interest rates rise,
money and investments will tend to flow to that country, diving up the value of its currency. (The
reverse is true when a country's interest rates fall).
Effect of exchange rates on interest rates and inflation

A weak dollar means that the prices of imported goods will rise when measured in U.S. dollars
(i.e., it will take more dollars to buy the same good). When the prices of imported goods rise, this
contributes to higher inflation, which also raises interest rates. Conversely, a strong dollar means
66 | P a g e
that the prices of imported goods will fall, which will lower inflation (which will lower interest
rates). The following table summarizes the relationship between interest rates, inflation, and
exchange rates:
Fixed and floating exchange rate mechanisms

An exchange rate is the rate at which one currency can be exchanged for another. In other words,
it is the value of another country's currency compared to that of another. There are two ways the
price of a currency can be determined against another. A fixed, or pegged, rate is a rate the
government (central bank) sets and maintains as the official exchange rate. A set price will be
determined against a major world currency (usually the U.S. dollar, but also other major currencies
such as the euro, the yen or a basket of currencies). In order to maintain the local exchange rate,
the central bank buys and sells its own currency on the foreign exchange market in return for the
currency to which it is pegged.
If, for example, it is determined that the value of a single unit of local currency is equal to US$3,
the central bank will have to ensure that it can supply the market with those dollars. In order to
maintain the rate, the central bank must keep a high level of foreign reserves. This ensures an
appropriate money supply, appropriate fluctuations in the market (inflation/deflation) and
ultimately, the exchange rate. The central bank can also adjust the official exchange rate when
necessary.
The reasons to peg a currency are linked to stability. Especially in today's developing nations, a
country may decide to peg its currency to create a stable atmosphere for foreign investment. With
a peg, the investor will always know what his or her investment's value is, and therefore will not
have to worry about daily fluctuations. A pegged currency can also help to lower inflation rates
and generate demand, which results from greater confidence in the stability of the currency. Fixed
regimes, however, can often lead to severe financial crises, since a peg is difficult to maintain in
the long run. This was seen in the Mexican (1995), Asian (1997) and Russian (1997) financial crises:
an attempt to maintain a high value of the local currency to the peg resulted in the currencies
eventually becoming overvalued.
Unlike the fixed rate, a floating exchange rate is determined by the private market through supply
and demand. A floating rate is often termed "self-correcting," as any differences in supply and
demand will automatically be corrected in the market. Look at this simplified model: if demand
for a currency is low, its value will decrease, thus making imported goods more expensive and
stimulating demand for local goods and services. This in turn will generate more jobs, causing an
auto-correction in the market. A floating exchange rate is constantly changing. In a floating
regime, the central bank may also intervene when it is necessary to ensure stability and to avoid
inflation. However, it is less often that the central bank of a floating regime will interfere.
67 | P a g e

SEED Preparatory Kit - Finance

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SEED REFERENCE GUIDE

2017 SIBM SEED REFERENCE GUIDE

I. INTRODUCTION TO FINANCE ROLES.............................................................................5

Investment banking ..................................................................................................... 5

Theory of demand ....................................................................................................... 6

Basic Accounting principles ....................................................................................... 10

Linkages between the 3 financial statements ........................................................... 11

IV. GENERAL FINANCIAL CONCEPTS ................................................................................ 12

Ratio Analysis ............................................................................................................. 12

Measures to regulate banking in India ...................................................................... 20

IV. CORPORATE FINANCE ............................................................................................... 34

Time Value of Money ................................................................................................ 34

Differences between FII and FDI ............................................................................... 45

V. CAPITAL MARKETS AND FINANCIAL INSTRUMENTS .................................................... 46

I. Introduction to finance roles

Law of Demand: There is an inverse relationship between

There are two reasons for the inverse relationship

Income Effect: There is an income effect when the price

Price elasticity of demand is a measure used in economics to show the responsiveness, or

Price elasticity of Demand= (% Change in Demand)/ (% Change in Price)

Inflation- CPI, WPI

There are several variations on inflation:

Difference between CPI and WPI

Government spending policies influence macroeconomic conditions. Through fiscal policy,

FISCAL POLICY MONETARY POLICY

Gross Domestic Product- GDP

C is equal to all private consumption, or consumer spending, in a nation's economy G is

Golden Rules of Accounting

Cash vs. Accrual accounting

Linkages between the 3 financial statements

IV. General Financial Concepts

Leverage and capital structure ratios

Degree of Operating Leverage

Degree of Financial Leverage (DFL)

Shareholders Equity Ratio

Long term Debt to Shareholders Net worth Ratio

Capital Gearing Ratio

Fixed Assets to Long Term Funds Ratio

Debt Service Coverage Ratio (DSCR)

Debt to Total Capital Ratio

Interest Coverage Ratio

Dividend Coverage Ratio

Current Ratio= (Current assets)/ (Current Liabilities)

Quick ratio= (Cash+ Marketable securities+ Receivables)/ (Current liabilities)

Cash Ratio = (Cash + Marketable securities)/ (Current liabilities)

Defensive interval ratio= (Cash+ Marketable securities+ Receivables)/ (Average daily

Cash conversion cycle

Working capital management

Composition of working capital

- Management of working capital means managing different components of current assets

Negative working capital

Is Negative Working Capital Good or Bad?

Difference between Hedging, Speculation and Arbitrage

o Asset Quality review

Under Indradhanush roadmap announced in 2015, the government had announced to

Balance sheets of banks

Central Bank's Balance Sheet

Central bank liabilities:

Why are cash flow statements not used in banking analysis?

How does a bank operate?

BASEL norms and type of capital (Tier 1 and 2)

Limits and Minima

Common Equity Tier 1 Capital

Elements of Additional Tier 1 Capital