Module 5

Asset/ Fund based financial services

INTRODUCTION
• Financial Services can be defined as the products and services offered by institutions like
banks of various kinds for the facilitation of various financial transactions and other related
activities in the world of finance like loans, insurance, credit cards, investment
opportunities.
• Fund Based Finance is a specialized method of providing structured working capital and
term loans that are secured by account receivables, inventory, machinery, equipment, and
real estate.
• Fund Based Financial Services(FBFS) are financing method that is driven by the assets of
companies.
• Assets include current assets such as account receivables, inventory and fixed assets such
as plant and machinery.
Features of Fund Based Services
• It is an efficient way to finance an expanding operation because borrowing capacity
expands along with sales
• It generates new business
• It permits borrowers to take advantage of purchase discounts because cash is received
immediately upon sales, permitting prompt payment to suppliers and thereby earning the
company a good enough reputation to reduce the cost of purchases.
Types of Fund Based Services
Fund Based Services are used for creating assets or supported by assets where the funds are
transformed into assets. Following are the types of fund-based financial services:
1. Lease financing
2. Hire purchase
3. Consumer credit / consumer finance
4. Factoring
5. Venture capital financing
6. Housing finance
LEASING
An Introduction
• Leasing is a source of medium-term finance for business firms.
 • Lease finance facilitates firms to acquire assets or avail the use of assets.
• Leasing is an asset-based financing facility and it is popularly used in equipment and
vehicle acquisitions.
• Motor vehicles, machinery, office equipment, computers, aircrafts and ships are some of
the assets for which lease finance is commonly used.
• Manufacturers of equipments use lease finance as a marketing tool to promote their
products. Companies such as Xerox, IBM, etc. have widely adopted this concept.
Meaning
Leasing means obtaining the services of an asset on rent or on hire.
In simple terms, a lease is a contract by which the legal owner of an asset (lessor) gives the right
to use the asset to another person (lessee) for a specified period in return for the payment of rent.
In leasing, the legal ownership of the asset and its economic usage are kept separate.
Definition
“Leasing is the process by which a firm can obtain the use of a certain fixed asset for which it
must make a series of contractual ,periodic ,tax deductible payments”.
Lease may also be defined as a contract between two parties for the hire of a specific asset wherein
the lessor retains ownership of the asset while the lessee has possession and use of the asset on
payment of specified rentals over a period of time.
Features of Lease transaction
1. Lease is a contract.
2. Lease contract is between lessor and lessee.
3. There is a separation of ownership of the asset and use of the asset.
4. Lease contract is for the use of asset by the lessee.
5. Lease contract is for a specific period.
6. Lessor is the legal owner of the asset.
7. Lessee is the person in possession of the asset and user of the asset.
8. Lessee pays a rent, called lease rent, to the lessor for using the asset.
Typical contents of a Lease Agreement
1. Description of the lessor, the lessee, and the equipment.
2. Amount, time and place of lease rental payments.
3. Time and place of equipment delivery.
4. Responsibility of lessee for taking delivery and possession, maintenance, repairs.
 5. Lessee’s right to enjoy the benefits of the warranties
6. Insurance to be taken by the lessee on the behalf of lessor
7. Variation in lease rentals due to any factors.
8. Option of lease renewal on expiry.
Elements of Leasing
1.Transaction: Lease is a transaction for renting out an asset. In a loan what is lent is money
whereas in a lease an asset is lent. It is, in legal terms, a bail transaction.
2. Lessor and lessee: Lease involves two parties – a lessor and a lessee, Lessor is the owner of
the asset and the lessee is the user of the asset.
3. Asset on lease: Lease contract centres on the existence of the asset. Primarily, a lease is for
using the asset. The asset must exist at the inception of lease as well as at the end of the lease
period. The asset is returnable to the lessor.
4. Lease term: This refers to the lease period. The contract of lease is operational during the lease
period. In a financial lease, normally we have a primary lease period and a secondary lease period.
During the primary lease period, the contract is usually not cancellable.
5. Upfront charges: In a lease arrangement, the lessee has to make certain payments at the
inception of lease. Lease management fees, advance lease rent and security deposit are some of
the payments.
6. Lease rent: Lessee pays lease rent to the lessor for using the asset. For the lessee, it is
expenditure and for the lessor it is an income.
7. Residual value: The value of the leased asset at the end of the lease period is referred to as the
‘residual value’. The determination of residual value depends on whether the lease contract has
the purchase option or not.
8. Options to the lessee: At the end of the lease period, the lessee may be given one or more
options regarding the asset he is using. He may be allowed to buy the asset at a nominal value or
renew the lease at a nominal rent. An option to buy the asset at a fair market value or a fixed value
might also be provided in the contract.
Leasing process
(1) Lease Selection –
• The leasing process starts when the lessee enters into a leasing contract with the lessor.
• Lessee approaches the Manufacturers and Suppliers, gathers all details about the required
asset (design, specifications, price, installation, warranty, servicing etc.) and then takes a
decision on the required asset and the supplier
 • The lessee then goes to the leasing company or broker (lessor) and a lease agreement is
broadly negotiated and finalized between them.
(2) Order, Delivery and payment –
In the next step of leasing process:
• The Lessor orders the required asset to the selected manufacturer of asset to be leased on
behalf of the lessee.
• The manufacturer delivers the asset at the site of the lessee
• The lessee inspects the delivery and gives a notice of acceptance to the lessor if he is
satisfied with the asset.
(3) Lease contract –
The most important part of the leasing process is the lease contract:
• Both the parties sign a lease agreement setting out the details of the terms of contract. It
usually ranges from 3 to 5 years.
• It may be fully pay out lease or nominal rentals may be charged.
(4) Lease Period –
• Regular lease rental are paid by the lessee.
• Lessee ensures proper maintenance of asset.
• Lessee is entitled to warranties and after sale services from the lessor.
• At the end of the lease period the lessee may either renew the lease or terminate it or buy
the asset.
(5) Lease Agreement –
The lease agreement consists of all the obligations of the lessor and lessee. It includes:
• The basic lease period during which lease is irrevocable
• The time and amount of periodic rental payments to be paid
• Details of options to renew the asset or purchase it or in absence of such an option the
lessor takes the possession of the asset
• Details regarding the responsibility of payment of cost of maintenance and repairs, taxes,
insurance and other expenses
• In a Net Lease Agreement – Lessee pays all the above costs
• In a Maintenance lease agreement – Lessor pays all the costs
Advantages of Leasing
To the lessee
• It is a simple agreement, free from cumbersome procedures therefore, it saves time and
effort.
• It helps in financing of capital goods like land, building, machinery etc. with small initial
investment.
• It acts as an additional source of finance and helps the lessee to expand his business
operations
• It is a cheaper source of finance than other alternatives
• A lease agreement allows for flexibility in rental payments and negotiation of agreement
terms at the convenience of the lessee
• The lessee receives tax benefits
• Risk of Obsolescence of asset is avoided as the lessee has the option the replace the asset
with the latest one.
To the Lessor
• The lessor is fully secure as in case of default by lessee, the lessor can take back the asset
as the ownership lies with him
• The lessor can lease assets with high depreciation rate and enjoy tax benefits by way of
depreciation
• It is a highly profitable business the lessor usually pays less interest on borrowings than
what he charges from the lessee as premium
• The ultimate return on initial investment is very high
Disadvantages of Leasing
To the Lessee
• He has the right of use only there is no ownership, he cannot make major changes or
alterations to the asset
• It is a costly option
• The lease may be cancelled due to poor financial position of the lessee
• The lessee losses the residual value of the asset
• The lessee losses out on tax benefits due to depreciation and investment benefits if any
 • The lessee may be subjected to penalties, if he terminates the contract before the expiry of
lease period
To the Lessor
• The lessor has to bear high risk of obsolesce of asset
• The lessor may not be able to charge sufficient rental due to enormous competition in the
leasing market
• The lessor does not get the advantage of increase in price of asset due to price level changes
as he can charge only fixed rentals during the entire lease period
• The lessor does not get any subsidies related to the asset as a usual buyer (user) would get
• It is a long term investment as the total cost of the asset is covered during the lease period
which usually ranges from 3 to 5 years

Types of Leasing Agreement

a) Financial Lease
• It is also known as full payout lease, capital lease, long-term lease, or net lease.
• In financial lease, the contractual period between the lessee and the lessor is generally equal
to the expected full economic life of the equipment.
• The lessor acts as a financer and the lessee takes the responsibility of maintenance and
servicing of the equipment.
• In a finance lease, the lessee selects the equipment, negotiates the price and terms of sale,
and fixes a lease financing company to buy the asset.
• Finance lease is a lease in form but in substance it is more like a secured loan. It will
normally be for a term which matches with the economic life or the useful life of the leased
asset.
 Features

• Financial leases allow the asset to be virtually exhausted by the same lessee. Financial
leases put the lessee in the position of a virtual owner.
• The lessor takes no asset-based risks or asset-based rewards. He only takes financial
risks and financial rewards, and that is why the name financial leases.
• The lease is non-cancelable, meaning the lessee cannot return the asset and not pay the
whole of the lessor’s investment.
• In this sense, they are full-payout, meaning the full repayment of the lessor’s investment
is assured.
• As the lessor generally would not take any position other than that of a financier, he would
not provide any services relating to the asset. As such, the lease is net lease.
• The risk the lessor takes is not asset-based risk but lessee-based risk. The value of the
asset is important only from the viewpoint of security of the lessor’s investment.
• In financial leases, the lessor’s payback period, viz., primary lease period is followed by
an extended period to allow exhaustion of asset value by the lessee, called secondary lease
period. As the renewal is at a token rental, this option is called bargain renewal option.
Alternatively, if the regulations permit, the lessee may be given a purchase option at a
nominal price, called bargain buyout or purchase option.
• In financial leases, the lessor’s rate of return is fixed: it is not dependant upon the asset-
value, performance, or any other extraneous costs. The fixed lease rentals give rise to an
ascertainable rate of return on investment, called implicit rate of return.
• Financial leases are technically different but substantively similar to secured loans.

b) Operating lease
• A lease other than a financial lease is usually called as operating lease.
• An operating lease is also known as service lease or maintenance lease.
• An operating lease is a contract between the lessor and lessee such that the cost of the asset
is not fully recovered from a single lessee.
• An operating lease will be for a term less than the economic life of the leased equipment
or the leased asset.
• It is generally a short –term and cancellable lease and the contractual period between the
lessor and lessee is generally less than the full expected useful economic life of the
equipment.
• The maintenance and other servicing costs are borne by the lessor and consequently the
rentals are far higher than in other types of leasing.
Features
1. Operating lease is a short term arrangement for the use of asset between the lessee and the
owner of the asset.
2. Various costs related to that asset like maintenance, taxes etc…. are paid by the owner of
the asset.
3. The term of operating lease is always shorter than the economic life of that asset.
4. The lessee can cancel the operating lease prior to the end date of the operating lease.
5. The terms related to an operating lease can vary significantly depending upon the
agreement between the lessee and the owner of the asset.
6. The rent which is paid by the lessee for the duration of the operating lease is lower than the
cost of asset.

c) Leveraged Lease
• There are three parties involved – lessor (leasing company), lessee (user of the equipment),
and the financer.

• Leasing company contributes by way of equity capital, financial institution, and/or banks
finance by the way of term loans towards the purchase of an asset to be leased.

d) Sale and Lease Back Lease

• A firm may sell an asset which it already owns to another party and lease it back from the
buyer.
• The lessee receives immediate cash for his assets and repays the lease rentals over the
stipulated period.
e. Direct Leasing
Direct leasing is a two-party transaction that involves an equipment supplier (manufacturer or
dealer) and the asset’s user (lessee), whereby the equipment is produced or purchased by the
supplier and then leased directly to the customer by the supplier, either as an operating or
finance lease. For direct leasing, a single contract is used by the lessor for both the
equipment’s acquisition for the customer and the supplier’s lease of the asset to the customer,
it comprising both the purchase contract and the leasing contract between the supplier and the
customer/lessee.

Documentation of leasing
Typical clauses in a lease agreement. The following clauses are usually found in a lease
agreement.
• The basic terms of the lease
• Rental and payment terms
• Adjustment Provisions
• Termination provisions
• Provisions protecting the Lessor from liabilities associated with the Equipment
• Provisions protecting the interest of the Lessor in the Equipment

• The Basic Terms of Lease Agreement

1. Parties
It is important to establish the identity of the lessor. A number of documents can be
misleading in that the name of a manufacturer or "intermediary" appears prominently at
the top but, on closer reading, it appears that an unconnected lessor is to be introduced.
2. Period
The agreement should cover when and how the period of letting begin. It should also
establish if there is a pre-lease period before delivery.
3. Equipment
 The assets may be called "Equipment", "Goods", "Machines", "Items" or something
similar.
• Rental and payment terms
From both sides` points of view the rental provisions are the backbone of the lease. The
lessor looks to the rentals over the fixed period to repay its funding costs on purchasing the
equipment and to provide its return or profit on the transaction.
1) Time for payment
The due dates for rental payments should be stated. Time will normally be expressed to
be of the essence (subject to agreed period of grace) to ensure that prompt payment is a
condition of the contract.
2) Interest for late payment
It is a necessary provision but it should not be excessive so as to constitute a penalty.
3) Method and place of payment
Payment should be made in cleared funds in sterling to a bank account or by another
method acceptable to the lessor.
4) Payment due on condition of equipment
An express provision should provide that rent remains payable in all circumstances: a
so-called "hell and high-water" provision.
• Termination provisions
If the Primary Period ends early the lessor will not receive all the anticipated primary
period rentals. It is therefore vital to identify all the situations in which early termination
may occur and, in each case, look for the provisions that state how the lessor is to be paid
out in that event.
Voluntary Termination
The period of notice should be checked by the lessor. The lessor may wish to restrict the
right to terminate towards the end of its financial year. The lessee should be liable to pay a
termination sum.
• Provisions protecting the Lessor from liabilities associated with the Equipment
As between the lessor and the lessee there should be a provision excluding all liability for
the condition of the equipment, implied warranties and any other obligation other than that
of giving quiet possession.
Lease Evaluation
Leasing is beneficial to both lessor and lessee.
So the evaluation of lease is important to both parties to evaluate the two proposals - buying
&leasing
Lessee’s View
• Lease evaluation from the lessee’s point of view involves a choice b/w debt financing
versus lease financing.
 • Debt financing means taking loan from the bank for use.
• Leasing compare advantages of buying &leasing according to discounted cash flow
technique, using;
NPV / NAL (Net Advantage of leasing)
• NPV /NAL for both the buying & leasing alternative is compared.
• The alternative having positive NPV/NAL is accepted.
• The alternative having negative NPV/NAL is rejected.
• If the NPV/NAL is neutral, either buying or leasing alternative can be used.
Lessor’s Perspective
• Lessor thinks that whether to accept a lease plan or not, OR
• Which plan among the various alternative to accept, OR
• How to quote lease rates.
• Lessors also use NPV/NPL method to analyse whether to accept a lease proposal or to
choose from alternative proposal.
• The alternative having positive NPV/NAL is accepted.
• The alternative having negative NPV/NAL is rejected.
CONSUMER CREDIT
Consumer credit, also called consumer debt, is credit extended to individuals to buy goods or
services. Most commonly associated with credit cards, consumer credit also includes other lines
of credit, including some loans.
Consumer credit typically covers to material goods, usually items that depreciate quickly, such
as vehicles or electronics such as televisions. It excludes investment purchases such as stocks,
bonds, or real estate and similar property.
Types
• Non installment Credit
Non installment credit is either secured or unsecured, depending on the company offering
the credit. This credit does not have monthly payments of a set figure, but instead is due
all at once in a lump sum payment of the full amount owed. Non installment credit tends
to be due in a short period of time, such as in a month.
• Installment Closed-End Credit
Installment closed-end credit allows the consumer to receive a certain amount of credit to
purchase one item or a few goods. One type of installment credit is a car loan. The car
company offers the consumer credit to buy the car. The credit does not extend beyond the
 sales price of the car. In addition, the person pays the credit in installments over a period
of time instead of paying it back in one lump sum.
• Revolving Open-End Credit
Revolving open-end credit is the type of credit a consumer typically finds with a credit
card. The consumer has a specified amount of credit she can use or not use at her leisure.
Then, the consumer must pay off part of the credit she uses at the end of a period, normally
a month. The credit does not close unless the company offering the credit closes the
account. Since it usually does not close, this makes the credit revolving.

HIRE PURCHASE AGREEMENT

The Hire Purchase Act defines a hire purchase as a type of instalment credit under which the hire
purchaser (hirer) agrees to take goods on hire of a stated rental with an option to purchase.
• Hire Purchase agreement is defined as the transaction in which the goods are let on hire
with an option to the hirer to purchase them, with the following stipulations;
a) Payment to be made in installments over a specified period.
b) The possession is delivered to the hirer at the time of entering into the contract.
c) The property in the goods passes to the hirer on payment of the last installment.
d) Each installment is treated as hire charges so that if default is made in payment of any
installment, the seller becomes entitled to take away the goods and
e) The hirer/purchaser is free to return the goods without being required to pay any further
installments falling due after the return.
The important clauses in a hire purchase agreement are:
1. Nature of Agreement: Stating the nature, term and commencement of the agreement.
2. Delivery of Equipment: The place and time of delivery and the hirer’s liability to bear delivery
charges.
3. Location: The place where the equipment shall be kept during the period of hire.
4. Inspection: That the hirer has examined the equipment and is satisfied with it.
5. Repairs: The hirer to obtain at his cost, insurance on the equipment and to hand over the
insurance policies to the owner.
6. Alteration: The hirer not to make any alterations, additions and so on to the equipment, without
prior consent of the owner.
7. Termination: The events or acts of hirer that would constitute a default eligible to terminate
the agreement.
8. Risk: of loss and damages to be borne by the hirer.
9. Registration and fees: The hirer to comply with the relevant laws, obtain registration and bear
all requisite fees.
10. Indemnity clause: The clause as per Contract Act, to indemnify the lender.
11. Stamp duty: Clause specifying the stamp duty liability to be borne by the hirer.
12. Schedule: of equipments forming subject matter of agreement.
13. Schedule of hire charges.
Features of hire purchase
1. Hire purchase is an agreement between two parties called Hire vendor and Hire purchase.
2. The hire purchaser becomes the owner of the asset after paying the last instalment.
3. The hire vendor has the right to repossess the asset in case of difficulties in obtaining the
payment of instalment.
4. Payment will be made in instalments.
5. The instalments in hire purchase include interest as well as repayments of principal.
6. Usually, the hiree charges interest on flat rate.
Advantages
1. Advantages to Buyer
1. Easiest method of Payment.
2. Purchases of Valuable Goods.
3. Encouragement to Savings.
4. Free repairs.
2. Advantages to Seller
1. Increase in Sales.
2. Increase in Income.
3. Easy realization of Installments.
4. Close relation between Buyer and Seller.
5. Possibility of Sale of other goods.
Disadvantages
1. Disadvantages to Purchaser.
 a. High Price
b. Fear of Repossession of Goods.
c. Purchase of Unnecessary Goods.
d. No Ownership on Goods.
2. Disadvantages to Seller.
a. Need of More Capital
b. Difficulty in Realizing Installments.
c. Difficulty in Repossession of Goods.
d. More expenditure on Accounting.
e. Bear of Loss of Depreciation of goods.
Components of Hire Purchase
The following are components of hire purchase.

• Hire Purchaser/Hiree: Entity which purchases goods on a hire purchase basis.

• Seller/Dealer: Entity who sells goods.
• Down Payment: Initial upfront payment processed. Example; 10% of the cash price.
• Hire Charges: Amount paid for hiring or using goods. In simple terms, this can also be
said as a rental charge for using an asset.
Hire Charge = Hire Purchase Price – Cash Price
Interest = Total amount due at the time of installment x rate interest /100 t rate of interest
• Cash Price: Current market price at which goods can be purchased.
• Hire Purchase Price: Price at which goods can be purchased under the hire purchase
agreement.
Contents of hire purchase agreement
1. The date on which the agreement is to be made.
2. The details of the seller/ finance company (of one part):
▪ Name
▪ Address
▪ Type of Business
▪ Type of organization like proprietorship/partnership firm/ Company etc.
3. The details of the purchaser/ hirer (of the other part).
4. The date on which the asset is let out on hire and the period up to which it is let out.
5. The name, type, model no. and make of the asset to be let out.
6. Details of installation expenses and the person who is going to bear it.
7. The cash price of the asset.
8. The hire purchase price i.e. (total of all installments + any deposit + any fees)
9. The payment details:
▪ Amount of installment
▪ Time of payment i.e. first day / last day / any date of the month.
▪ Nature of interval i.e. monthly, quarterly etc.
▪ Mode of payment i.e. cash/ cheque.
10. The authority of inspection of the asset by the owner or a person assigned by him.
11. Details of the rights of the hirer, in case he wants to terminate the agreement.
12. Consequences when the hirer defaults in paying the installment amount or breaches any point
in the contract i.e. the owner has the rights to re-take possession of the assets on these grounds.
13. A statement that the owner at his will can grant relaxation of any sort.
The agreement shall be signed by the two parties indulged in the presence of two witnesses.
Difference between hire purchase and credit sale
Difference between leasing and hire purchase
 FACTORING
Introduction
Factoring as a financial service has grown significantly in the global business arena and has
gained the acceptance in the Indian business sector too. Business firms have found out a better
means of managing the receivables arising from credit sales through the factoring mechanism.
Concept: Factoring as a concept emerges from the need for the business firms to improve their
cash flow position. Firms generally extend credit to its customers and sometimes large amount
gets the receivables for a longer period.
Meaning
Factoring is a continuous arrangement between a financial institution (the factor) and a business
firm(client) that sells goods and services whereby the factor purchases the client’s book debts or
the accounts receivables
Factoring is a receivable management and financing service designed to improve the client's
cash flow and to cover risks associated with credit sales.
The HSBC defines “factoring as a structured working capital finance solution that includes
financing against receivables, collection of receivables on the due date, credit protection and
credit advisory services.”
 • The factoring is offered under an agreement between the factor and seller.
• Under the agreement, the factor purchases the seller’s accounts receivable, normally
without recourse , and assumes the responsibility for the debtor’s financial ability to pay.
• If the debtor goes bankrupt or is unable to pay it’s debts, the factor will pay the seller.
• When the seller and buyer are located in different countries, then the service is called
international factoring.

Features
salient features of factoring can be outlined as follows:
1. Factoring is a mode of financing as well as a financial service provided by the specialist
companies called factors.
2. Factoring is a contractual service arising out of the agreement between the business firm
(client) and the factors.
3. Factoring enables the conversion of outstanding receivables into cash flows.
4. Factoring is a continuous arrangement between the factor and the client firms, because the
invoices of the client firm are continuously factored in.
5. Factoring involves an outright sale of book debts to the factor by the client.
6. Factor makes an advance payment (generally ranging from 80% to 90%) against the invoices
factored by the client firm.
7. Factor may assume the credit risk (without recourse factoring), or may not assume the credit
risk (with recourse factoring) arising from the collection of receivables.
8. In addition to financing through the advance payment, the factor undertakes the services of
credit collection, sales ledger maintenance, etc.
Mechanism of Factoring
In a factoring arrangement, there are three participants – the factor, the client and the
customers of the client.
• The client is the business firm that avails the factoring service.
• The factor is the service provider and the customers of the client are the purchasers of
goods and services on credit terms. They owe the money for the value of goods and
services bought by them which, in accounting terms, is called book debts or accounts
receivable or, simply, debtors.
• The client approaches the factoring company to factor the receivables.
 • The factor is thus an intermediary between the seller (client firm) and the buyer
(customers).
The process flow in a factoring arrangement is shown in Fig

1. Sends invoices to customer: the first activity in the process flow is the credit sale by the
client firm and the despatch of invoices to the customer
2. Assigns invoice to factor: Simultaneously, the client assigns invoices to the factor. Box
5.1 gives a summary of the features of factoring mechanism.
3. Pre-payment up to 80%: Subsequently, the factor sends a copy of invoice and notice of
assignment to the customer. Then factor makes a prepayment of (advance), say, 80%-
90% of the invoice value to the client.
4. Statement to customer: The balance is retained as the margin or 'factor reserve' Factor
maintains the accounts relating to receivables and sends statements to the customer at
frequent intervals to expedite collection.
5. Payment to factor: On the due date, the customer makes the payment to the factor.
6. Balance 20% on realisation: Finally, the factor releases the margin money after adjusting
the service charges and settles the account.
Factor charges
Three charges for the factoring service
• Service charges for sale ledger maintenance, collection etc.
 • For the advances maid upfront to the client, the factor charges the client an interest
charge.
• A nominal process charge for processing the proposals.
Forms of Factoring
Factoring services could be of different types.
• Full Factoring
Full factoring is the most comprehensive type of factoring arrangement. It is also called
standard or old-line factoring.
In this type of factoring, all services are included apart from financing.
Sales ledger administration, collection of accounts receivable and assuming the credit risk
are the standard features of full factoring.
• Recourse and Non-recourse Factoring
Recourse factoring or with recourse' factoring means that the factor does not assume the
credit risk. The factor can recover the bad debt losses from the client firm. Otherwise, all
other services are performed as in full factoring.
On the other hand, in a 'without recourse' or 'non-recourse factoring, the factor absorbs
the risk of inability of customers to pay the outstanding bills. The risks in such
transactions are covered by the factor in a non-recourse factoring.
• Advance Factoring
Once the factorable debts are identified, the drawing limit is made available to the client.
The advance payment is limited to about 80%-90% of the debts or invoices identified for
factoring. Provision of advance against the factored invoices is the way to finance the
fund requirements of the client firms. Further, this may be of either with recourse’ or
‘without recourse’ arrangement.
• Maturity Factoring
Maturity factoring is also known as collections factoring. In this type, unlike the standard
factoring mechanisms, no advance financing is made by the factor to the client.
The factor administers the sales ledger, renders the debt collection service and pays the
factored amount at the end of the credit period. Again, the factoring could be with or
without recourse.
• Undisclosed factoring
In this type, the customers are not notified about the arrangement between the factor and
the client.
Even though the debts are assigned to the factor, the client continues to maintain the sales
ledger.
The factor receives the copies of the invoice and provides finance as required by the
client.

• Purchase bill factoring

 Purchase bill factoring or reverse factoring is the reverse of the regular factoring
transactions.
Instead of sales invoices being financed, the purchased bills are financed by the factor.
For example, SBI Factor offers a scheme called 'Cash 4 Purchase’ that is a case of purchase
bill factoring. Generally, this facility is offered in conjunction with the export factoring and
only the bills of regular suppliers of the client are considered for financing in this type of
factoring.
• Export Factoring
Factoring of receivables arising from the domestic trade, called as domestic factoring.
In addition to this, factoring is a popular instrument in the international trade also. It is
called international factoring or export factoring.
Under export factoring, the invoices drawn on the overseas buyers (importers) is factored.
The factor provides finance up to 90% of the invoice amount immediately.
In international factoring, a two-factor system that involves an export factor and an
import factor facilitates the process.
The factor who handles the collection of export receivables is called the export factor and
the factor in importer's country who handles collection of receivables and credit
protection is called the import factor. It is in this context that organisations like FCI play
a coordinating role between the factors located in different countries.

The sequence of activities in an export factoring transaction will be as follows:

1. The exporter ships the goods to importer.

2. The exporter assigns his invoices through the export factor to the import factor, who
assumes the credit risk.
3. The import factor investigates the credit standing of the buyer of the exporter's goods
and establishes lines of credit. This allows the buyer to place an order on open account
terms without opening L/C.
4. The export factor prepays up to 90% of the value of invoice.
5. The importer pays the proceeds to the import factor, who transfers the amount to export
factor.
6. The export factor deducts prepayment already made, other charges and pays the balance
proceeds to the exporter.

Benefits of Factoring
Factoring, as we have described earlier, is both a form of financing and a service providing
facility. The following are the benefits of factoring
1. Factoring substitutes market credit: Factoring has an important role in working capital
finance. Generally, bank borrowings supplements the market credit or suppliers' credit. Factoring
replaces high-cost market credit.
2. Effective receivables management: Factoring accelerates the receivables turnover and
improves the return on capital. Outstanding receivables are turned over into cash quickly through
factoring.
3. Liquidity: Factoring helps the client to raise cash, even up to 90% of the invoice value, almost
instantly. This builds the liquidity position of the client.
4. No collaterals: Only the invoices are assigned to the factor. No other collateral or security is
required.
5. Cash discounts: The client can utilise the available cash to go for cash purchases of raw
materials or use the cash to make prompt payment to the suppliers and avail the cash discounts.
This enables cost cutting by the clients.
6. Reduction in operating cycle time: The average receivables collection period is reduced
substantially and as a consequence the total operating cycle time of the client is reduced. This
contributes to efficient working capital management.
7. Credit management: Factoring eases the burden of the client with regard to managing the
credit sales. The time and money involved in maintaining a credit department are saved to a
greater extent.
8. Benefits to exporters and importers: Export get the credit protection and there is no need for
ECGC risk cover. For the importers, the of opening the L/C and the associated financing costs
are saved because the imports can be made without opening the L/C.
9. Advisory: Factoring companies offer advisory services to its clients including credit
assessment for its overseas buyers through its own network or through the correspondent factors.
Functions of Factor:
A factor performs a number of functions for his client.
These functions are:
1. Maintenance of Sales Ledger:
A factor maintains sales ledger for his client firm. An invoice is sent by the client to the customer,
a copy of which is marked to the factor. The client need not maintain individual sales ledgers for
his customers.
On the basis of the sales ledger, the factor reports to the client about the current status of his
receivables, as also receipt of payments from the customers and as part of a package, may generate
other useful information. With the help of these reports, the client firm can review its credit and
collection policies more effectively.
2. Collection of Accounts Receivables:
Under factoring arrangement, a factor undertakes the responsibility of collecting the receivables
for his client. Thus, the client firm is relieved of the rigours of collecting debts and is thereby
enabled to concentrate on improving the purchase, production, marketing and other managerial
aspects of the business.
3. Credit Control and Credit Protection:
Another useful service rendered by a factor is credit control and protection. As a factor maintains
extensive information records (generally computerized) about the financial standing and credit
rating of individual customers and their track record of payments, he is able to advise its client
on whether to extend credit to a buyer or not and if it is to be extended the amount of the credit
and the period there-for.
In addition, factor provides credit protection to his client by purchasing without recourse to him
every debt of approved customers (within the stipulated credit limit) and assumes the risk of
default in payment by customers only in case of customers’ financial inability to pay.
4. Advisory Functions:
At times, factors render certain advisory services to their clients. Thus, as a credit specialist a
factor undertakes comprehensive studies of economic conditions and trends and thus is in a
position to advise its clients of impending developments in their respective industries.
Factors also help their clients in choosing suitable sales agents/seasoned personnel because of
their close relationship with various individuals and non-factored organizations.
Thus, as a financial system combining all the related services, factoring offers a distinct solution
to the problems posed by working capital tied in trade debts.
Advantages of factoring
The following are the advantages:
▪ It reduces the credit risk of the seller.
▪ The working capital cycle runs smoothly as the factor immediately provides funds on the
invoice.
▪ Sales ledger maintenance by the factor leads to a reduction of cost.
▪ Improves liquidity and cash flow in the organization.
▪ It leads to improvement of cash in hand. This helps the business to pay its creditors in a
timely manner which helps in negotiating better discount terms.
▪ It reduces the need for the introduction of new capital in the business.
▪ There is a saving of administration or collection cost.
Disadvantages of factoring
The following are the disadvantages:
▪ Factor collecting the money on behalf of the company can lead to stress in the company
and the client relationships.
▪ The cost of factoring is very high.
▪ Bad behavior of factor with the debtors can hamper the goodwill of the company.
▪ Factors often avoid taking responsibility for risky debtors. So the burden of managing such
debtor is always in the company.
▪ The company needs to show all the details about company customers and sales to factor.
International factoring
When the seller and buyer are located in different countries and a factoring agreement takes place
it is called international factoring.

FORFAITING
Forfaiting is a financing as well as a risk management tool available to the exporters. Forfaiting
enables the exporters to convert their credit sales into cash sales by discounting their receivables
with the forfaiter. By selling the export receivables to the forfaiter, the exporter is relieved of the
risks of international trade.
The term ‘forfaiting’ in French means ‘relinquishing all rights.
 • The terms forfaiting is originated from a old French word ‘forfait’, which means “to
surrender something or give up one’s right”.
• In international trade, forfaiting may be defined as the purchasing of an exporter’s
receivables at a discount price by paying cash.
• By buying these receivables, the forfaiter frees the exporter from credit and the risk of not
receiving the payment from the importer.
Forfaiting Process
Forfaiting process involves five parties – the exporter, exporter's bank, the importer, the
importer's bank and the forfaiter.

First, the exporter and the importer negotiate the terms of the proposed transaction with regard to
the quantity, price, currency of payment, delivery period and the credit period. Then, the exporter
approaches the forfaiting agency through the Indian arm of the forfaiter or EXIM Bank to
ascertain the terms of forfaiting.
Forfaiter collects the details about the importer, credit terms and the nature of documentation,
etc., from the exporter to ascertain the country risk and credit risk involved in the proposed
transaction.
Once the risk appraisal is completed, the forfaiter is required to specify the discount rate which
depends on the nature and extent of risks. The exporter has to see that the rate is reasonable and
would be acceptable to the buyer. Prior approval of EXIM Bank is necessary with regard to the
discount rate.
The exporter then quotes the contract price to the importer by loading the discount rate and
commitment charges on the sale price.
If the deal is finalised, the exporter will sign a commercial contract with the importer and will
simultaneously execute a forfaiting contract with the forfaiter through EXIM Bank.
Export takes place in the usual way against documents guaranteed by the importer's bank. The
exporter discounts the bill with the forfaiter who in turn, presents the bill to the importer for
payment on the due date. Alternatively, he can even sell the bills in the secondary market.
Advantages of forfeiting
1. It provides liquidity and improves cash flow.
2. Working capital is not locked as the exporter gets funds from forfeiting bank.
3. Political, transfer and currency risks are eliminated.
4. The possibility of bad debt caused by importers or guarantor banks unable to pay is completely
eliminated.
5. Forfeiting is an excellent tool for the exporters who wishes to expand sales in international
market.
6. It acts as a protective tool when it comes to international finance. It is better tool than insurance,
mainly because it provides the exporter with cash at the time of shipment.
7. In countries where protection against credit, economic and political risks is higher, forfeiting
can be a very dependable tool for exporter’s.
8. The risk of a debtor’s non-repayment is eliminated and the risk of currency fluctuations and
interest rates are also eliminated.
Disadvantages or Drawbacks of Forfaiting
The following are some of the disadvantages of forfaiting.
1. Forfaiting is not available for deferred payments especially while exporting capital goods for
which payment will be made on a deferred basis by the importer.
2. There is discrimination between Western countries and the countries in the Southern
Hemisphere which are mostly underdeveloped (countries in South Asia, Africa and Latin
America).
3. There is no International Credit Agency which can guarantee for forfaiting companies which
affects long-term forfaiting.
4. Only selected currencies are taken for forfaiting as they alone enjoy international liquidity.
Forfaiting: An Evaluation
Forfaiting in India has a greater potential for growth than what has been achieved so far. It is still
under utilised by the exporters. Lack of awareness of this instrument among the exporters of the
reluctance to use this mode of financing are cited as reasons for the slow growth of the forfaiting
business. Indian forfaiting practices differ from the global practices.

BILL DISCOUNTING
Bill Discounting is a discount/fee which a bank takes from a seller to release funds before the
credit period ends. This bill is then presented to seller's customer and full amount is collected.
Bill Discounting is mostly applicable in scenarios when a buyer buys goods from the seller and
the payment is to be made through letter of credit.
• It is an arrangement whereby the seller recovers an amount of sales bill from the financial
intermediaries before it is due.
• It is a business vertical for all types of financial intermediaries such as banks, financial
institutions etc.
• When a buyer buys goods from the seller, the payment is usually made through letter of credit.
The credit period may vary from 30 days to 120 days. Depending upon the credit worthiness of
the buyer, the bank discounts the amount that needs to be paid at the end of credit period.
• It means that the bank will charge the interest amount for the credit period as an advance from
the buyer’s account. After that, the bill amount is paid as per the end of the time span with respect
to the agreed upon document between the buyer and seller.
• Bill Discounting is a major trade activity. It helps the seller's get funds earlier on a small fees or
discount. It also helps the bank earn some revenue. The borrower or (seller's) customer can pay
money on the due date of the credit period.
Procedure of bill discounting
• The seller sells the goods on credit and raises invoice on the buyer.
• The buyer accepts the invoice. By accepting, the buyer acknowledges paying on the due date.
• Seller approaches the financing company to discount it.
• The financing company assures itself of the legitimacy of the bill and creditworthiness of the
buyer.
• The financing company avails the fund to the seller after deducting appropriate margin, discount
and fee as per the norms.
• The seller gets the funds and uses it for further business.
• On the due date of payment, the financial intermediary or the seller collects the money from the
buyer. ‘Who will collect the money’ depends on the agreement between the seller and financing
company.
 HOUSING FINANCE
The terms “Housing Finance” or “Home Loan” means finance for buying or modifying a
property.
Put simply, housing finance is what allows for the production and consumption of housing. It
refers to the money we use to build and maintain the nation’s housing stock. But it also refers to
the money we need to pay for it, in the form of rents, mortgage loans and repayments.
The purpose of a housing finance system is to provide the funds which home-buyers need to
purchase their homes.
India’s national housing policy insists on providing more dwelling houses to the citizens. It is
only natural for the government to create institutions which can provide housing finance.
At the international level, institutions such as World Bank and Asian Development Bank provides
both grants and loans, especially soft loans for removing slums and for the creation of housing
colonies. In fact in India, the World Bank has financed Sites and Service Schemes to a number
of state governments, thereby, both housing and promotion of small scale industries are
simultaneously encouraged.
Types of housing loans
Types of Housing Finance
Direct Finance- purchase another house, For letting it out for rent, Buy an old house, Purchase
of plot borrower Declares that he intends to construct a house on the plot
Supplementary Finance - alteration/repairs
Indirect Finance - To other housing financial institution, provided after obtaining “Pain Passu”
or he “Second Mortgage”
Housing Loans under Priority Sector
The following housing finance limits will be considered as Priority Sector Advances:
Direct Finance
(i) Loans up to Rs. 15 lakh in rural, semi-urban, urban and metropolitan areas for construction of
houses by individuals, with the approval of their Boards.
(ii) Loans up to Rs.1 lakh in rural and semi urban areas and Rs. 2 lakhs in urban areas for repairs
to damaged houses by individuals.
Indirect Finance
Assistance given to any governmental agency for construction of houses, or for slum
clearance and rehabilitation of slum dwellers, subject to a ceiling of Rs. 5 lakh of loan amount
per housing unit.
Assistance given to a non-governmental agency approved by the National Housing Bank for the
purpose of refinance for reconstruction of houses or for slum clearance and rehabilitation of slum
dwellers, subject to a ceiling of Rs. 5 lakh of loan amount per housing unit.
Advantages of Housing Finance
1. Among the financial services, housing finance creates employment, both directly and
indirectly.
2. Industries such as cement, brick manufacturing, sanitary products, electrical fittings and
glass industries experience more demand due to house construction.
3. Rural housing develops not only rural areas but prevents migration of labor to urban areas.
4. Housing finance helps in creation of more houses which results in building up more
infrastructure facilities, such as roads, electricity generation, drinking water facilities, etc.
5. Factories or industrial establishments create townships by providing more housing
facilities to their employees. Housing finance thereby reduces congestion in urban areas.
6. Due to housing finance, there is a vertical expansion and re building of dilapidated houses
and re modelling of the existing houses.
7. Housing facilities not only improve, they also reflect the culture of the country. Chandigarh
city is an example for modern housing which has been built by a French architect.
8. Non conventional energy gets popularized due to modern housing facilities which is one
of the major benefits of housing finance.
VENTURE CAPITAL FINANCING
Concept
• “Venture” means a project or activity which is new, exciting, and difficult because it
involves the risk of failure.
• “Capital” means the resources to start the enterprise.
• Venture Capital is capital that is invested in projects that have a high risk of failure, but
that will bring large profits if they are successful.
• Venture capital means risk finance. The project may be innovative but they are risky.
Definition
Jane Koloski Morris defines “venture capital as providing seed, start-up and first stage financing
and also funding the expansion of companies that have already demonstrated their business
potential but do not yet have access to the public securities market or to credit oriented
institutional funding sources.”
Characteristics of Venture capital
Venture capital concept has certain unique characteristics.
1. Risky projects: The projects possess higher than average risk levels and it is difficult to
quantify the risk through the conventional risk measurement tools. The project may be a
new product, a new technology or a new process that results in cost savings for the
companies.
2. . Early-stage financing: Every project has a life cycle and this consists of two stages – early
stages and later stages. Venture capital finances the products or services which are at the
early stages of their life cycle. It helps the entrepreneur from the concept stage to the start
of commercial operations. The term venture capital, in a broader perspective, includes
seed-stage financing, early stage-financing and later stage-financing.
3. Entrepreneur centric: Venture capital supports the business idea of the entrepreneur. It is
the business plan that is considered important in the process. The idea might have been
evolved out of research and development by the entrepreneur. The background of the
entrepreneur, in terms of education, and the experience in the product development are
weighed heavily in the venture capital process.
4. Partnering: A venture capital financing firm is seen as a partner in the business. He brings
in his own experience of implementing a project and works for the success of the project.
He serves in the Board of Directors and contributes to the efficient management of the
project.
5. Form of finance: Venture capital assistance is mostly in the form of participation in the
equity capital of the company. In some cases, it could be in the quasi-equity instruments
like convertible preference shares. In India, venture capital is extended in the form of
conditional loans also.
6. Turnaround investments: Apart from green field investments which have been untreated
so far, venture capital also includes investment in turnaround cases. The term venture
capital is so inclusive now that it includes a whole range of financing from seed capital to
buyouts.
7. Long term: Venture capital investors invest in companies for a longer term. They stay with
the assisted companies for a long period to realise the gains on their investments. The
projects take a longer time to be commercially successful and until that time the venture
capital investors hold on to their investments. Venture capital investments remain illiquid
until the exit time.
8. Prospects: If the companies that seek venture capital finance are successful in their projects,
the returns from the investments will be above average. The very project itself will be of
such a nature that it has the possibility of earning above average returns once it is
commercially successful.
Stages of Venture Capital
STAGE 1: SEED CAPITAL
In this first stage of venture funding, the venture or the startup company in need of the funds
contacts the venture capital firm or the investor. The venture firm shall share its idea of business
with the investors and convince them to invest in the project. The investor or venture capital firm
shall then conduct research on the business idea and analyze its future potential. If the expected
returns in future are good, the investor (Venture capitalist) shall invest in the business.
STAGE 2: STARTUP CAPITAL
Startup capital is the second stage of venture funding. If the venture is able to attract the investor,
the idea of the business of the venture is brought into reality. A prototype product is developed
and fully tested to know the actual potential of the product. Generally, a person from the venture
capital firm takes a seat in the management of the business to monitor the operations regularly
and keep a check that every activity is done as per the framed plan. If the idea of business meets
the requirement of the investor and has sufficient market in the trail run, the investor agrees to
participate in the future course of the business.
STAGE 3: EARLY STAGE / SECOND STAGE CAPITAL
After the startup capital stage comes the early/first/second stage capital. In this stage, the investor
significantly increases the capital invested in the venture business. The capital increase is mainly
towards increasing the production of goods, marketing or other expansion say building a network
etc. The company with higher capital inflow moves towards profitability as it is able to reach a
wide range of customers.
STAGE 4: EXPANSION STAGE
This is the fourth stage of venture funding. In this stage, the company expands its business by
way of diversification and differentiation of its products. This is possible only if the company is
earning good profits and revenue. To reach up to this stage the company needs to be operational
for at least 2 to 3 years. The expansion gives the venture new wings to enter into untapped
markets.
STAGE 5: BRIDGE / PRE IPO STAGE
This is the last stage of venture funding. When the company has developed substantial share in
the market with its products, the company may opt for going public. One main reason for going
public is that the investors can exit out of the company after earning profits for the risks they have
taken all the years. The company mainly uses the amount received by way of IPO for various
purposes like merger, elimination of competitors, research and development, etc
Advantages of Venture Capital
Venture capital offers considerable benefits to the entrepreneur. The advantages of venture capital
are described below.
1 Long-term finance: Venture capital is usually in the form of participation in the equity of the
company. Venture financier stays with the company for a longer time. They are interested in the
capital gain from the sale of their stake after a long period. Venture capitalists are not interested
in quick returns in a short period.
2. Business partner: Venture capitalists are business partners of the entrepreneur. Risk and
rewards are shared by him. He provides advice and shares the experience gathered from similar
companies that they have assisted. Venture capital firms have a network of contacts in many areas
which can be useful to add value to the business of the company.
3. Additional funding: Venture capital firms do not stop with the initial funding alone. If need
arises, additional rounds of financing is done at different stages. The company is relieved of the
difficulties of searching for sources of finance at critical stages of development.
4. Favourable impact on the economy: Venture capitalist catalyses innovations and the spirit of
entrepreneurship in the economy It leads commercialisation of technology in many sectors.

Venture Capital Finance in India

The evolution of venture capital industry in India dates back to the 1970s.
Objective of VC financing in India is to;
1. Encourage the indigenous technology and its commercial applications.
2. Adopt and modify the applications of imported technology in such a manner that it will be
appropriate to the Indian environment.
3. Setting up of pilot projects.
4. Technological innovations and modernization.
5. Developing appropriate technology.
6. Meeting the cost of market surveys and market promotion programmes.
Venture Capital Institutions in India
1. IDBI Venture Capital Fund
2. Technology Development and Information Company of India Ltd.(TDICI)→ ICICI & Unit
Trust of India
3. Risk Capital and Technology Finance Corporation Ltd. – subsidiary of IFCI.
 FEE BASED/ ADVISORY SERVICES
Fee based financial services are those services wherein financial institutions operate in specialized
fields to earn a substantial income in the form of fees or dividends or brokerage on operations.
• Issue management
• Portfolio management
• Corporate counseling
• Loan syndicate
• Merger and acquisition
• Capital restricting
• Credit rating
• Stock broking
STOCK BROKING
➢ Stock broking in India is now a mature service sector with all the checks and balances put
in place by the market regulator - SEBI.
➢ Stock broker is the interface between buyers and sellers of securities. He functions as a
member of a stock exchange to carry out the trade in securities.
➢ It is mandatory that both stock brokers and sub brokers have to get themselves registered
with SEBI.
➢ A broker is an intermediary who arranges to buy and sell securities on behalf of clients. He
acts on behalf of an investor who wants to execute a buy or sell order.
➢ Investors cannot directly buy or sell securities. They can do so only through brokers.
Therefore, the trade involves member-to-member dealings on behalf of clients.

➢ According to the SEBI (Stock Brokers and Sub-Brokers) Rules, 1992, a stock broker means
a member of a recognised stock exchange. No stock broker is allowed to buy, sell or deal
in securities, unless he or she holds a certificate of registration granted by the SEBI.
➢ A sub-broker is not a member of recognised stock exchange. He is an affiliate of a stock
broker. He acts on behalf of stock broker and assist the clients in trading of securities.
➢ A sub-broker can do business with more than one stock broker. However, he has to
separately register with the SEBI for each broker.
SEBI Guidelines
The SEBI registration of stock brokers is conditional in nature. According to the regulations,
SEBI may grant a certificate of registration subject to the fulfilment of certain conditions which
are as follows:
1. He holds the membership of any stock exchange.
2. He shall abide by the rules, regulations and bye-laws of the stock exchange or stock exchanges
of which he is a member.
3. In case of any change in the status and constitution, he shall obtain prior permission of SEBI
to continue to buy, sell or deal in securities in any stock exchange.
4. He shall pay the amount of fees for registration in the prescribed manner.
5. He shall take adequate steps for redressal of grievances of the investors within one month of
the date of the receipt of the complaint and keep SEBI informed about the number, nature and
other particulars of the complaints.
Sub-brokers are also required to be registered with SEBI for engaging in stock broking activities.
An eligible sub-broker has to submit a recommendation from the stock broker with whom he is
affiliated and two references of which one should be his banker. The grant of certificate is subject
to the conditions that
1. He has to pay the prescribed fee.
2. He takes adequate steps for redressal of investor grievances within one month of the receipt of
the complaint and keeps SEBI informed about the number, nature and other particulars of the
complaints.
3. He is authorised in writing by a broker for affiliation in buying, selling or dealing in securities.
Functions of Stock Brokers
Stock broking is a client-based activity and therefore requires considerable attention by the
brokers. The services of order taking and execution of orders in accordance with the client's
instructions have to be carefully carried out. The clients need to be satisfied with the services
delivered by the broker. Otherwise, loss of client base and erosion of profits will occur. There is
a greater need for applying customer relationship management principles in the matter of dealing
with the investors.
A stock broker should render prompt and competent services to his client and protect their
interest. Specifically, a stock broker performs a number of functions.

1. Client registration.
2. Obtaining margin money from client.
3. Execute the buv/sell order on behalf of client with utmost sincerity and exercise due
diligence
4. Issue contract note evidencing the transaction.
5. Ensure delivery of securities/payment to the client.
 6. Maintain the books, records and documents as required.
7. Redress the investor grievances.
8. Protect the interest of his clients regarding their rights to dividends, bonus shares, rights
issues and any other rights related to such securities.
9. Provide advisory services and portfolio management services.
10. Publish their own research reports and make them available at a cost for investors.

CREDIT RATING
• A credit rating evaluate the credit worthiness of a debtor, especially a business or a
government.
• It is an evaluation made by a credit rating agency of the debtors ability to pay back the debt
and the likelihood of default.
• Credit ratings are determined by credit rating agencies.
• The credit rating represents the credit rating agencies evaluation of qualitative and
quantitative information for a company or government, including non public information
obtained by the credit rating agencies analysts
Meaning
➢ Credit ratings are not based on mathematical formulas, instead credit rating agencies use
their judgment and experience in determining what public and private information should
be considered in giving a rating to a particular company or government.
➢ The credit rating is used by individuals and entities that purchases the bonds issued by
companies and governments to determine the likelihood that the government will pay its
bond obligations.
➢ A poor credit rating indicates a credit rating a credit rating agency’s opinion that the
company or government has a high risk of defaulting, based on the agency’s analysis of
the entity’s history and analysis of long term economic prospects
Need for credit rating
➢ It is necessary in view of the growing number of cases of defaults in payment of interest
and repayment of principal sum borrowed by way of fixed deposits, issue of debentures or
preference shares or commercial papers.
➢ Maintenance of investors’ confidence, since defaults shatter the confidence of investors in
corporate instruments.
 ➢ Protect the interest of investors who cannot into merits of the debt instruments of a
company.
➢ Motivate savers to invest in industry and trade.
Objectives
✓ To rate the debt instruments as objectively as possible in order to build market/investor
confidence in them.
✓ To promote the growth of primary market in particular and capital market in general.
✓ To protect the interests of investors especially the small and gullible investors by giving
adequate clues in the form of ratings regarding safety and/profitability of investments.
✓ To ensure optimum allocation of capital, as market absorbs highly rated debt instruments.
✓ To minimize the cost of floatation.
Features
✓ Guiding the lay investors about corporate entities.
✓ Current assessment of the creditworthiness of an issuer of securities with respect to specific
obligations.
✓ It provides lenders with a simple system of gradation.
✓ It is an opinion of credit rating agencies indicating relative safety of timely payment of
interest and principal on a debenture, preference share, fixed deposit.
✓ It is not a general evaluation of issuing organization but a specific disclosure reflecting the
opinion on repayment capacity of issuer body.
✓ Based on current information about issuer and securities.
✓ Helps investment decision by the investors.
Classification of credit rating
1. Equity Rating
2. Bond Rating
3. Commercial Paper Rating
4. Individual Rating
5. Asset Backed Securities Rating
6. Country Rating
7. Rating of States
 8. Other Ratings
Parameters for rating
• Total volume of outstanding debt and their nature.
• Ability of the company to service the debt.
• Earning capacity of the firm
• Track record of promoters and directors
• Operational efficiency
• The current ratio
• The value of assets pledged
• The interest coverage ratio
• The efficiency and quality of management.
Process and methodology of credit rating
1. Request for rating
2. Rating agreement
3. Assignment of rating team
4. Data collection
5. Management meetings and plant visits
6. Preview meeting
7. Rating committee meeting
8. Rating communication
9. Rating surveillance
Rating methodology
The rating methodology involves an analysis of the industry risk, the issuer’s business and
financial risks. A rating is assigned after assessing all the factors that could affect the credit
worthiness of the entity.

1. Business Analysis
2. Financial Analysis
3. Management Evaluation
 4. Environmental Analysis
5. Fundamental Analysis

Benefits of credit rating

A. To investors
a) Safeguards against bankruptcy
b) Easy understanding of risk
c) Credibility of issuer
d) Saving of resources
e) Ability to take direct investment decisions
f) Choice of investment
g) Rating surveillance
B. To issuing company
a) Lower cost of borrowing
b) Extensive borrowing
c) Rating as marketing tool
d) Self discipline by companies
e) Reduction of cost in public issues
f) Motivation for growth
Limitations of credit rating
1. Biased rating and misrepresentations
2. Static study
3. Concealment of material information
4. No guarantee for soundness of the company
5. Down grading
Credit rating agencies
• Credit information bureau of India ltd was established in 2000 to provide comprehensive
credit information about consumer and commercial borrowers to credit granting
institutions.
 • Brickwork rating India Pvt. Ltd is another rating agency established in 2007.
• It offering rating and grading of different instruments issued by corporate, govt, local
bodies, international agencies etc.
• Small and medium enterprises rating agency (SMERA) promoted by SIDBI is also a new
entrant in the field.
• Credit rating agencies are regulated by SEBI.
• At present there are 6 SEBI registered credit rating agencies. They are
1. CRISIL
✓ Credit Rating and Information Services of India Limited
✓ Largest credit rating agency in India.
✓ It was promoted in 1987 jointly by ICICI Ltd and UTI as a public limited company to rate
debt instruments.
✓ It aimed to provide the investors a guide as to the risk of timely payment of interest and
principal.
✓ It launched ‘CRISIL Rating Scan “ in 1989 to announce new and current ratings and
disseminate the CRISIL rating rationale.
✓ CRISIL offers various services which are broadly classified as:
1. Credit rating services
2. Research, information and evaluation services
3. Advisory services
4. Training services
CRISIL offers
➢ Credit rating service for banks and NBFCs
➢ A methodology and frame work for rating of structured obligations and asset securitisation
programmes.
➢ Ratings on real estate developers projects, credit quality assessment of state electricity
boards and state govts.
➢ Rating on mutual funds, bank loan, bond fund, collective investment schemes, public
finance etc.
➢ Develop and launches municipal bond rating, financial strength rating for insurance
companies, rating of foreign structured obligations, grading og health care institutions etc.
➢ Rating and grading for stock brokers, IPOs, corporate governance etc.
2. CARE Ltd
✓ Credit Analysis and Research Ltd.
✓ CARE was promoted by IDBI and several other banks and insurance companies and
investment institutions in 1993.
✓ CARE is set up with two divisions: CARE RATINGS and CARE RESEARCH
✓ Its headquarters is located at Mumbai having several regional offices.
✓ The various services offered by CARE are
i. Credit Rating
ii. Information and Advisory Services
iii. Equity Research and
iv. Other services like Rating of parallel markets of LPG and Kerosene, CARE loan rating,
credit analysis rating etc.
In addition to debt ratings CARE ratings provides the following specialized grading/rating
services:
• Corporate Governance Ratings
• IPO Grading
• Mutual Fund Credit Quality Ratings
• Claims Paying Ability Rating Of Insurance Companies
• Issuer Ratings
• Micro Finance Institution Grading
• Grading of Construction Entities
• Loan Rating etc
✓ The other services offered include corporate governance rating, credit risk rating of mutual
fund, rating of claims paying ability of insurance companies, project finance rating, issuer
rating, IPO grading, line of credit rating etc…
✓ The company has signed MoUs with Indian Overseas bank, state bank of India and Indian
bank for assigning ratings to the bank loans.
4. FITCH Rating India Private Ltd.
• First private sector credit rating agency in India.
• In July 2000, fitch rating a leading international credit rating agency has acquired 33%
stake in Duff and Phelps credit rating India Pvt Ltd.
 • The merged entity has been renamed as Fitch Ratings India Pvt. Ltd.
• Fitch India is now a 100% subsidiary of fitch group.
• Fitch India is recognised by RBI, SEBI and National Housing Bank.
• The rating methodology of fitch includes the use of both qualitative and quantitative
analysis to assess the business and financial risk of issuers.
• The rating assigned by fitch is comparable across industry groups and countries.
• In addition to this fitch offers infrastructure ratings, public finance ratings, securitisation
ratings, IPO grading, SSI/SME ratings, bank loan ratings etc…
5. BRICKWORK RATINGS INDIA PVT . LTD
• New entrant in credit rating business
• Incorporated in 2007 with the mission of providing unbiased information to Indian
investors for making better investment decisions.
• It is founded by bankers and credit rating professionals.
• It is the fifth credit rating agency to be recognized by SEBI.
• The services offered by Brickwork can be classified into:
i. Rating services
ii. Training services
iii. Research services
• It undertakes rating assignment based on the request from the issuer directly.
6. SME RATING AGENCY OF INDIA LTD.
• SMERA promoted by small industries development bank of India in September 2005 in
association with Dun and Bradstreet information services India Pvt. Ltd and several leading
banks.
• It is the countries first rating agency that focuses primarily on the Indian Micro, Small and
Medium Enterprise segment.
• SMERA’s objective is to provide reliable ratings that facilitate greater and easier flow of
credit from the banking sector to MSMEs.
• The services includes
i. Long term and short term instruments ratings
ii. MSME ratings
iii. IPO grading
iv. Green field and brown field ratings
v. Micro finance institutions rating etc….