Table of Contents

Contents 2

Introduction to Finance Roles 4

Economics 6
Theory of Demand 7
Theory of Supply 8
Equilibrium 8
Types of Markets 9
Important Economics Terms 10
Difference between CPI and WPI 10
Fiscal and Monetary Policy 12
Balance of Payment 12
Currencies and Exchange Rates 13

Accounting 14
Accounting Principles 14
Cash vs Accrual Accounting 16
Financial Statements 17
Balance Sheet 17
Profit and Loss statement 20
Cash Flow Statement 22
An Overview of Financial Statements 25
Linkages Between the Three Financial Statements 25
Impact of Transactions On The Financial Statements 25

General Financial Concepts 27

Ratio Analysis 27
Working Capital Management 31
Negative working capital 32
Hedging, Speculation and Arbitrage 33

Banking 34
Balance Sheet of Banks 34
Balance Sheet of a Central Bank 35
Banking Ratios 35
Measures To Regulate Banking In India 36
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 Basel Norms And Types Of Capital (Tier 1 And 2) 38
NBFCs 42
NBFC Crisis in India 43

Time Value of Money 44

Corporate Finance 46
Capital Investments & Capital Budgeting 46
Important terminology 52
Capital Financing (Equity vs Debt) 53
Dividends and Return of Capital 55
Types of risk 55

Financial Markets and Instruments 60

Investment 60
Fixed Income Instruments 60
Stock Market 61
Initial Public Offering 64
Analysis of Stock 67
Market Segment 70
Valuation of shares 70
Forces That Move Stock Prices 72
Debt 73
Types of Bonds 74
Pricing of debentures/bonds 75
Other Investments 76

Conceptual Questions 79

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 Introduction to Finance Roles
Investment banking
An investment banker is in the business of raising money for companies, governments or other entities. The
investment banker can work within a financial institution or for a division of a large bank. Investment bankers
will be involved with large and potentially complicated financial transactions. They help shape financial deals
to raise money for expansion, acquisition, merger or sale of a business. This also includes the IPO of a
company‘s stock, as this is done to raise money for the company to meet its objectives. This role generally
prefers expertise in following areas of Finance: Mergers & Acquisitions, Corporate Valuation, Risk
Management, Financial Markets and Global Economy.

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 ETFs). This role generally prefers expertise
in following areas of Finance: Corporate Valuation, Financial Markets, Risk Management, Technology
advancements in Trading and Global Economy.

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. This role generally prefers expertise in following areas of Finance: Corporate
Valuation, Financial Markets and Global Economy.

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. This role generally prefers expertise in following areas of Finance: Corporate
Finance, Financial Markets, Risk Management and Global Economy.

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. This
role generally prefers expertise in following areas of Finance: Risk Management, Valuation, Financial Markets
and Global Economy.
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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 professionals
assess, review and protect company financial wellbeing and ensure that cash flow is adequate. This role
generally prefers expertise in following areas of Finance: Corporate Finance, Risk Management, Financial
Markets and Global Economy.

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. This role generally prefers expertise in following
areas of Finance: Corporate Finance, Risk Management, Financial Markets and Global Economy.

Credit analysis
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. This role generally prefers expertise in following areas of Finance: Risk
Management, Valuation, Financial Markets and Global Economy.

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 Economics

Economics: It studies how individuals, businesses, governments and nations make choices on allocating
resources to satisfy their wants and needs, and tries to determine how these groups should organize and
coordinate efforts to achieve maximum output.
Basis for
Microeconomics Macroeconomics
Comparison

The branch of economics that studies the The branch of economics that studies the
Meaning behaviour of an individual consumer, firm, behaviour of the whole economy, (both
family is known as Microeconomics. national and international) is known as
Macroeconomics.

Deals with Individual economic variables Aggregate economic variables

Business Applied to operational or internal issues

Environment and external issues
Application

Covers various issues like demand, supply, Covers various issues like, national income,
Scope product pricing, factor pricing, production, general price level, distribution,
consumption, economic welfare, etc. employment, money etc.

Helpful in determining the prices of a product Maintains stability in the general price level
Importance along with the prices of factors of production and resolves the major problems of the
(land, labour, capital, entrepreneur etc.) economy like inflation, deflation, reflation,
within the economy. unemployment and poverty as a whole.

It is based on unrealistic assumptions, i.e. In It has been analysed that 'Fallacy of

microeconomics it is assumed that there is a Composition' involves, which sometimes
Limitations full employment in the society, which is not doesn't proves true because it is possible that
at all possible. what is true for aggregate may not be true
for individuals too.

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.

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Law of Demand: There is an inverse relationship between the price of a good and demand, other things
remaining constant.

Reasons for the inverse relationship between price and demand are:
Law of diminishing marginal utility: Consumption of products provides satisfaction. However, this
satisfaction or utility decreases with every next unit of the item to be consumed. It is called the law of
diminishing marginal utility. Due to the phenomenon of the law of diminishing marginal utility, the demand
curve slopes downwards.

Income Effect: With a decrease in the price of a product, the consumers can purchase more goods. Whatever
money he saves from the purchase of that particular good is considered an increase in his real income. This
adds up to his purchasing power as well. Now he can buy more quantity of the same product or allocate than
he was used to doing previously. When the price of a product increases, the real income of the consumer's
decreases and they will purchase less of its less quantity.

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.
Ceteris Paribus is a Latin phrase which literally translates to ―holding other things constant‖. For example,
when determining the cause an increase in demand for a product, we could say that the price of a
complementary product increases, Ceteris Paribus, then the demand will decrease. This simply means we hold
all the other factors of demand as constants, i.e. we assume they will not change in order to separate out cause
and effect. The demand curve‘s current position depends on those other things being equal, so when they
change, so does the demand curve‘s position.
Examples:
a. The price of a substitute good drops. This implies a leftward shift.
b. The price of a complement good drops. This implies a rightward shift.
c. Incomes increase. This implies a rightward shift (for most goods).
d. Preferences change. This could cause a shift in either direction, depending on how preferences change.

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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.

Equilibrium

Law of Demand and Supply explains how market economies allocate resources and determine the prices of
goods and services.
The four basic laws of supply and demand are:
1. If demand increases (demand curve shifts to the right) and supply remains unchanged, a shortage
occurs, leading to a higher equilibrium price.
2. If demand decreases (demand curve shifts to the left) supply remains unchanged, a surplus occurs,
leading to a lower equilibrium price.
3. If demand remains unchanged and supply increases (supply curve shifts to the right), a surplus occurs,
leading to a lower equilibrium price.
4. If demand remains unchanged and supply decreases (supply curve shifts to the left), a shortage occurs,
leading to a higher equilibrium price.

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 Types of Markets
Perfect Competition
Classical theory states that perfect competition is a market system characterized by and infinite number of
buyers and sellers. All sellers are selling the same homogenous product. With so many market players, it is
impossible for any one participant to influence the prevailing price in the market. If they attempt to do so,
buyers and sellers have infinite alternatives to pursue.

Monopoly
A monopoly is the exact opposite form of market system as perfect competition. In a pure monopoly, there is
only one producer of a particular good or service, and generally no reasonable substitute. In such a market
system, the monopolist is able to charge whatever price they wish due to the absence of competition, but their
overall revenue will be limited by the ability or willingness of customers to pay. Example: government
monopoly of rail transportation through Indian Railways
Types of monopoly
 Natural monopoly: Here, the costs of production are minimized by having a single firm produce the
product.
 Geographic monopoly: Based on the absence of other sellers in a certain geographic area.
 Technological monopoly: Based on the ownership or control of a manufacturing method or process.
 Government monopoly: Organization that is owned and operated by the government.

Monopsony
Market systems are not only differentiated according to the number of suppliers in the market. They may also
be differentiated according to the number of buyers. Whereas a perfectly competitive market theoretically has
an infinite number of buyers and sellers, a monopsony has only one buyer for a particular good or service,
giving that buyer significant power in determining the price of the products produced.

Oligopoly
An oligopoly is similar in many ways to a monopoly. The primary difference is that rather than having only
one producer of a good or service, there are a handful of producers that make up a dominant majority of the
production in the market system. While oligopolists do not have the same pricing power as monopolists, it is
possible, without diligent government regulation that oligopolists will collude with one another to set prices in
the same way a monopolist would. Example: The market for sportswear such as Adidas, Nike, Umbro, and
Puma.

Monopolistic Competition
Monopolistic competition is a type of market system combining elements of a monopoly and perfect
competition. Like a perfectly competitive market system, there are numerous competitors in the market. The
difference is that each competitor‘s product is sufficiently differentiated from others. For example, the market
for cereals is a monopolistic competition. The products are all similar but slightly differentiated in terms of
taste and flavours. Another such example is toothpaste.

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 Important Economics Terms

Gross Domestic Product: GDP is the final value of the goods and services produced within the geographic
boundaries of a country during a specified period of time, normally a year. GDP growth rate is an important
indicator of the economic performance of a country.
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 = Sum of all private consumption, or consumer spending, in a nation's economy
G = Sum of government spending
I = Sum of all the country's businesses spending on capital
NX = The nation's total net exports, calculated as total exports minus total imports.
Nominal GDP: The nominal GDP is the value of all the final goods and services that an economy produced
during a given year. It is calculated by using the prices that are current in the year in which the output is
produced.
Real GDP: The real GDP is the total value of all of the final goods and services that an economy produces
during a given year, accounting for inflation. It is calculated using the prices of a selected base year.
Nominal GDP includes both prices and growth, while real GDP is pure growth. It is what nominal GDP would
have been if there were, no price changes from the base year. As a result, nominal GDP is usually higher.

Inflation: 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 Central Bank of the country watches inflation closely as
a part of its role in setting interest rates. It is measured using:
 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. Goods included: Food articles (food grains, fruits, vegetables, meats, fish), non-food
articles (fibre, oil seeds), fuel, manufactured goods, and power.

Difference between CPI and WPI

Basis for
Wholesale Price Index (WPI) Consumer Price Index (CPI)
Comparison

Wholesale Price Index (WPI), amounts to the Consumer Price Index (CPI),
Meaning average change in prices of commodities at indicates the average change in the
wholesale level. prices of commodities, at retail
level.
Published by Office of Economic Advisor Central Statistics Office

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Measurement of
First stage of transaction Final stage of transaction
Inflation

Covers Goods only Goods and Services

Prices of goods traded between business Prices of goods purchased by

Focuses on
houses. consumers.

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
 Disinflation: is a temporary slowing of the pace of price inflation, which used to describe instances
when the inflation rate has reduced marginally over the short term.
 Stagflation: It is the combination of high unemployment and economic stagnation with inflation
 Interest Rates: Interest rate is the amount charged, expressed as a percentage of principal, by a lender
to a borrower for the use of assets. Interest rates are typically noted on an annual basis, known as the
annual percentage rate (APR).

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 Fiscal and Monetary Policy
Monetary policy is the process by which the monetary authority of a country, typically the central bank or
currency board, controls either the cost of very short-term borrowing or the monetary base, often targeting an
inflation rate or rate to ensure price stability and general trust in the currency. Further goals of a monetary
policy are usually to contribute to the stability of gross domestic product, to achieve and maintain low
unemployment, and to maintain predictable exchange rates with other currencies.
Fiscal policy is the use of government revenue collection and expenditure to influence the economy. The
objective of fiscal policy is to create healthy economic growth. Through fiscal policy, government attempts to
improve unemployment rates, control inflation, stabilize business cycles and influence interest rates in an
effort to control the economy.

Balance of Payment
It is a systematic record of all economic transactions between residents of one country and residents of other
countries (including the governments). A country's balance of payments tells whether it saves enough to pay
for its imports. It also reveals whether the country produces enough economic output to pay for its growth.
Current Account: The current account measures a country's trade balance plus the effects of net income and
direct payments. When the activities of a country's people provide enough income and savings to fund all their
purchases, business activity and government infrastructure spending, then the current account is in balance.
Capital Account: Capital account shows credit and debit entries for non-produced non- financial assets and
capital transfers between residents and non-residents. The account also shows acquisitions and disposals of
non-produced non-financial assets, such as land sold to embassies and sales of leases and licenses, as well as
capital transfers, that is, the provision of resources for capital purposes by one party without anything of
economic value being supplied as a direct return to that party.
Financial Account: The financial account measures 1) changes in domestic ownership of foreign assets and
2) foreign ownership of domestic assets. If foreign ownership increases more than domestic ownership does, it
creates a deficit in the financial account. This means the country is selling off its assets, like gold, commodities
and corporate stocks, faster than it is acquiring foreign assets.

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 Currencies and Exchange Rates
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 that the prices of imported goods
will fall, which will lower inflation (which will lower interest rates).
Fixed Exchange Rate and Floating Exchange Rate
Basis for
Fixed Exchange Rate Flexible Exchange Rate
Comparison

Fixed exchange rate refers to a rate, Flexible exchange rate is a rate that varies
Meaning which the government sets and according to the market forces.
maintains at the same level.

Determined by Government or central bank Demand and Supply forces

Changes in Devaluation and Revaluation Depreciation and Appreciation

currency price

Takes place when there is rumour about

Speculation Very common
change in government policy.

Self-adjusting Operates through variation in supply of Operates to remove external instability by

mechanism money, domestic interest rate and price. change in forex rate.

Dirty Floating Exchange Rate

A dirty float is a floating exchange rate where a country's central bank occasionally intervenes to change the
direction or the pace of change of a country's currency value. In most instances, the central bank acts as a buffer
against an external economic shock before its effects become disruptive to the domestic economy. A dirty float
is also known as a "managed float."

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 Accounting
Accounting Principles
These are called Generally Accepted Accounting Principles, or GAAP. Key GAAPs are
 Going Concern Concept: This principle assumes that a business will go on, that is, it will continue in
the near future – it has no finite life. We use this principle to project cash flows in the future.
 Legal Entity: The business is an entity separate from owners even if it is a small, one- person business
running out of home. Therefore, the business accounts are taken separate from the owners.
 Conservatism: Be cautious and conservative while accounting. Recognize income only when it is
definite.
 Accrual Concept: Income and expense are recognized/recorded when a transaction occurs- not when
cash changes hands. Income and expense are recorded irrespective of cash.
 Matching Concept: The business must match the expenses incurred for a period, to the income earned
during that period.
 Cost Concept: All assets are recorded on the books at purchase price, not market price, with some
exceptions.
Rules of debit and Credit:
Journal and Ledger entries can be made by classifying accounts into different categories. These categories have
their own rules of debit and credit. One can use either the traditional classification, or the modern classification.
Which classification to use is a matter of choice, as both results in the same entry.
1. Traditional classification - accounts are classified into the following three types:
a. Personal Accounts - these accounts relate to persons. Personal accounts are of the following
three types:
i. Natural - Accounts in individual names. Eg- Ramesh’s account. Creditors and debtors
are the most common type of natural personal accounts.
ii. Artificial - accounts of companies and institutions. eg - ABC Ltd.’s account. Whenever
a company acts as a creditor or a debtor, it will be treated as a personal account.
iii. Representative - These accounts represent a person or a group of persons, without
naming the persons. Eg - if salary payment to employees is due, a salaries payable
account will be shown in the books. Similarly, if payment to be received by customers
is due, a trade receivables account will be shown in the books.
Trade receivables and Trade payables are personal accounts. Accounting rule for personal
accounts:
Debit the receiver, credit the giver.
b. Real Accounts - these accounts relate to tangible and intangible assets.
i. Tangible assets include cash, land, plant & machinery, building, furniture, vehicles,
inventory or any other thing that the business owns and has a physical presence.
ii. Intangible assets include - patents, licenses, trademarks, goodwill etc.
Accounting rule for real accounts:
Debit what comes in, Credit what goes out.
c. Nominal accounts - these accounts relate to revenues, expenses, gains & losses.
Revenues and Gains include - sales, commission received, interest earned, discount received
etc. and these are credited.
Expenses and losses include - salary paid, interest paid, purchases, loss due to fire and theft,
etc. and these are debited.

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 Type of Account Debit Credit
Personal Receiver Giver
Real What comes in What goes out
Nominal Expenses & Losses Revenues & Gains

Example -
(a) ABC Ltd. takes a loan from Suresh.
Accounts involved - Suresh and Cash
Since Suresh is a personal account, the rule Debit the receiver and credit the giver says that Suresh should
appear on the credit side, as Suresh is the giver here.
The company receives cash from Suresh. Since cash is a tangible asset, it is classified as a real account. Since
cash is coming in, the rule Debit what comes in and credit what goes out says that Cash should appear on the
debit side.
Therefore, the journal entry in the books of ABC Ltd. will be:
Cash Dr.
to Suresh Cr.
(b) ABC Ltd. pays salary to employees:
Accounts involved - Salary and Cash
Since salary paid is an expense, it is a nominal account. Expenses and losses are always debited.
Cash is a tangible asset, therefore it is a real account, and is going out. Therefore, as per the rule; Debit what
comes in and credit what goes out; Cash should be credited.
Therefore, the journal entry will be:
Salary Dr
to Cash Cr.

2. Modern classification- accounts are classified into the following types:

a. Assets - what the business owns and whatever is owed to the business. eg - Land, Building,
inventory, furniture, cash, patents, licenses, loans given out by the business, trade receivables,
debtors, etc.
b. Liabilities - whatever the business owes. eg - Loans taken from others, trade payables, creditors,
bank overdraft, etc. Outstanding expenses - expenses that have been incurred but not yet paid.
Outstanding expenses are also liabilities. For example - If previous month’s rent is yet to be paid
to the landlord, a liability under the head Rent Payable will arise.
c. Capital - capital means the amount provided by the owners of the business. When the owners of
a business pump money into the business, a Capital Account is shown in the books. When the
owners of the business take money out from the business, a Drawings Account is shown in the
books.
d. Revenue (& gains) - sales, commissions earned, rent received, interest received, discount
received etc.
e. Expenses (& Losses) - salaries, depreciation, purchases, interest paid, discount allowed, loss due
to fire or theft, etc.

Rules for debit and Credit:

Assets + Expenses = Liabilities + Shareholder’s equity + Revenues
 If any of the five accounts undergoes an increase, it will go to the same side as the side on which
it appears in the above equation.
 If any of the five accounts undergoes a decrease, it will go to the side opposite to the side on
which it appears in the equation.

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 Type of account Debit Credit

Asset Increase Decrease

Expenses Increase Decrease

Liabilities Decrease Increase

Capital Decrease Increase

Revenues Decrease Increase

Example - Salary is paid to employees.

Accounts involved - Salary and Cash
Salary is an expense account, it undergoes an increase (expense is incurred), therefore it will go to the left side
(which is Debit), since it appears on the left side in the equation.
Cash is an asset, and it is decreasing (being paid out), therefore it will go to the right side (opposite to the side
on which it appears in the equation).
Therefore, the Journal Entry will be:
Salary Dr
to Cash Cr

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 cannot provide.

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 Financial Statements

There are 3 Financial statements:

Balance Sheet
A company‘s financial position or health is shown on the balance sheet. It shows the business‘s financial
position on a particular date.
The T-form of balance sheet displays the business‘s assets on the left side of the page and liabilities and net
worth on the right side: Debit = Credit
This is the GOLDEN formula which always holds true for Balance sheet,

Asset = Liabilities + Stockholder’s equity (Net Worth)

Assets are normally debit balances and are what a business owns. Assets are broken into two main categories:
current assets and fixed assets. Current assets usually mean anything that can be converted into cash within
one year. Fixed assets, often called long-term assets, are more permanent items like buildings and major
equipment.

Liabilities are normally credit balances and are what a business owes. Liabilities are divided into two main
categories just like assets. They are shown as current liabilities (that which is owed within one year) and long-
term debt. Current liabilities include bills for such items as included in accounts payable, inventory, rent,
salaries, etc. Long term debt includes items that by agreement do not need to be paid back quickly, such as a
mortgage or long term note.
The difference between assets and liabilities equals net worth, which is often called stockholders‘ equity for
publicly-traded corporations. That is, after all the bills and notes are paid, anything left over is called net worth.
Another definition is that net worth is what is due the owner(s)/stockholders of the business once all liabilities
have been paid.

Net Worth = Assets – Liabilities (or) Assets = Liabilities + Net Worth

A balance sheet uses the principle of double entry accounting. It is called double entry because each business
action affects two or more accounts. For example, a sale will increase cash or accounts receivable but decrease
inventory. An account can be cash, inventory, money you owe (accounts payable), or owed to you (accounts
receivable), etc. Accounts payable and accounts receivable are called accrual accounts. The balances in these
accounts represent cash that must be paid to suppliers or will be received from customers at some future time.
Accounts are organized on the balance sheet in categories with current and fixed assets on the left side of the
sheet and current and long term liabilities as well as net worth on the right side of the sheet. Assets and
liabilities plus net worth must always balance.
Let‘s suppose that a new business was started with the owner‘s savings of $100,000. The beginning balance
sheet would look something like this:

LIABILITIES & EQUITY ASSET

Net Worth Cash

$100,000 $100,000

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The owner then decides to stock her store, and purchases $70,000 of merchandise (Inventory), but pays only
$35,000 in cash (this will reduce Cash by 35,000) and promises to pay the other $35,000 in thirty days (this
creates a new account called Accounts Payable) which is placed under the category of Current Liabilities
because the bill must be paid within one year. The balance sheet would now look like this.

LIABILITIES & EQUITY ASSET

Net Worth Cash

$100,000 $65,000

Accounts Payable Inventory

$35,000 $70,000

The balance sheet is in balance with the addition of $35,000 that is owed to the vendor. It is placed under
current liabilities because it is due to be paid back in a specified period of time which is less than one year.
Currents assets are those items that can be converted into cash within a year. Now let‘s suppose that the owner
buys a building for $100,000. She puts $25,000 down and obtains a $75,000 mortgage for the remainder.

The balance sheet would now look like this:

LIABILITIES & EQUITY ASSET

Current Liabilities Current Asset

Accounts Payable Cash

$35,000 $40,000

Inventory
Long term Debt
$70,000
Mortgage
Fixed Asset
$75,000
Building
Net Worth
$100,000
$100,000

Total Total
$210,000 $210,000

(Note the addition of two new accounts: one called long term debt—because it is to be paid over a period
longer than one year, and a second account called fixed asset which includes property, plant and equipment.)

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Balance Sheet Terminologies
Following are the definitions of the terms used in the balance sheet.

Current Assets: The sum of cash, notes and accounts receivable (less reserves for bad debts), inventories
and any other item that can be converted into cash in a short time, usually less than one
year.

Accounts The money owed to the company for merchandise, products or services sold but not yet
collected.
Receivable:

Inventory: For a manufacturing firm it is the sum of finished merchandise on hand, raw materials
and material in process. For retailers and
wholesalers, it is the stock of saleable goods on hand

Fixed Assets: Land, buildings, building equipment, fixtures, machinery, tools, furniture, office devices,
patterns, drawings, less accumulated depreciation.

Depreciation: Reduction in the asset‘s usefulness due to wear and tear.

Current The total of amount owed by the company that are due within one year.
Liabilities:

Short-Term Sometimes called notes payable, money borrowed by the company that will be paid back
within one year.
Debt:

Accounts Sometimes called trade payable, these are the total amount of money owed by the
Payable: company to a supplier for all goods and services received but not yet paid for. These
goods and services include rent, utilities, office supplies and materials that are used to
make goods for sale or are to be resold as they were received.

Accruals: Expenses that are accumulated against current profits but have not yet been paid for in
cash.

Mortgage: Legal paper that pledges property to cover a debt.

Long-Term Sometimes called long term liabilities, it is all the obligations such as mortgages, bonds,
Debt: term loans and that is to be paid after a year from the date of settlement.

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 Net-Worth What is represented on the balance sheet as the difference between assets and liabilities.
(Owner’s/ In other words, what is due the owners/stockholders of company.
Equity):

Common Stock: Money paid to the company by investors to own a piece of the company.

Retained Income/profit left in the company from the company‘s creation less any amount paid out
Earnings: to owners as dividends/withdrawals.

Why is Net Worth Not Always the Same as Market Value?

A fundamental principle of finance is that all business transactions are recorded on the balance sheet at the
dollar value actually agreed upon at the time of the transaction. For example, in the prior balance sheet, the
business owner purchased a building for $100,000. That is the dollar amount that appears on the company‘s
balance sheet under the Buildings account regardless of how the building was financed (all cash versus long
term debt) and regardless of what the building is appraised at or worth today. Recording all business
transactions at their historic cost is a fundamental accounting principle. For this reason, the net worth of a
company shown on the balance sheet should not be confused with the sales or appraised value. Net worth or
stockholders‘ equity on the balance sheet merely reflects the difference between assets and liabilities i.e. what a
company owns less what they owe.
On the other hand, the market value of any company is the worth of the company based on the total value of its
outstanding shares in the market, also called as market capitalization. Market value tends to be greater than a
company's book value, since market value captures non-tangibles as well as future growth prospects.

Profit and Loss statement

We have discussed two of the three ways in which a company normally obtains the economic resources
necessary to operate its business: incurring debt and seeking new investors. A third way in which a company
can obtain resources is through its own operations. 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.
 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.

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 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.
Revenue – Expenses = Income
Income Statement: It is similar to Profit and loss statement to derive profit of the business.
The simplest form of Income statement is as follows:

Revenue (Sales + Other Income) Less: Cost of

Goods Sold
= Gross Profit
Less: Selling, General and Administration expenses
= Operating Profit (EBITDA)
Less: Depreciation and amortization Expenses
= EBIT (Often called Operating profit depending on the industry)
Less: Interest Paid
= Profit Before Tax (EBT)
Less: Tax Paid
= Net Income/Profit after Tax (PAT)
Less: Dividend paid to Preference shareholders
= Net income available to Common shareholders

Glossary of Income Statement Terms

Following are the definitions of the terms used in the income statement.

Net Sales The total dollar volume of all cash or credit sales less returns, allowances, discounts and
rebates.

Cost of Goods For a retail or wholesale business it is the total price paid for the products sold plus the
Sold cost of having them delivered to the store during the accounting period.
For a manufacturing firm, it is the beginning inventory plus
purchases, delivery costs, material, labour and overhead less the ending inventory.

Gross Profit Profit before operating expenses and taxes have been deducted.

Operating The selling, general and administrative/overhead expenses to run the business. Examples
Expenses of these costs are rent, utilities, administrative
departments such as accounting, marketing, human resources, etc.

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 Operating The amount left over after subtracting operating expenses from gross profit.
Income

Why Does Income Not Always Equal Cash?

With the accrual method of accounting, sales are recorded in the income statement when the goods and/or
services associated with those sales are delivered or shipped to a customer. The cost of goods sold is recorded in
the income statement at the same time the sales are recorded. Sales and cost of goods sold are recorded
regardless of when the business receives cash for the goods delivered or when the business had to pay cash for
the expense associated with cost of goods sold.

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. It can be calculated using two methods:

Direct method- When using the direct method, you list cash flows in the operations section of the cash flow
statement. Cash flows due to operations arise from customer collections and cash paid to suppliers,
employees and others. The section also reports cash paid for income tax and interest. The problem in trying
to use the direct method is that a company might not keep the information in the required form. For
example, companies using accrual accounting lump together cash and credit sales.

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 Indirect Method- In the indirect method, you adjust net income to convert it from an-

accrual to a cash basis. This requires you to add back non-cash expenses such as depreciation, amortization, loss
provision for accounts receivable and any losses on the sale of a fixed asset. You also adjust net income for
changes between the starting and ending account balances in current assets -- excluding cash -- and current
liabilities for the period.

 Cash flows from investing activities: Basically, cash from non-operating. 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.

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Cash Flow Classifications:

Type of Cash Flow Inflows Outflows

Operating Activities Cash collected from customers Cash paid to employees and
suppliers

Interests and Dividends received Interest paid on debt or leases

Sale proceeds from trading securities Acquisition of trading securities

Taxes paid

Investing Activities Sale proceeds from fixed assets Acquisition of fixed assets

Sale proceeds from debt and equity Acquisition of debt and equity
investments investments

Principal received from loans made to others Loans made to others

Financing Activities Principal amounts of debt issued Principal paid on debt or leases

Proceeds from issuing stock Payments to reacquire stock

Dividends paid to shareholders

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An Overview of Financial Statements

Point of Income Statement Balance Sheet Cash Flow

Distinction
Time frame Period of time A point in time Period of time

Purpose Profitability Financial position Cash movements

Measures Revenue, expenses, Assets, liabilities, Increases and

profitability shareholders' equity decreases in cash

Starting Point Revenue Cash balance Net income

Ending Point Net income Retained earnings Cash balance

Linkages Between the Three Financial Statements

Finally, it is important to note that the income statement, statement of retained earnings, and
balance sheet articulate. This means they ―mesh together‖ in a self-balancing fashion. The income for the
period ties into the statement of retained earnings, and the ending retained earnings ties into the balance sheet.
This final tie-in causes the balance sheet to balance. The links between the three are:
 Balance sheet and Income Statement: The main link between the two statements is that profits generated
in the Income Statement are added to shareholder's equity on the Balance 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 as an asset.
 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.

Impact of Transactions On The Financial Statements

The following are some instances showing the impact of transactions on the financial statements:
 Buying a new asset upfront
If Company A purchased $30,000 of equipment, agreeing to pay for it upfront, then the balance sheet,
income statement as well as cash flow statement would be revised. There will be an impact on the assets,
increasing the fixed assets by $30,000. At the same time, since the asset is purchased with an upfront
payment, this will result in cash outflows for the company. The cash flow from investing activities will
show a reduction of $30,000.
Simultaneously, the asset also needs to be depreciated over its useful life, Thus, a certain percentage of
depreciation will also be calculated in the value of the asset and shown as an expense in the income
statement.
 Purchase of Asset with debt
Cash Flow Statement: the additional investment in factories would show up under Cash Flow from Investing
as a net reduction in Cash Flow. Simultaneously, the additional $100 worth of debt raised would show up as
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 an addition to Cash Flow, canceling out the investment activity, so the cash number stays the same.
Income Statement: No Effect
Balance Sheet: there is now an additional $100 worth of aseets, so fixed assets are up by
$100 and total of Assets is therefore up by $100. On the other side, debt is up by $100 as well and so both
sides balance.

 Depreciation increased by $10

Income Statement: The Operating Income would decline by $10 and assuming a 40% tax rate, Net Income
would go down by $6,
Cash Flow Statement: Since Depreciation is a non-cash expense that gets added back, overall Cash Flow
from Operations goes up by $4. ($10 increase in depreciation less $6 reduction in net income) There are no
changes elsewhere, so the overall Net Change in Cash goes up by
$4.

Balance Sheet: Fixed Assets go down by $10 on the Assets side because of the Depreciation, and Cash is up
by $4 from the changes on the Cash Flow Statement.
Overall, Assets is down by $6. Since Net Income fell by $6 as well, Shareholders' Equity on the Liabilities
& Shareholders' Equity side is down by $6 and both sides of the Balance Sheet balance.

 Company A pays a supplier for goods bought on credit worth $10,000

Cash flow: The amount of $10,000 is an outflow recorded as a reduction in Cash Flow from Operating
activities, thus bringing down the final cash flow.
Income Statement: No Effect

Balance Sheet: The current liabilities in the form of accounts payable will reduce by $10,000. Thus, total
liabilities will automatically come down by $10,000. On the assets‘ side, there will be a reduction in cash by
$10,000, thus automatically balancing the statement.

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 General Financial Concepts
Ratio Analysis

Key terms:
Gross profit= net sales - cost of goods sold
Operating profit = EBIT = earnings before interest and tax
Net income=PAT= earnings after tax but before dividend
Total capital= long term debt + short term debt + equity

Profitability Ratios
It refers to the analysis of profits in relation to revenue from operations or funds (or assets) employed in the
business and the ratios calculated to meet this objective are known as ‘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. The
calculation is:
Gross Profit Margin = Gross profit / Net sales

Operating Ratio: It is computed to analyse cost of operation in relation to revenue from operations. It is
calculated as follows:
Operating Ratio= (Cost of Revenue from Operations + Operating Expenses) / Net Revenue from Operations

Operating expenses include office expenses, administrative expenses, selling expenses, distribution expenses,
depreciation and employee benefit expenses etc. Cost of operation is determined by excluding non-operating
incomes and expenses such as loss on sale of assets, interest paid, dividend received, loss by fire, speculation
gain and so on.
Operating Profit Ratio: It is calculated to reveal operating margin. It may be computed directly or as a residual
of operating ratio.
Operating Profit Ratio= 100 – Operating Ratio.
Where Operating Profit = Revenue from Operations – Operating Cost
Significance: Operating ratio is computed to express cost of operations excluding financial charges in relation to
revenue from operations.

Net Profit Margin: The net profit margin shows how much of each dollar sales 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 considering all expenses including taxes, interest,
and depreciation. The calculation is :
Net profit margin = Net income/ Net sales

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 utilizes 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.
Return on Assets (ROA) = [Net income + Interest expense x (1 – tax rate)] / Average total assets
The higher the percentage, the better, because that means the company is doing a good job using its assets to
generate sales.

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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. 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.
Return on Equity (ROE) = Net income / Average total shareholders’ equity

Capital Structure Ratios-

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. 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 :
Debt to equity = Total debt / Total shareholders’ equity
Total shareholders’ equity= Equity Paid Up + Preference Shares + Retained Earnings

Shareholders Equity Ratio: It is assumed that larger the proportion of the shareholders’ equity, the stronger is
the financial position of the firm. 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. This ratio indicates the degree to which unsecured creditors are protected against loss in the
event of liquidation. The ratio is calculated as follows:
Shareholders’ equity ratio = Total assets / Total shareholders’ equity

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. It also indicates the
changes in benefits accruing to equity shareholders by changing the levels of fixed interest bearing funds in the
organization.
Capital Gearing ratio = Total shareholder’s equity / Total debt

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.
DSCR = Net Operating Income / Debt service costs

Debt to Total Capital Ratio: The relationship between creditors fund and owner‘s capital can also be
expressed in terms of another leverage ratio. This is the debt to total capital ratio. Here, the outsider‘s 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 comprised of total debt capital, equity capital, preference capital
and free reserve.
Debt to Total Capital ratio = Total debt/ Total capital

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Interest Coverage Ratio: This ratio measures the interest servicing capacity of a firm. 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.
Interest Coverage ratio = EBIT / Interest expense

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.
Dividend Coverage ratio = (Net income – Preferred Dividend) / Common Dividend

Liquidity ratios
It is generally considered by analyst to determine the ability of firm to pay its short term liabilities.

Current Ratio
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. Ideal ratio is 2:1
Current ratio = Current assets / Current liabilities

Quick ratio
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.
Quick ratio = (Cash + Marketable securities + Net receivables) / Current liabilities

Cash Ratio
It is the most conservative liquidity measure. These three just differentiate on basis of assumed liquidity
Cash ratio = (Cash + Marketable securities) / Current liabilities

Leverage Ratios
The degree of operating leverage (DOL) is defined as the percentage change in operating income (EBIT) that
results from a given percentage change in sales:
To calculate a firm‘s DOL for a particular level of unit sales, Q, DOL is:

Where, Q = quantity of units sold, P = price per unit, V = variable cost per unit, F = fixed costs
Multiplying, we have:

where, S = sales, TVC = total variable costs, F = fixed costs

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By examining how sensitive a company's operating income is to a change in revenue streams, the degree of
operating leverage directly reflects a company's cost structure, and cost structure is a significant variable when
determining profitability. If fixed costs are high, a company will find it difficult to manage short-term revenue
fluctuation, because expenses are incurred regardless of sales levels. This increases risk and typically creates a
lack of flexibility that hurts the bottom line. Companies with high risk and high degrees of operating leverage
find it harder to obtain cheap financing.
The degree of financial leverage (DFL) is interpreted as the ratio of the percentage change in net income (or
EPS) to the percentage change in EBIT:

For a particular level of operating earnings, DFL is calculated as:

Example: ABC Corp. is preparing to launch a new project that will require substantial external financing. The
company‘s management wants to determine whether it can safely issue a significant amount of debt to finance
the new project. Currently, the company‘s EBIT is $500,000, and interest payments are $100,000. In order to
make the decision, the company‘s management wants to examine the degree of financial leverage ratio:

It shows that a 1% change in the company‘s leverage will change the company‘s operating income by 1.25%.

The degree of total leverage (DTL) combines the degree of operating leverage and financial leverage. DTL
measures the sensitivity of EPS to change in sales. DTL is computed as:

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 Working Capital Management
Cash conversion cycle
Cash conversion cycle is the length of time it takes to turn the firm‘s 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.

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.
Management of working capital means managing different components of current assets and current liabilities.

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

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Management of Inventory: Inventories refer to raw material, work-in-progress and finished goods. There are
three major motives for holding inventories, 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.

Management of Accounts Receivable: 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.

Management of Accounts Payable: Accounts payable emerges due to credit purchase. 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

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.
 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.

 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.

 Goods Sold at Loss Consistently: If we are selling at negative margin, it will take current assets below the
current liabilities
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

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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.

Hedging, Speculation and Arbitrage

Hedging is a risk management technique used to reduce any substantial losses or gains suffered by an
individual or an organisation. Suppose a long term investor owns a portfolio of stocks worth Rs 10 lakhs. 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 may close the trade for a profit. Conversely, if the value of the index falls, the trade
might be closed for a loss

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 Banking
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.
3. Overdraft: Banks advance loans to its customer‘s 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 Central and State
securities 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.

Balance Sheet of Banks

Liabilities Assets
 Share capital: the contribution which shareholders have  Bank's cash in hand, cash with other
contributed for starting the bank banks and cash with central bank (RBI)
 Reserve funds: the money, which the bank has  Money made available at short notice to
accumulated over the years from its undistributed other banks and financial institutions for a
profits very short period of 1-14 days
 Deposits: money owned by customers and therefore it  Loans and advances provided to its
is a liability of a bank customers
 Borrowings from central banks or reserve banks
 Others

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Balance Sheet of a Central Bank

Liabilities Assets

 Currency, which is held by the public federal government's  securities, mainly in the form
bank account, which the central bank uses to deposit its revenues, of Treasuries
mostly in the form of tax revenues, into its account, and paying its  foreign exchange reserves,
bills, mostly in electronic format which are mainly held in the
 Commercial bank accounts, otherwise known as reserves, where form of foreign bonds issued
commercial banks keep their deposits with the Fed. Vault cash, by foreign governments
which is cash held in the
 loans to commercial banks
banks' vaults, is also part of the commercial banks' reserves,
because the cash is used to service its customers.
 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.

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.

 Loan/Deposit Ratio: It 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 could.

 Efficiency Ratio: It is given by Non-Interest Expense/Revenue. 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.

 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. Example, 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).

 Capital Adequacy Ratio: It is a measure of the riskiness of a bank's capital. The bank's available capital is
expressed as a percentage of a bank's risk-weighted credit exposures. Also known as ―
Capital to Risk Weighted Assets Ratio (CRAR).‖ Although not an especially popular ratio prior to the
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 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 bank‘s margin of error.
Nowadays, capital ratios also play a larger role in determining whether regulators will sign off on
acquisitions and dividend payments.

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.

Measures To Regulate Banking In India

The Insolvency and Bankruptcy Code (IBC) in India and the National Company Law Tribunal (NCLT)
The Insolvency and Bankruptcy Code, 2015 was introduced in Lok Sabha in December 2015. It was passed by
Lok Sabha on 5 May 2016. The Insolvency and Bankruptcy Code, 2016 (IBC) is the bankruptcy law of India
which seeks to consolidate the existing framework by creating a single law for insolvency and bankruptcy. The
provisions of the Code are applicable to companies, limited liability entities, firms and individuals (i.e. all
entities other than financial service providers). The Code creates various institutions to facilitate resolution of
insolvency. These are as follows:
1. Insolvency Professionals
2. Insolvency Professional Agencies
3. Information Utilities.
4. Adjudicating authorities
5. Insolvency and Bankruptcy Board

The National Company Law Tribunal (NCLT) is a quasi-judicial body in India that adjudicates issues
relating to Indian companies. The NCLT was established under the Companies Act 2013 and was constituted on
1 June 2016 by the government of India & is based on the recommendation of the justice.

Prompt Corrective Action (PCA)

PCA is a framework under which banks with weak financial metrics are put under watch by the RBI. It aims to
check the problem of Non-Performing Assets (NPAs) in the Indian banking sector. The framework was
reviewed in 2017 and is intended to help alert the regulator as well as investors and depositors if a bank is
heading for trouble. The idea is to head off problems before they attain crisis proportions. The PCA framework
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deems banks as risky if they slip some trigger points - capital to risk weighted assets ratio (CRAR), net NPA,
Return on Assets (RoA) and Tier 1 Leverage ratio. The PCA framework is applicable only to commercial banks
and not to co-operative banks and non-banking financial companies (NBFCs).
PCA Measures :
 RBI can place restrictions on dividend distribution, branch expansion, and management compensation.
 Only in an extreme situation, would a bank be a likely candidate for resolution through amalgamation,
reconstruction or winding up.
 RBI may place restrictions on credit by PCA banks to unrated borrowers or those with high risks, but it
doesn‘t invoke a complete ban on their lending.
 RBI may also impose restrictions on the bank on borrowings from interbank market.
 Banks may also not be allowed to enter into new lines of business.

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 and induct talent from private sector
 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 over a given period.
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

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 when the RBI believed that asset classification was not being done properly and that
banks were resorting to ever-greening of accounts. Banks were postponing bad-loan classification and deferring
the inevitable.
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. Bad loans in the Indian
banking system jumped 80 per cent in FY16, according to RBI data, mainly on account of the AQR.
In February, 2019, Reserve Bank of India (RBI) Governor, Shaktikanta Das shrugged off liquidity concerns
pertaining to non-banking financial companies (NBFCs) and ruled out an asset quality review in the immediate
future, saying such a move might not be well-received by the market.

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Basel Norms And Types 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
assets classification system. 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.
Other problem was that the risk weights do not attempt to take account of risks other than credit risk, viz.,
market risks, liquidity risk and operational risks that may be important sources of insolvency exposure for
banks.

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.
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.
It is widely felt that the shortcoming in Basel II norms is what led to the global financial crisis of 2008. That is
because Basel II did not have any explicit regulation on the debt that banks could take on their books, and
focused more on individual financial institutions, while ignoring systemic risk.

BASEL III

Post crisis, Basel III norms were introduced to ensure that banks don‘t take on excessive debt, and that they
don‘t rely too much on short term funds and 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

38 | P a g e
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:
 Tier 1 Capital (going-concern capital)
o Common Equity Tier 1
o Additional Tier 1
 Tier 2 Capital (gone-concern capital)
The guidelines aim to promote a more resilient banking system by focusing on four vital banking parameters
viz. capital, leverage, funding and liquidity

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

Capital Adequacy: It captures the proportion of capital that a bank should keep aside for it's risky assets.
Capital adequacy is measured by the ratio of capital to risk-weighted assets (CRAR). A sound capital base
strengthens confidence of depositors

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)

Management: To assess a bank‘s management quality, it requires professional judgment of a bank‘s

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, worker‘s 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.

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. A 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.

Liquidity: A FI must always be liquid to meet depositors‘ and creditors‘ demand to maintain public confidence.
Cash maintained by the banks and balances with central
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.

Sensitivity to market risk: The main concern for FIs is risk management. It is because of the degree to which
changes in interest rates, foreign exchange rates, commodity prices, or equity prices can adversely affect a
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financial institution‘s earnings. The major risks to be examined include: (i) market risk; (ii) exchange risk; (iii)
maturity risk; (iv) contingent risk.

Mega Merger of Public Sector Banks

Government of India (GoI) has consolidated 10 Public Sector Banks into 4 banks. The announcement of this
mega merger was made by the Union Finance Minister Nirmala Sitharaman in 2019. However, RBI notified
it in the late March through its circular to merge banks in the new financial year (i.e.1st April 2020). As per the
finance minister, the merger would help to manage the capital more efficiently. The amalgamation of the PSBs
is based on bad loans intensity and regional factors.
After these mergers, the country has 12 public sector banks, including seven large public sector banks and five
smaller ones. There were as many as 27 PSBs in 2017.

Rationale behind the merger

A key reason for the merger is the weight of mounting bad loans over the years. It aimed at improving
operating efficiency, governance and accountability and facilitating effective monitoring. The move aimed at
creating next-generation banks with a strong national presence and global outreach accompanied with enhanced
capacity to increase credit to the various important sectors of the economy. Creating globally stronger banks,
doing away with needless overlaps in operations and infrastructure, and ushering in economies of scale
to bring down costs have always been at the heart of any consolidation drive.
With this mega bank merger, the number of PSBs will be consolidated from 27 banks in 2017 to 12 banks in
2020. Following is the list of the affected PSU banks as a result of this merger:

Sr. No. Bank Name Associate Banks

1. Oriental Bank of Commerce

Punjab National Bank(PNB)
United Bank of India

2. Indian Bank Allahabad Bank

3. Canara Bank Syndicate Bank

4. Union Bank of India Andhra Bank and Corporation Bank

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 bank‘s 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

40 | P a g e
through which it can control the amount that banks lend. 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: 4.5%

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. Present value of SLR: 18%

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: 4.9%

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 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: 3.35%

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.

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
41 | P a g e
price of money in the system.

It smoothens the availability of money through the year to make sure that liquidity conditions don‘t 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 don‘t 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.
But, 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 didn‘t stop the process.With rising fiscal deficit, the RBI has been criticised for
accommodating larger government debt by way of OMO.
The central bank’s signal that it will move to a ‘neutral’ liquidity stance from a ‘deficit’ stance, hints at more
liquidity in the system in future.

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:

 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
o Giving loans to businesses for purchasing the physical assets – tractors, machinery etc.
o Leasing these assets to businesses

 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 MotilalOswal, UTI Mutual Fund etc.

 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.

NBFCs can be further classified into those taking deposits or those not taking deposits. Only those NBFCs can
take deposits, that
o Hold a valid certificate of registration with authorization to accept public deposits.
o Have minimum stipulated Net Owned Funds (NOF – i.e. owners‘ funds)
o 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

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NBFC Crisis in India

The NBFC (Non-Banking Financial Company) crisis started with the failure of one of the most respected
NBFCs in India, IL&FS, followed by struggles at DHFL, Reliance Capital, and the latest, Altico. This NBFC
crisis is unique in the sense that it is both a driver and a reflection of the economic slowdown. As NBFCs
struggled in the wake of a general wave of fear relating to the sector after the IL&FS crisis, banks cut down on
their NBFC exposures, further exacerbating NBFCs‘ funding positions. When lending by and to NBFCs goes
down, demand in multiple sectors is affected, creating a vicious cycle.
Reasons for the crisis:
 Timing Mismatch: Indian Non-Banking Financial Companies (NBFCs) have been playing a very risky
game. They have been borrowing money short term and have been lending it out long term. This asset
liability timing mismatch is obviously a red flag. However, the NBFCs have been able to roll it over and
pay their debts when due. This is the reason the Non-Banking Financial Companies (NBFCs) were able
to function without too many problems. The problem started when IL&FS, i.e. one of the NBFC‘s
mismanaged its funds. As a result, it is now not able to pay back its creditors. Since the IL&FS panic has
scared the investors away, the Non-Banking Financial Companies (NBFCs) are not able to issue new
debt in order to roll over the old debt.
 Mutual Funds: These Non-Banking Financial Companies (NBFCs) also heavily relied on funds
available from debt mutual funds. The problem is that the NBFCs have caused a market crash. As a
result, both retail and institutional investors have reduced the quantum of investments in mutual funds.
Hence, the supply of funds from there died down as well, adding to the woes of the Non-Banking
Financial Companies (NBFCs).
 Asset Quality Issues: A lot of these Non-Banking Financial Companies (NBFCs) are classified as
housing finance companies. They lend money either to the developers or to the homebuyers. The end
result is that the money lent out by these companies is heavily invested in the housing sector. The
problem is that the Indian housing sector has gone bust. Stalwarts like Amrapali group, Supertech,
Unitech, etc. have all gone bust. This is the reason why the asset quality of these Non-Banking Financial
Companies (NBFCs) is also in question. These companies are facing a double impact with both their
assets and liabilities under increasing scrutiny.

Steps taken:
As an immediate response to the crisis, RBI undertook a series of short-term measures to prevent the NBFC
players from blowing up the entire financial system. The RBI changed its rules in order to make it easier for
Non-Banking Financial Companies (NBFCs) to obtain capital. Banks were earlier restricted in the number of
loans they could make to NBFCs. Banks were earlier allowed to lend a maximum of 10% of their loans to
NBFCs. This limit was temporarily raised to 15% for a few months. The immediate effect of this step was to
release close to $10 billion worth of liquidity to the cash-starved NBFC sector.

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 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 learning 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 there investment 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 cashflows. 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.

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 worthless 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.

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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.

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 Corporate Finance
Corporate finance deals with the capital structure of a corporation, including its funding and the actions that
management takes to increase the value of the company. Corporate finance also includes the tools and analysis
utilized to prioritize and distribute financial resources.
The ultimate purpose of corporate finance is to maximize the value of a business through planning and
implementation of resources, while balancing risk and profitability.
The three important activities that govern corporate finance:

Capital Investments & Capital Budgeting

Investing and capital budgeting includes planning where to place the company‘s long-term capital assets in
order to generate the highest risk-adjusted returns. This mainly consists of deciding whether or not to pursue an
investment opportunity, and is accomplished through extensive financial analysis.
By using financial accounting tools, a company identifies capital expenditures, estimates cash flows from
proposed capital projects, compares planned investments with projected income, and decides which projects to
include in the capital budget. This is known as Capital Budgeting.
As part of capital budgeting, a company might assess a prospective project's lifetime cash inflows and outflows
to determine whether the potential returns that would be generated meet a sufficient target benchmark.
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?

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 rupee received today is more
valuable than a rupee 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 Nordstrom‘s department store would require additional cash in sales registers, increased accounts
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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

Capital budgeting techniques (Investment appraisal criteria) under certainty can also be divided into the
following two groups:
 Non-Discounted Cash Flow Criteria: - (a) Pay Back Period (PBP) (b) Accounting Rate Of Return (ARR)
 Discounted Cash Flow Criteria: - (a) Net Present Value (NPV) (b) Internal Rate of Return (IRR) (c)
Profitability Index

Non-Discounted Cash Flow Criteria:

Payback Period
The information on timing of net cash flows is an input to a simple and often-used capital budgeting technique
called payback period. This method measures the time required for a project‘s cash inflows to equal the original
investment. At the end of the payback period, a company has recouped its investment.
Example-

At the end of the third year, all but $1,600 of the initial investment of $8,700 has been recovered. The
$2,900 inflow in the fourth year is assumed to occur evenly throughout the year. Therefore, it should take
approximately 0.55 ($1,600/$2,900) of the fourth year to cover the rest of the original investment, giving a
payback period for this project of 3.55 years (or slightly less than 3 years and7 months). When the cash flows
from a project are equal each period (an annuity), the payback period is determined as follows:
Payback Period = Investment /Annuity

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Accounting/Average Rate of Return (ARR): This method is also known as the return on investment (ROI),
return on capital employed (ROCE) and is using accounting information rather than cash flow. Meaning: The
ARR is the ratio of the average after tax profit divided by the average investment. Method to compute ARR:
There are a number of alternative methods for calculating ARR. The most common method of
computing ARR is using the following formula:

For example, A project requires an investment of Rs. 10,00,000. The plant & machinery required under
the project will have a scrap value of Rs. 80,000 at the end of its

useful life of 5 years. The profits after tax and depreciation are estimated to be as follows:
Decision Rule: If the ARR is higher than the minimum rate established by the management, accept the
project. If the ARR is less than the minimum rate established by the management, reject the project.

Discounted Cash Flow Criteria

Net Present Value (NPV): The net present value method determines whether the rate of return on a project is
equal to, higher than, or lower than the desired rate of return. Each cash flow from the project is discounted to
its present value using the rate specified by
the company as the desired rate of return. The total present value of all cash outflows of an investment project
subtracted from the total present value of all cash inflows yields the net present value (NPV) of the project.

Method to compute NPV:

o Cash flows of the investment project should be forecasted based on realistic assumptions. These cash
flows are the incremental cash inflow after taxes and are inclusive of depreciation (CFAT) which is
assumed to be received at the end of each year. CFAT should take into account salvage value and
working capital released at the end.
o Appropriate discount rate should be identified to discount the forecasted cash flows. The appropriate
discount rate is the firm‘s opportunity cost of capital which is equal to the required rate of return expected
by investors on investments of equivalent risk.
o Present value (PV) of cash flows should be calculated using opportunity cost of capital as the discount
rate.
o NPV should be found out by subtracting present value of cash outflows from present value of cash
inflows. The project should be accepted if NPV is positive (i.e. NPV >0).

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Decision Rule: If the NPV is greater than 0, accept the project. If the NPV is less than 0, reject the project.

For example, calculate NPV for a Project X initially costing Rs. 250000. It has 10% cost of capital. It
generates following cash flows:

As the project has positive NPV, i.e. present value of cash inflows is greater than the cash outlays, it should
be accepted.
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Profitability Index (PI): Profitability Index (PI) or Benefit-cost ratio (B/C) is similar to the NPV approach. PI
approach measures the present value of returns per rupee invested. It is observed in shortcoming of NPV that,
being an absolute measure, it is not a reliable method to evaluate projects requiring different initial investments.
The PI method provides solution to this kind of problem. It is a relative measure and can be defined as the ratio
which is obtained by dividing the present value of future cash inflows by the present value of cash outlays.

Decision Rule: Accept the project when PI>1. Reject the project when PI<1

Internal Rate of Return (IRR):

The internal rate of return (IRR) is the discount rate that equates the NPV of an investment opportunity with
Rs.0 (because the present value of cash inflows equals the initial investment). It is the compound annual rate of
return that the firm will earn
if it invests in the project and receives the given cash inflows. Mathematically, IRR can be determined by
solving following equation for r:

Methods to compute IRR:

 When any project generates uneven cash flow, the IRR can be found out by trial and error. If the calculated
present value of the expected cash inflow is lower than the present value of cash outflows a lower rate should
be tried and vice versa. This process can be repeated unless the NPV becomes zero. For example, A project
costs Rs. 32,000 and is expected to generate cash inflows of Rs. 16,000, Rs.14,000 and Rs. 12,000 at the end
of each year for next 3 years. Calculate IRR. Let us take first trial by taking 10% discount rate randomly. A
positive NPV at 10% indicates that the project‘s true rate of return is higher than 10%. So another trial is
taken randomly at 18%. At 18% NPV is negative. So the project‘s IRR is between 10% and 18%.

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 When any project generates equal cash flows every year, we can calculate IRR as follows.
For example, an investment requires an initial investment of Rs. 6,000. The annual cash flow is estimated at Rs.
2000 for 5 years. Calculate the IRR.
NPV = (Rs.6,000) +Rs.2,000 (PVAIF5,r) = 0 Rs. 6,000 = 2,000 (PVAIF5,r)
PVAIF= 3

The rate which gives a PVAIF of 3 for 5 years is the project‘s IRR approximately. While referring PVAIF table
across the 5 years row, we find it approximately under 20% (2.991) column. Thus 20% (approximately) is the
project‘s IRR which equates the present value of the initial cash outlay (Rs. 6000) with the constant annual cash
flows (Rs. 2000 p.a.) for 5 years.

Decision Rule:
If the IRR is greater than the cost of capital, accept the project. (r >k) If the IRR is less than the cost of capital,
reject the project. (r<k)

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 rupees 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
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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.

Important terminology

Discount rate

In general, a rupee today is worth more than a rupee tomorrow for two simple reasons. First, a rupee today can
be invested at a risk-free interest rate, and can earn a return. A rupee tomorrow is worth less because it has
missed out on the interest you would have earned on that rupee 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.
The weighted average cost of capital (WACC) is the rate at which a company‘s future cash flows need to be
discounted to arrive at a present value for the business. It reflects the perceived riskiness of the cash flows. Put
simply, if the value of a company equals the present value of its future cash flows, WACC is the rate we use to
discount those future cash flows to the present.

Where:

 Debt = market value of debt

 Equity = market value of equity
 rdebt = cost of debt
 requity = cost of equity

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Cost of Equity
The cost of equity is calculated using the Capital Asset Pricing Model (CAPM) which equates rates of return to
volatility (risk vs reward). Below is the formula for the cost of equity:
Requity = Rf + β × (Rm − Rf)
Where:
Rf = the risk-free rate (typically the 10-year U.S. Treasury bond yield) β = equity beta (levered)
Rm = annual return of the market

The cost of equity is an implied cost or an opportunity cost of capital. It is the rate of return shareholders
require, in theory, in order to compensate them for the risk of investing in the stock. The Beta is a measure of a
stock‘s volatility of returns relative to the overall market (such as the NSE Nifty/ BSE Sensex).

Risk-free Rate: The risk-free rate is the return that can be earned by investing in a risk-free security, e.g.,
government securities. The Indian government 10-year Bond rate could be taken as benchmark for the same.

Equity Risk Premium (Rm − Rf): ERP is defined as the extra yield that can be earned over the risk-free rate by
investing in the stock market. One simple way to estimate ERP is to subtract the risk-free return from the market
return.

Beta: Beta is a measure of a stock's volatility in relation to the overall market. By definition, the market, such as
the BSE Sensex / NSE Nifty, has a beta of 1.0, and individual stocks are ranked according to how much they
deviate from the market. A stock that swings more than the market over time has a beta above 1.0. If a stock
moves less than the market, the stock's beta is less than 1.0. Beta is calculated using regression analysis.
Numerically, it represents the tendency for a security's returns to respond to swings in the market.

Cost of Debt
The cost of debt is the effective interest rate a company pays on its debts. It‘s the cost of debt, such as bonds and
loans, among others. To calculate the cost of debt, a company must determine the total amount of interest it is
paying on each of its debts for the year. Then it divides this number by the total of all of its debt. The result is
the effective rate of interest.
The cost of debt formula is the effective interest rate multiplied by (1 - tax rate). For example, a company with a
10% cost of debt and a 25% tax rate has a cost of debt of 10% x (1-0.25) = 7.5% after the tax adjustment. That‘s
because the interest payments companies make are tax deductible, thus lowering the company‘s tax bill.

Capital Financing (Equity vs Debt)

This core activity includes decisions on how to optimally finance the capital investments (discussed above)
through the business‘ equity, debt, or a mix of both. Long-term funding for major capital expenditures or
investments may be obtained from selling company stocks or issuing debt securities in the market through
investment banks.
Balancing the two sources of funding (equity and debt) should be closely managed because having too much
debt may increase the risk of default in repayment, while depending too heavily on equity may dilute earnings
and value for original investors.
The optimal capital structure is estimated by calculating the mix of debt and equity that minimizes the WACC
of a company while maximizing its market value. The lower the cost of capital, the greater the present value of
the firm‘s future cash flows, discounted by the WACC. Thus, the chief goal of any corporate finance department
should be to find the optimal capital structure that will result in the lowest WACC and the maximum value of
the company (shareholder wealth).
Unfortunately, there is no magic ratio of debt to equity to use as guidance to achieve real- world optimal capital
structure. What defines a healthy blend of debt and equity varies according to the industries involved, line of
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business, and a firm's stage of development, and can also vary over time due to external changes in interest rates
and regulatory environment.

Debt investors take less risk because they have the first claim on the assets of the business in the event of
bankruptcy. For this reason, they accept a lower rate of return and, thus, the firm has a lower cost of capital
when it issues debt compared to equity.
Equity investors take more risk, as they only receive the residual value after debt investors have been repaid. In
exchange for this risk, investors expect a higher rate of return and, therefore, the implied cost of equity is greater
than that of debt.
Capital structures can vary significantly by industry. Cyclical industries like mining are often not suitable for
debt, as their cash flow profiles can be unpredictable and there is too much uncertainty about their ability to
repay the debt.
Other industries, like banking and insurance, use huge amounts of leverage and their business models require
large amounts of debt.
Private companies may have a harder time using debt over equity, particularly small businesses which are
required to have personal guarantees from their owners.
Companies with consistent cash flows can tolerate a much larger debt load and will have a much higher
percentage of debt in their optimal capital structure. Conversely, a company with volatile cash flows will have
little debt and a large amount of equity.
To gauge how risky a company is, potential equity investors look at the debt/equity ratio. They also compare the
amount of leverage other businesses in the same industry are using— on the assumption that these companies
are operating with an optimal capital structure—to see if the company is employing an unusual amount of debt
within its capital structure.
However, because investors are better off putting their money into companies with strong balance sheets, it
makes sense that the optimal balance generally should reflect lower levels of debt and higher levels of equity.

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 Dividends and Return of Capital
This activity requires corporate managers to decide whether to retain a business‘s excess earnings for future
investments and operational requirements or to distribute the earnings to shareholders in the form of dividends
or share buybacks.
Retained earnings that are not distributed back to shareholders may be used to fund a business‘ expansion. This
can often be the best source of funds, as it does not incur additional debts nor dilute the value of equity by
issuing more shares.
At the end of the day, if corporate managers believe they can earn a rate of return on a capital investment that‘s
greater than the company‘s cost of capital, they should pursue it. Otherwise, they should return excess capital to
shareholders via dividends or share buybacks.
Dividends are payments made by publicly-listed companies as a reward to investors for putting their money into
the venture.
A share repurchase, or buyback, is a decision by a company to buy back its own shares from the marketplace.

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.
 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

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
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manipulation than some other figures and ratios calculated out of the income statement or balance sheet.

Market Capitalisation = price per share * no. of shares = value of equity of the company.
Enterprise Value = Market Cap + Market Value of Debt - Cash + Minority Interest + Preferred Stock = Value
of total equity as well as net debt (net debt = debt - cash) of the company.

The aim of valuation is to determine what the market capitalisation or the enterprise value of the firm should be.
The Cash flows are forecasted for a few years, and then a constant perpetual growth rate is assumed.
DCF Valuation for non-financial companies:
For non-financial companies, free cash flow is the net cash (inflow - outflow) that the company earns in a given
financial year, from its core operations. Any cash flows that are not generated from the core operations of the
company are not included in Free Cash Flows. Eg - for a car manufacturer, the core business operation is
manufacturing and selling cars. Therefore, if the business earns interest from its investments, it will not be
included in Free Cash Flows because it was not generated from core operations of the company.
A company can invest the cash generated back into the core activities of the business in two ways:
 Increase in Non-Cash Working Capital: Non Cash WC = Trade Receivables + Inventory - Trade
Payables
 Capital Expenditure: Capex refers to the purchase of fixed assets that will help in the core operations
of the firm. eg - plant, machinery & equipment, land & building purchased for business activities (for
real estate companies, land & buildings purchased for renting out or leasing out are considered capex) .
The cash flows left after reinvesting into the business are available to the capital providers of the firm. The cash
flow available to both, debt as well as equity investors is known as FCFF, while the cash flows available to only
equity investors is known as FCFE. The cash flows that are to be discounted back for finding intrinsic value are
of two types:
 Free Cash Flow to the firm (FCFF) - Discounted for finding enterprise value. The Discount rate used is
Weighted Average Cost of Capital (WACC).
 Free Cash Flow to equity (FCFE) - Discounted for finding equity value. The Discount Rate used is Cost
of Equity.

Free Cash Flow to the firm (FCFF): (also known as Unlevered Free Cash Flow)
The cash flow generated from core business operations, available to both equity and debt investors, is known as
FCFF.
FCFF = Net Income + Depreciation - Change in Net Working Capital + Interest*(1-Tax Rate) - Capex

Net Income + Depreciation - Change in Net Working Capital = Cash Flow from Operating Activities.
Interest is added back to Net Income because it is a cash-flow that is available to debt investors.
Capex is also considered a part of core business operations while calculating free cash flows, therefore, cash
outflow on capex is subtracted.
Alternative formulae:
FCFF = Cash Flow from Operating Activities + Interest*(1-Tax Rate) - Capex
FCFF = Ebit*(1-Tax Rate) + Depreciation - Change in Net Working Capital + Interest*(1-Tax Rate) - Capex
(because Ebit*(1-Tax Rate) = Net Income)

Free Cash Flow to equity (FCFE): (also known as levered Free Cash Flow)
The cash flow generated from core business operations, which is available to equity investors only, is known as
FCFE.
FCFE = Net Income + Depreciation - Change in Net Working Capital - Capex + Net Borrowing
(Net Borrowing = New Debt Raised - Principal Repayment)
After-tax interest is not added back to the net income here, because it is a cash flow that is available to only the

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debt investors, not the equity investors.
Net Borrowing is the net amount raised from debt investors. This amount is available to the equity holders;
therefore it is added to FCFE.

Why was net borrowing not added to FCFF?

If net borrowing is positive = > New Debt Raised is greater than principal repayment. Therefore, there has been
a net inflow to equity holders and a net outflow from debt holders. When both equity holders and debt holders
are considered together, the inflow and outflow cancel out.
Interest payment is not an outflow from equity holders to debt holders, the cash used to make interest payments
was generated from business operations.

Alternative formulae:
FCFE = Cash Flow from Operating Activities - Capex + Net Borrowing
FCFF = Ebit*(1-Tax Rate) + Depreciation - Change in Net Working Capital + Interest*(1-Tax Rate) - Capex
+ Net Borrowing

DCF Valuation example:

The following table shows the expected future cash flows of ABC Ltd. (manufacturing firm)

Year FCFE

1 90

2 100

3 110
WACC = 10%
Cost of Equity = 12%
FCFE will show a perpetual growth rate of 3% after year 3. The company has 100 shares.
Find the Value of Equity and price per share of the firm using DCF.
Solution:
Value of Equity = Sum of present values of all future FCFEs, using cost of equity as the discount rate.
=> Value of Equity = 90/(1+12%) + 100/(1+12%)^2 + 110/(1+12%)^3
+ Present Value of Terminal Value
= 238.37 + PV of Terminal Value
Terminal Value is the sum of present value of all future cash flows after the forecasting period (assuming a
constant perpetual growth rate). Here, the forecast is available for 3 years, and after that, a constant perpetual
growth rate is assumed.
Terminal Value = Cash Flow Next Year / (Discount Rate - Growth Rate)
Cash Flow Next Year = Cash Flow in Current Year * (1+ Perpetual Growth Rate)
=> Terminal Value in year 3 = 110*(1+3%)/(12% - 3%)
= 1258.89
This value needs to be discounted to current year, using cost of equity as the discount rate.
=> PV of Terminal Value = 1258.89/(1+12%)^3
= 896.05
=> Value of equity = 238.37 + 896.05 = 1134.42
Price per share = Value of Equity/No. of shares
= 1134.42/100 = 11.34 Rs per share.
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DCF Valuation for financial companies:
Terms such as Working Capital, Debt and Free Cash Flows are not meaningful for financial companies
(primarily banks). Therefore, the intrinsic value of equity of financial companies can be found by discounting
expected future dividends of the firm. This DCF valuation method is known as the Dividend Discount Model.
The discount rate used for discounting dividends is the cost of equity of the firm.

In summary the detailed steps explained above, can be broken down to following for DCF Valuation:
a. Estimate Cash flows (FCFE or FCFF)
b. Estimate Growth Profile (1 stage, 2 stage, etc.) & Growth Rates
c. Calculate Discount Rate (WACC or Cost of equity)
d. Calculate the Terminal Value
e. Calculate fair value of company and its equity

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:
a. Defending a company that is trading at a discount to the sum of its parts from a hostile takeover
b. 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

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 company‘s 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 company‘s net income or cash flow levels indicate a value lower
than its adjusted net asset value

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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).

Enterprise value (EV) is a measure of a company's total value, often used as a more comprehensive alternative
to equity market capitalization. EV includes in its calculation the market capitalization of a company but also
short-term and long-term debt as well as any cash on the company's balance sheet. Enterprise value is a popular
metric used to value a company for a potential takeover.
Enterprise value =Market capitalization + Total debt – Cash and cash equivalents
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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 Financial Markets and Instruments
Investment

The money you earn is partly spent and the rest saved for meeting future expenses. Instead of keeping the
savings idle you may like to use savings in order to get returns on it in the future. This is called Investment.
One needs to invest to:
 Earn return on your idle resources
 Generate a specified sum of money for a specific goal in life
 Make a provision for an uncertain future

One of the important reasons why one needs to invest wisely is to meet the cost of Inflation. Inflation is the rate
at which the cost of living increases. The cost of living is simply what it costs to buy the goods and services you
need to live. Inflation causes money to lose value because it will not buy the same amount of a good or a service
in the future as it does now or did in the past. For example, if there was a 6% inflation rate for the next 20 years,
a Rs. 100 purchase today would cost Rs. 321 in 20 years. This is why it is important to consider inflation as a
factor in any long-term investment strategy. When it comes to investing one has to choose an asset class that
suits the individual‘s risk and return temperament.
An asset class is a category of investment with particular risk and return characteristics. The following are some
of the popular assets class.
 Fixed income instruments
 Equity
 Real estate
 Commodities (precious metals)
 Others

Fixed Income Instruments

These are investable instruments with very limited risk to the principle and the return is paid as an interest to the
investor based on the particular fixed income instrument. The interest paid, could be quarterly, semi-annual or
annual intervals. At the end of the term of deposit, (also known as maturity period) the capital is returned to the
investor.
Typical fixed income investment includes:
 Fixed deposits offered by banks
 Bonds issued by the Government of India
 Bonds issued by Government related agencies such as HUDCO, NHAI etc
 Bonds issued by corporates

Equity

Investment in Equities involves buying shares of publicly listed companies. The shares are traded both on the
Bombay Stock Exchange (BSE), and the National Stock Exchange (NSE).
When an investor invests in equity, unlike a fixed income instrument there is no capital guarantee. However, as
a trade-off, the returns from equity investment can be extremely attractive. Indian Equities have generated
returns close to 14% – 15% CAGR (compound annual growth rate) over the past 15 years.
Investing in some of the best and well run Indian companies has yielded over 20% CAGR in the long term.
Identifying such investments opportunities requires skill, hard work and patience.

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Real Estate

Real Estate investment involves transacting (buying and selling) commercial and non- commercial land. Typical
examples would include transacting in sites, apartments and commercial buildings. There are two sources of
income from real estate investments namely
– Rental income, and Capital appreciation of the investment amount.
The transaction procedure can be quite complex involving legal verification of documents. The cash outlay in
real estate investment is usually quite large. There is no official metric to measure the returns generated by real
estate, hence it would be hard to comment on this.

Commodity – Bullion

Investments in gold and silver are considered one of the most popular investment avenues. Gold and silver over
a long-term period has appreciated in value.
Investments in these metals have yielded a CAGR return of approximately 8% over the last 20 years. There are
several ways to invest in gold and silver. One can choose to invest in the form of jewellery or Exchange Traded
Funds (ETF).

Other (Alternative Investment)

Alternative investments include private equity, hedge funds, managed futures, real estate, commodities and
derivatives contracts.
Alternative investments typically have a low correlation with those of standard asset classes, which makes them
suitable for portfolio diversification. Because of this, many large institutional funds such as pensions and private
endowments have begun to allocate a small portion of their portfolios, typically less than 10%, to alternative
investments such as hedge funds. Investments in hard assets such as gold and oil also provide an effective hedge
against rising inflation, as they are negatively correlated with the performance of stocks and bonds.
Many alternative investments have high minimum investments and fee structures compared to mutual funds and
exchange-traded funds (ETFs). There is also less opportunity to publish verifiable performance data and
advertise to potential investors. Most alternative assets have low liquidity compared to conventional assets. For
example, investors are likely to find it considerably more difficult to sell an 80-year old bottle of wine compared
to 1,000 shares of Apple, due to a limited number of buyers.

Stock Market

The stock market refers to the collection of markets and exchanges where the issuing and trading of equities or
stocks of publicly held companies, bonds, and other classes of securities take place. This trade is either through
formal exchanges or over-the-counter (OTC) marketplaces.

Also known as the equity market, the stock market is one of the most vital components of a free-market
economy. It provides companies with access to capital in exchange for giving investors a slice of ownership.
The primary market provides the channel for sale of new securities. Primary market provides opportunity to
issuers of securities; Government as well as corporates, to raise resources to meet their requirements of
investment and/or discharge some obligation.
They may issue the securities at face value, or at a discount/premium and these securities may take a variety of
forms such as equity, debt etc. They may issue the securities in domestic market and/or international market.

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Difference between public issue and private placement
When an issue is not made to only a select set of people but is open to the general public and any other investor
at large, it is a public issue. But if the issue is made to a select set of people, it is called private placement. As
per Companies Act, 2013, an issue becomes public if it results in allotment to 50 persons or more. This means
an issue can be privately placed where an allotment is made to less than 50 persons excluding Qualified
Institutional Buyers and Employee Stock Options.
Securities market is classified into two interdependent segments, i.e. Primary Market and Secondary Market.
Market. The former is a market where securities are offered for the first time for receiving public subscription
while the latter is a place where pre-issued securities are dealt between the investors.

Difference between the Primary Market and the Secondary Market

Basis for Comparison Primary Market Secondary Market

The place where formerly
Meaning The market place for new shares is called
issued securities are traded is
primary market.
known as Secondary Market.

Another name New Issue Market (NIM) After Market

Type of Purchasing Direct Indirect

It supplies funds to budding

Financing It does not provide funding to
enterprises and also to existing
companies.
companies for expansion and
diversification.
How many times a Only once Multiple times
security can be sold?

Buying and Selling Company and Investors Investors

between

Who will gain the Company Investors

amount on the sale of
shares?

Intermediary Underwriters Brokers

Price Fixed price Fluctuates, depends on

the demand and supply
force

Organizational Not rooted to any specific spot or It has physical

difference geographical location. existence.

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An 'Index'

An index is an indicator or measure of something, and in finance, it typically refers to a statistical measure of
change in a securities market. In the case of financial markets, stock and bond market indices consist of a
hypothetical portfolio of securities representing a particular market or a segment of it. (You cannot invest
directly in an index.) The S&P 500 and the US Aggregate Bond Index are common benchmarks for the
American stock and bond markets, respectively.
There are two main market indices in India. The S&P BSE Sensex representing the Bombay stock exchange and
CNX Nifty representing the National Stock exchange. S&P stands for Standard and Poor‘s, a global credit
rating agency. S&P has the technical expertise in constructing the index which they have licensed to the BSE.
Hence the index also carries the S&P tag.
The S&P BSE SENSEX, also called the BSE 30 or simply the SENSEX, is a free-float market-weighted stock
market index of 30 well-established and financially sound companies listed on Bombay Stock Exchange.
Similarly, The Nifty 50 is a well diversified 50 stock index accounting for 12 sectors of the economy.

CNX Nifty consists of the largest and most frequently traded stocks within the National Stock Exchange. It is
maintained by India Index Services & Products Limited (IISL) which is a joint venture of National Stock
Exchange and CRISIL. In fact the term ‗CNX‘ stands for CRISIL and NSE.

Practical uses of the Index

Some of the practical uses of Index are discussed below:

Information
The index reflects the general market trend for a period of time. The index is a broad representation of the
country‘s state of economy. A stock market index that is up indicates people are optimistic about the future.
Likewise, when the stock market index is down it indicates that people are pessimistic about the future.

Benchmarking
For all the trading or investing activity that one does, a yardstick to measure the performance is required.
Assume over the last 1 year you invested Rs.100,000/- and generated Rs.20,000 return to make your total
corpus Rs.120,000/-. How do you think you performed? Well on the face of it, a 20% return looks great.
However, what if during the same year Nifty moved to 7,800 points from 6,000 points generating a return on
30%?
Well suddenly it may seem to you, that you have underperformed the market! If not for the Index you can‘t
really figure out how you performed in the stock market. You need the index to benchmark the performance of a
trader or investor. Usually the objective of market participants is to outperform the Index.

Trading

Trading on the index is probably one of most popular uses of the index. Majority of the traders in the market
trade the index. They take a broader call on the economy or general state of affairs and translate that into a
trade.
For example, imagine this situation. At 10:30 AM the Finance Minister is expected to deliver his budget speech.
An hour before the announcement Nifty index is at 6,600 points. You expect the budget to be favourable to the
nation‘s economy. What do you think will happen to the index? Naturally the index will move up. So, in order
to trade your point of view, you may want to buy the index at 10,600. After all, the index is the representation of
the broader economy. So as per your expectation the budget is good and the index moves to 10,900. You can
now book your profits and exit the trade at a 300 points profit! Trades such as these are possible through what is
known as ‗Derivative‘ segment of the markets.

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Index construction methodology

It is important to know how the index is constructed /calculated especially if one wants to advance as an index
trader. Index is a composition of many stocks from different sectors which collectively represents the state of
the economy. To include a stock in the index it should qualify certain criteria. Once qualified as an index stock,
it should continue to qualify on the stated criteria. If it fails to maintain the criteria, the stock gets replaced by
another stock which qualifies the prerequisites.
Based on the selection procedure the list of stocks is populated. Each stock in the index should be assigned a
certain weightage. Weightage in simpler terms define how much importance a certain stock in the index gets
compared to the others. For example, if ITC Limited has 7.6% weightage on Nifty 50 index, then it is as good as
saying the that the 7.6% of Nifty‘s movement can be attributed to ITC.
There are many ways to assign weights but the Indian stock exchange follows a method called Free float market
capitalization
The weights are assigned based on the free float market capitalization of the company, larger the market
capitalization, higher the weight. Free float market capitalization is the product of total number of shares
outstanding in the market, and the price of the stock.
For example, company ABC has a total of 100 shares outstanding in the market, and the stock price is at 50 then
the free float market cap of ABC is 100*50 = Rs. 5,000. ABC company‘s weight will be Rs.5000/Total Market
Capitalization of all chosen stocks.

Initial Public Offering

An IPO (initial public offering) is referred to a flotation, which an issuer or a company proposes to the public in
the form of ordinary stock or shares. It is defined as the first sale of stock by a private company to the public.
They are generally offered by new and medium- sized firms that are looking for funds to grow and expand their
business.
Companies fall into two broad categories:
A privately held company has fewer shareholders and its owners don‘t have to disclose much information about
the company. Most small businesses are privately held, with no exceptions that large companies can be private
too, like Domino‘s Pizza and Hallmark Cards being privately held. Shares of private companies can be reached
through the owners only and that also at their discretion. On the other hand, public companies have sold at least
a portion of their business to the public and thereby trade on an a stock exchange. This is why doing an IPO is
referred to going public

Why go public?

The main reason for going public is to raise the good amount of cash through the various financial avenues that
are offered. Besides, the other factors include:
 Public companies usually get better rates when they issue debt due to increased scrutiny.
 As long as there is market demand, a public company can always issue more stock.
 Trading in the open markets means liquidity.
 Being Public makes it possible to implement things like employee stock ownership plans, which help to
attract top talent of the industry.

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Factors to be considered before applying for an IPO:
 The historical record of the firm providing the Initial Public Offerings
 Promoters, their reliability, and past records
 Products offered by the firm and their potential going forward
 Whether the firm has entered into a collaboration with the technological firm
 Project value and various techniques of sponsoring the plan
 Productivity estimates of the project
 Risk aspects engaged in the execution of the plan

General Terms involved in IPO:

Prospectus: A formal legal document describing the details of the company is created for a proposed IPO, also
making the investors aware of the risks of an investment. It is also known as the offer document.

Book building: It is the process by which an attempt is made to determine the price at which the securities are
to be offered based on the demand from investors.

Over-Subscription: A situation in which the demand for shares offered in an IPO exceeds the number of shares
issued.

Green shoe option: It is referred to as an over-allotment option. It is a provision contained in an underwriting

agreement whereby the underwriter gets the right to sell investors more shares than originally planned by the
issuer in case the demand for a security issue proves higher than expected.

Price band: Price band refers to the band within which the investors can bid. The spread between the floor and
the cap of the price band is not more than 20% i.e. the cap should not be more than 120% of the floor price. This
is decided by the company and its merchant bankers. There is no cap or regulatory approval needed for
determining the price of an IPO.

Flipping: Flipping is reselling a hot IPO stock in the first few days to earn a quick profit. The reason behind this
is that companies want long-term investors who hold their stock, not traders.

Underwriting: IPO is done through the process called underwriting. Underwriting is the process of raising
money through debt or equity.The first step towards doing an IPO is to appoint an investment banker. Although
theoretically a company can sell its shares on its own, on realistic terms, the investment bank is the prime
requisite. The underwriters are the middlemen between the company and the public. There is a deal negotiated
between the two.
E.g. of underwriters: Goldman Sachs, Credit Suisse and Morgan Stanley to mention a few.
The deal could be a firm commitment where the underwriter guarantees that a certain amount will be raised by
buying the entire offer and then reselling to the public, or best efforts agreement, where the underwriter sells
securities for the company but doesn‘t guarantee the amount raised. Also to off shoulder the risk in the offering,
there is a syndicate of underwriters that is formed led by one and the others in the syndicate sell a part of the
issue.

Red herring: During the cooling off period, the underwriter puts together there herring. This is an initial
prospectus that contains all the information about the company except for the offer price and the effective date.

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How does IPO work in India:

The IPO process starts when the company lodges a registration declaration in accordance with SEBI. The entire
listing declaration is then studied by the SEBI. This is followed by the prelude brochure proposed by the
sponsor and then an authorized catalogue prior to the share offering. The value and time of the IPO are then
determined.

Market Capitalisation
The market value of a quoted company, which is calculated by multiplying its current share price (market price)
by the number of shares in issue is called as market capitalization. E.g. Company A has 120 million shares in
issue. The current market price is Rs. 100. The market capitalisation of company A is Rs. 12000 million.

Stockholders’ Equity
Stockholders‘ Equity (also known as Shareholders Equity) is an account on a company‘s balance sheet that
consists of share capital plus retained earnings. It also represents the residual value of assets minus liabilities.
By rearranging the original accounting equation, Assets = Liabilities + Stockholders Equity, it can also be
expressed as Stockholders Equity = Assets – Liabilities.

Components of Stockholders Equity

Stockholders Equity is influenced by several components:

 Share Capital – amounts received by the reporting entity from transactions with its owners referred to
as share capital.
 Retained Earnings – amounts earned through income referred to as Retained Earnings and
Accumulated Other Comprehensive Income.

Retained Earnings = Beginning Period Retained Earnings + Net Income/Loss – Cash Dividends – Stock
Dividends

 Net Income & Dividends – Net income increases retained earnings while divided payments reduce
retained earnings.

 Preference Shares - Preference shares, more commonly referred to as preferred stock, are shares of a
company‘s stock with dividends that are paid out to shareholders before common stock dividends are
issued. If the company enters bankruptcy, the shareholders with preferred stock are entitled to be paid
from company assets first. Most preference shares have a fixed dividend, while common stocks
generally do not. Preferred stock shareholders also typically do not hold any voting rights, but common
shareholders usually do.

 Outstanding Shares - The number of outstanding shares a company owns is an integral part of
shareholders' equity. It is the amount of company stock that has been sold to investors and not
repurchased by the company. This figure includes the par value of common stock, as well as the par
value of any preferred shares the company has sold.

 Additional Paid-in Capital - Shareholders' equity also includes the amount of money paid for shares of
stock above the stated par value, known as additional paid-in capital. This figure is derived from the
difference between the par value of common and preferred stock and the price each has sold for, as well
as shares that were newly sold.
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  Treasury Stock - The final item included in shareholders' equity is treasury stock, which is the amount
of shares that have been repurchased from investors by the company. This figure is subtracted from a
company's total equity, as it represents a smaller number of available shares for investors once it is
repurchased.

Types of Stock Investor:

Growth Investors

The objective here is to identify companies which are expected to grow significantly because of emerging
industry and macro trends. A classic example in the Indian context would be buying Hindustan Unilever,
Infosys, Gillette India back in 1990s. These companies witnessed huge growth because of the change in the
industry landscape thereby creating massive wealth for its shareholders.

Value Investors

The objective here is to identify good companies irrespective of whether they are in growth phase or mature
phase but beaten down significantly due to the short term market sentiment thereby making a great value buy.
An example of this in recent times is L&T. Due to short term negative sentiment; L&T was beaten down
significantly around August/ September of 2013. The stock price collapsed to 690 all the way from 1200. At
690 (given its fundamentals around Aug 2013), a company like L&T is perceived as cheap, and therefore a great
value pick. Eventually it did pay off, as the stock price scaled back to 1440 around May 2014.

Analysis of Stock

Technical Analysis

Technical analysis is a trading tool employed to evaluate securities and identify trading opportunities by
analysing statistics gathered from trading activity, such as price movement and volume. Unlike fundamental
analysts who attempt to evaluate a security's intrinsic value, technical analysts focus on charts of price
movement and various analytical tools to evaluate a security's strength or weakness.

Advantages

Probably one of the greatest versatile features of technical analysis is the fact you can apply TA (Technical
Analysis) on any asset class as long as the asset type has historical time series data. Time series data in technical
analysis context is information pertaining to the price variables namely – open high, low, close, volume etc.
Here is an analogy that may help. Think about learning how to drive a car. Once you learn how to drive a car,
you can literally drive any type of car. Likewise you only need to learn technical analysis once. Once you do so,
you can apply the concept of TA on any asset class– equities, commodities, foreign exchange, fixed income etc.

This is also probably one of the biggest advantages of TA when compared to the other fields of study. For
example, when it comes to fundamental analysis of equity, one has to study the profit and loss, balance sheet,
and cash flow statements. However fundamental analysis for commodities is completely different.
If you are dealing with agricultural commodity like Coffee or Pepper then the fundamental analysis includes
analysing rainfall, harvest, demand, supply, inventory etc. However, the fundamentals of metal commodities are
different, so is for energy commodities. So, every time you choose a commodity, the fundamentals change.

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 However, the concept of technical analysis will remain the same irrespective of the asset you are studying. For
example, an indicator such as ‗Moving average convergence divergence‘ (MACD) or ‗Relative strength index‘
(RSI) is used exactly the same way on equity, commodity or currency.

Disadvantages
 Interference:
Technical analysis is very subjective. Quick changes in schedules may have an adverse impact on the
trading results. What may seem on the chart to signal to enter the market, in fact will be only a noise,
that can be tracked only on large frames. It is possible to increase the accuracy of the signals by the
number of indicators used, however, it is not a panacea, because it reduces the number of entry signals
into the market.
 Controversial Conclusions
Someone sees the cup half empty, some half full, although the level‘s one and the same! Technical
indicators may show the signals. Different traders may interpret exactly the opposite. Interestingly, both
traders will find legitimate confirmation of his conclusions, and even quite logical.
 The Time Lag
Unfortunately, Forex trading requires fast reaction. In addition to the fact that the signals can be delayed,
the trader may also be late in decision.
 Exceptions
Disadvantages of technical analysis are also evident in the fact that the figures and postulates do not
work 100%. Maybe you saw the build of the figure, but the external factors will work such as the
volume of trades that negate a successful market entry or exit.
To sum up. Theory often diverges from practice. Each tool has its own characteristics, and it works not
in every situation. Only experience, only testing instruments on a demo account will allow you to choose
the optimal strategy. And, of course, be prepared for possible financial losses!

Fundamental Analysis

Fundamental Analysis (FA) is a holistic approach to study a business. When an investor wishes to invest in a
business for the long term (say 3 – 5 years) it becomes extremely essential to understand the business from
various perspectives. It is critical for an investor to separate the daily short-term noise in the stock prices and
concentrate on the underlying business performance. Over the long term, the stock prices of a fundamentally
strong company tend to appreciate, thereby creating wealth for its investors.

Fundamental analysts study anything that can affect the security's value, from macroeconomic factors such as
the state of the economy and industry conditions to microeconomic factors like the effectiveness of the
company's management.

The end goal is to arrive at a number that an investor can compare with a security's current price in order to see
whether the security is undervalued or overvalued.

Fundamental analysis uses public data to evaluate the value of a stock or any other type of security. For
example, an investor can perform fundamental analysis on a bond's value by looking at economic factors such
as interest rates and the overall state of the economy, then studying information about the bond issuer, such as
potential changes in its credit rating. For stocks, fundamental analysis uses revenues, earnings, future growth,
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return on equity, profit margins, and other data to determine a company's underlying value and potential for
future growth. All of this data is available in a company's financial statements.

An analyst uses works to create a model for determining the estimated value of a company's share price based
on publicly available data. This value is only an estimate, the analyst's educated opinion, of what the
company's share price should be worth compared to the currently trading market price. Some analysts may
refer to their estimated price as the company's intrinsic value.

If an analyst calculates that the stock's value should be significantly higher than the stock's current market
price, they may publish a buy or overweight rating for the stock. This acts as a recommendation to investors
who follow that analyst. If the analyst calculates a lower intrinsic value than the current market price, the stock
is considered overvalued and a sell or underweight recommendation is issued.

The problem with defining the word fundamentals is that it can cover anything related to the economic well-
being of a company. They obviously include numbers like revenue and profit, but they can also include
anything from a company's market share to the quality of its management.
The various fundamental factors can be grouped into two categories: quantitative and qualitative. The financial
meaning of these terms isn't much different from their standard definitions. Here is how a dictionary defines
the terms:
Quantitative – capable of being measured or expressed in numerical terms.
Qualitative – related to or based on the quality or character of something, often as opposed to its size or
quantity.

In this context, quantitative fundamentals are hard numbers. They are the measurable characteristics of a
business. That's why the biggest source of quantitative data is financial statements. Revenue, profit, assets, and
more can be measured with great precision.

The qualitative fundamentals are less tangible. They might include the quality of a company's key executives,
its brand-name recognition, patents, and proprietary technology.
Neither qualitative nor quantitative analysis is inherently better. Many analysts consider them together.

Advantages
 Fundamental Analysis is a good tool for long-term investments that try to achieve a growth of capital as
it will help to identify assets that represent a good value in longer-term investment.
 One of the most notable but less obvious rewards of fundamental analysis is the development of solid
understanding of the business and industry due to the in-depth, extensive research and analysis required
to conduct fundamental analysis.

Disadvantages
 Intrinsic or Fair Value is based on assumptions. Any changes in the key fundamental factors such as
growth can greatly alter the achievable result of the analysis.
 Being useful for revealing an undervalued company or a company with a high future growth prospects,
it does not provide us with any kind of information that would help with timing the entry and purchase
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 of the assets. In other words, you might find an undervalued stock which prices has been below its
intrinsic value, and it could very well hold at that level for substantial period of time before showing
any sign of meeting your expectations for near- term growth.

Market Segment
A market segment is a division within which a certain type of financial instrument is traded. Each financial
instrument is characterized by its risk and reward parameters.
The exchange operates in three main segments.
a. Capital Market – Capital market segments offers a wide range of tradable securities such as equity,
preference shares, warrants and exchange traded funds. Capital Market segment has sub segments under
which instruments are further classified. For example, common shares of companies are traded under the
equity segment abbreviated as EQ. So if you were to buy or sell shares of a company you are essentially
operating in the capital market segment.

b. Futures and Options – Futures and Option, generally referred to as equity derivative segment is where
one would trade leveraged products
c. Whole sale Debt Market – The whole sale debt market deals with fixed income securities. Debt
instruments include government securities, treasury bills, bonds issued by a public sector undertaking,
corporate bonds, corporate debentures etc.

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

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 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.

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.

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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.

Forces That Move Stock Prices

Stock prices are driven by a variety of factors, but ultimately the price at any given moment is due to
the supply and demand at that point in time in the market.
Fundamental factors drive stock prices based on a company's earnings and profitability from producing and
selling goods and services.
Technical factors relate to a stock's price history in the market pertaining to chart patterns, momentum, and
behavioural factors of traders and investors.
Then there is Market Sentiment The key fundamental factors are:
 The level of the earnings base (represented by measures such as EPS, cash flow per share, dividends
per share)
 The expected growth in the earnings base
 The discount rate, which is itself a function of inflation
 The perceived risk of the stock
Technical factors are the mix of external conditions that alter the supply of and demand for a company's
stock. Some of these indirectly affect fundamentals. Technical factors include the following:
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  Inflation
 Economic Strength of Market and Peers
 Demographics
 News

Market sentiment refers to the psychology of market participants, individually and collectively. Market
sentiment is often subjective, biased, and obstinate. For example, you can make a solid judgment about a
stock's future growth prospects, and the future may even confirm your projections, but in the meantime, the
market may myopically dwell on a single piece of news that keeps the stock artificially high or low. And
you can sometimes wait a long time in the hope that other investors will notice the fundamentals.

Market sentiment is being explored by the relatively new field of behavioural finance. It starts with the
assumption that markets are apparently not efficient much of the time, and this inefficiency can be explained
by psychology and other social science disciplines. Many of the ideas in behavioral finance confirm
observable suspicions: that investors tend to overemphasize data that come easily to mind; that many
investors react with greater pain to losses than with pleasure to equivalent gains; and that investors tend to
persist in a mistake. Some investors claim to be able to capitalize on the theory of behavioral finance. For
the majority, however, the field is new enough to serve as the "catch-all" category, where everything we
cannot explain is deposited.

Different types of investors depend on different factors. Short-term investors and traders tend to incorporate
and may even prioritize technical factors. Long-term investors prioritize fundamentals and recognize that
technical factors play an important role. Investors who believe strongly in fundamentals can reconcile
themselves to technical forces with the following popular argument: technical factors and market sentiment
often overwhelm the short run, but fundamentals will set the stock price in the long-run. In the meantime,
we can expect more exciting developments in the area of behavioral finance, especially since traditional
financial theories cannot seem to explain everything that happens in the market.

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.
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 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.
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)- These are bonds that are rated below investment grade by the credit rating
agencies. As these bonds are riskier than investment grade bonds, investors expect to earn a higher yield.

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6. Convertible bonds- These bonds let 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 these which the principal amount
and the interest payments are indexed to inflation.
8. Asset-backed securities- The 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:
 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%.

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 When inflation goes 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 thereby drives up interest rates, which causes a decrease in bond
prices.

Other Investments

Mutual Fund
A mutual fund is an investment vehicle made up of a pool of moneys collected from many investors for the
purpose of investing in securities such as stocks, bonds, money market instruments and other assets. Mutual
funds are operated by professional money managers, who allocate the fund's investments and attempt to
produce capital gains and/or income for the fund's investors. A mutual fund's portfolio is structured and
maintained to match the investment objectives stated in its prospectus. Mutual fund units, or shares, can
typically be purchased or redeemed as needed at the fund's current net asset value (NAV) per share, which
is sometimes expressed as NAVPS. A fund's NAV is derived by dividing the total value of the securities in
the portfolio by the total amount of shares outstanding.

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.
An ETF is a type of fund that owns the underlying assets (shares of stock, bonds, oil futures, gold bars,
foreign currency, etc.) and divides ownership of those assets into shares. Shareholders do not directly own
or have any direct claim to the underlying investments in the fund; rather they indirectly own these assets.
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.
There exists potential for favourable taxation on cash flows generated by the ETF, since capital gains from
sales inside the fund are not passed through to shareholders as they commonly are with mutual funds.

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Derivatives
A derivative is a financial security with a value that is reliant upon or derived from an underlying asset or
group of assets. The derivative itself is a contract between two or more parties based upon the asset or
assets. Its price is determined by fluctuations in the underlying asset. The most common underlying assets
include stocks, bonds, commodities, currencies, interest rates and market indexes. Derivatives can either be
traded over-the-counter (OTC) or on an exchange.

Future Contract
Futures are financial contracts obligating the buyer to purchase an asset or the seller to sell an asset, such as
a physical commodity or a financial instrument, at a predetermined future date and price. Futures contracts
detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures
exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash.

Forward Contract
A forward contract is a customized contract between two parties to buy or sell an asset at a specified price
on a future date. A forward contract can be used for hedging or speculation, although its non-standardized
nature makes it particularly apt for hedging. Unlike standard futures contracts, a forward contract can be
customized to any commodity, amount and delivery date. A forward contract settlement can occur on a cash
or delivery basis. Forward contracts do not trade on a centralized exchange and are therefore regarded as
over-the- counter (OTC) instruments. While their OTC nature makes it easier to customize terms, the lack of
a centralized clearinghouse also gives rise to a higher degree of default risk. As a result, forward contracts
are not as easily available to the retail investor as futures contracts.

Swap Contract
A swap is a derivative contract through which two parties exchange financial instruments. These
instruments can be almost anything, but most swaps involve cash flows based on a notional principal
amount that both parties agree to. Usually, the principal does not change hands. Each cash flow comprises
of one leg of the swap. One cash flow is generally fixed, while the other is variable, that is, based on a a
benchmark interest rate, floating currency exchange rate, or index price.The most common kind of swap is
an interest rate swap. Swaps do not trade on exchanges, and retail investors do not generally engage in
swaps. Rather, swaps are over-the-counter contracts between businesses or financial institutions.

Options Contract
Options are a type of derivative security. They are a derivative because the price of an option is intrinsically
linked to the price of something else. Specifically, options are contracts that grant the right, but not the
obligation to buy or sell an underlying asset at a set price on or before a certain date. The right to buy is
called a call option and the right to sell is a put option. People somewhat familiar with derivatives may not
see an obvious difference between this definition and what a future or forward contract does. The answer is
that futures or forwards confer both the right and obligation to buy or sell at some point in the future. For
example, somebody short a futures contract for cattle is obliged to deliver physical cows to a buyer unless
they close out their positions before expiration. An options contract does not carry the same obligation,
which is precisely why it is called an ―option.

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Call and Put Options
A call option might be thought of as a deposit for a future purpose. For example, a land developer may want
the right to purchase a vacant lot in the future, but will only want to exercise that right if certain zoning laws
are put into place. The developer can buy a call option from the landowner to buy the lot at say $250,000 at
any point in the next 3 years. Of course, the landowner will not grant such an option for free, the developer
needs to contribute a down payment to lock in that right. With respect to options, this cost is known as the
premium, and is the price of the options contract. In this example, the premium might be
$6,000 that the developer pays the landowner. Two years have passed, and now the zoning has been
approved; the developer exercises his option and buys the land for $250,000 – even though the market value
of that plot has doubled. In an alternative scenario, the zoning approval doesn‘t come through until year 4,
one year past the expiration of this option. Now the developer must pay market price. In either case, the
landowner keeps the $6,000.
A put option, on the other hand, might be thought of as an insurance policy. Our land developer owns a
large portfolio of blue chip stocks and is worried that there might be a recession within the next two years.
He wants to be sure that if a bear market hits, his portfolio won‘t lose more than 10% of its value. If the
S&P 500 is currently trading at 2500, he can purchase a put option giving him the right to sell the index at
2250 at any point in the next two years. If in six months‘ time the market crashes by 20%, 500 points in his
portfolio, he has made 250 points by being able to sell the index at 2250 when it is trading at 2000 – a
combined loss of just 10%. In fact, even if the market drops to zero, he will still only lose 10% given his put
option. Again, purchasing the option will carry a cost (its premium) and if the market doesn‘t drop during
that period the premium is lost.

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 Conceptual Questions
1. Is it possible to have positive cash flows and negative net income?
2. Which is a better indicator of profits? PAT vs FCFF
3. Is it possible to have negative working capital?
4. If Depreciation is a non-cash expense, why does it affect the cash balance?
5. Could you ever end up with negative shareholders' equity? What does it mean?
6. While looking at the financial statements of a company, where will your focus be?
7. Which are the most important ratios to look for in a company in your opinion?
8. Is too much debt always bad for a company? Which companies can sustain high debt levels?
9. As a banker, what factors will you consider before giving a loan to a company?
10. Should a company always maintain a high cash balance?
11. If you are given Rs 1 lakh, where and how will you invest it?

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