Foundations in Finance

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Basi c Fi nance Pr ogr am

COPYRIGHT 2006 i-flex Solutions Ltd For internal use only
5
Basic Finance Program
TABLE OF CONTENTS

1. THEORY OF INVESTMENT MODULE 1 1
2. CORPORATE FINANCE MODULE 2
3. FINANCIAL MARKETS & MARKET PARTICIPANTS I
MODULE 3
4. FINANCIAL MARKETS & MARKET PARTICIPANTS II
MODULE 4
5. FINANCIAL ACCOUNTING MODULE 5
6. BFSI MODULE 6
7. BFSI TECHNOLOGY MODULE 7

T h e o r y o f I n v e s t m e n t
M o d u l e - 1

9
Theory of Investment Module 1
TABLE OF CONTENTS
1. SAVINGS AND ACCUMULATION OF SAVINGS.. 1
1.1. Why are Savings Important..
1.2. Types of Savings
2. INVESTMENT AVENUES..
2.1. What is Investment
2.2. Investment Avenues..
2.3. How is it possible to maximize savings..
2.4. Accumulation of savings...
3. CALCULATING RETURNS
3.1. Return on Assets...
3.2. Return on Investment
4. INVESTMENT STRATEGIES
4.1. Investment Strategies...
4.2. Speculation.
5. LIQUIDITY.
5.1. What is Liquidity.
5.2. Liquidity Risk..
6. INTEREST.
6.1. Simple Interest...
6.2. Compound Interest...
7. TIME VALUE OF MONEY.
7.1. Future Value..
7.2. Present Value.
7.3. Annuity.
7.3.1. Ordinary Annuity....................
7.3.2. Annuity Due
7.4. Net Present Value (NPV)
7.5. Internal Rate of Return (IRR) .
8. INFLATION ..
8.1. Inflation .....................
8.2. Factors ...
9. RISK & RETURNS .
9.1. Risk .
9.2. Relationship between Risk & Returns ..
9.3. Types of Risk in Connection with Investments
9.4.1. Types of Non-Operational Risks .
10. FINANCIAL PLANNING .
10.1. What is Financial Planning .
10.2. Steps in Financial Planning

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11. INSURANCE ..
11.1. What is Insurance
11.2. Principles of Insurance
11.3. Types of Insurance Available Worldwide .

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Chapter 1
Savings & Accumulation of Savings
When we talk about investments, the first thing that comes to mind is MONEY!!!
To make any kind of investments, the major requirement is money. Where does this money come from?
Money can come from the following sources:
Borrowings, inheritances, winnings and income.
The most regular source of money is income. But all that is income cannot be used for investment. A
portion of what is left over after meeting day-to-day expenses can be utilized for investments.
This portion of excess income over expenditure is termed as Savings
1.1 Why are savings important?
Life is unpredictable and so we need to plan for the future. Moreover, the source of your income
may not remain constant or it may not remain permanent. In order to have a resource that you can
depend during such occurrences, it is necessary to get into the habit of saving money.
Savings also enable you to upgrade your lifestyle and standard of living, buy comforts and luxuries,
and help you to enjoy life without cutting down on your day-to-day expenses.
1.2 Types of Savings
Savings can be of three types: short-term, medium-term and long-term.
Short-term savings refer to savings that you might make and use up for your annual holiday,
or for the purchase of home appliances. Short-term generally refers to a period not exceeding
one year.
Medium-term savings might be those that can be used for occasions in the family, childrens
education, purchase of a larger house, etc. Medium-term usually refers to a period greater than
one year, but not exceeding five years.
Long-term savings typically refer to retirement savings. Usually, long-term refers to an
investment horizon exceeding five years.

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Chapter 2
Investment Avenues
2.1 What is investment?
Investment is the deployment of savings for earning higher returns thereon.
The purchasing power of money decreases due to inflation. It is therefore necessary to generate
returns which are higher than the rate of inflation by a wide margin. Only then is real capital
appreciation possible.
Moreover, higher returns mean that you can achieve your targets sooner and start living a better life
earlier.
Investments can be classified as: Short-term, medium term and long term investments
depending upon the duration for which they are held.
They can also be classified as investments held for trading and permanent investments.
2.2 Investment Avenues:
Savings can be channelised into investments in any of the following ways:
Ploughing cash back into business: This will result in a growth in business, and
consequently a growth in profits.
Fixed Deposits: Savings can be deployed into fixed deposits with banks or companies. This is
a safe form of investment, but the returns are low.
Mutual funds: These are an indirect method of investment in the equity, debt and derivative
markets. They are supposed to bear lower risk as compared to direct investment in the
markets, and if used wisely and well, can help build capital over a period of time. Mutual funds
are usually well-structured, transparent and regulated.
Hedge Funds: These are the instruments of investment of the rich people, with the minimum
investment generally being one million dollars and multiples. Hedge funds are not highly
regulated, but they can generate very high returns. Very risky.
Investment in the markets: Savings can be invested directly in various markets like equity,
bonds, commodities, derivatives, and currencies. Usually considered as high risk, but can
generate very high returns too. Most markets nowadays are well-structured, transparent and
regulated.
Property: Purchase of house-property, holiday homes, timeshares, land (residential,
agricultural or industrial).
Other fixed assets: Machinery for production, vehicles, etc are some examples of fixed assets.
Precious metals: Investment in gold, silver, platinum, precious stones, either made
independently or in the form of jewelry.
High end investments: Antiques, art (paintings, sculptures, etc.), watches, limited editions,
collections of rare items (stamps, coins, pens, etc.) very expensive. Done as a hobby, but can
generate exceptional returns.

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Compulsory investments: For salaried persons, a part of the income every year is generally
invested into compulsory investments like Provident Fund, Pension Fund, PPF, Postal Savings,
Life and Medical Insurance, etc. This is done to lower the income-tax outgo for the individual,
and results in long-term savings.
2.3 How is it possible to maximize savings?
Some simple rules, if followed, can help in maximizing savings.
Follow financial prudence.
Live within your means.
Avoid taking excessive risks for marginally incremental gains.
Do not buy what you cannot afford.
Be disciplined with your savings, and save regularly.
2.4 Accumulation of Savings
Some of the end uses of savings are:
Channelisation into investments.
Expending of savings for education, purchase of assets, etc.
For use in emergencies.

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Chapter 3
Calculating Returns
3.1 Return on Assets
ROA means the total net earnings or income generated by investment in the asset concerned. This
includes capital gain (or loss) as well as income that the asset has generated, like rent (hire
charges) or dividend (or interest earned).
ROA also sometimes referred as Return on Investment (ROI) is calculated as:
ROA = Income generated from the asset + Capital Gain (or loss)
Earnings on assets refer to the income that the asset generates on a regular basis. This can be hire
charges or rent if the asset is rented or leased out or it can be interest or dividend if the money is
invested in any of the avenues mentioned chapter 2.
It also refers to regular income being generated from business.
3.2 Return on Investment
This is the ratio of total returns to the initial investment, expressed as a percentage. It is usually
expressed as a per annum basis.

ROI (%) = Profits/Investment
ROI (%) = (Annual income) + (Selling price Purchase Price)
Purchase price
= Current yield + Capital gain or loss
Consider an asset purchased for Rs. 5,00,000 and leased out at Rs. 10,000 per month for one year.
The asset is sold after one year to fetch Rs. 4,80,000. The ROI in this case would work out to be:
ROI = Income generated + Capital gains
ROI = 1,20,000 + (-20,000) = Rs. 1,00,000
ROI (%) = 1,00,000/5,00,000 = 20.00%
Rita sells her investment in Excellent Products Ltd. at Rs. 375 per share after holding it for exactly 1
year. Assuming that she has received a dividend of Rs. 10 per share during the year and her ROI is
10%, what is the price at which she bought the shares?
Can ROI be negative?

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Chapter 4
Investment Strategies
4.1 Investment Strategies:
Where investment with specific goals in mind is required, one size fits all strategy does not work.
Individuals need to plan their investment strategies in accordance with their age, income, savings,
financial goals, etc.
A younger person has a longer investment horizon and a longer time period in which to save and
accumulate capital. Moreover, he may have less responsibilities, and so may be able to save more,
as well as take more risks.
Conversely, a middle-aged person has a slightly shorter investment horizon to save and
accumulate capital. He may also have additional family responsibilities, and may not be able to
save more, in spite of having a larger income. He would also prefer not to take high risks with the
capital that he has accumulated so far.
On the other hand, a person who is nearing retirement will prefer very low risk investments, and his
prime concern is the preservation of the accumulated corpus. High returns are not very important.
Such a person will prefer bonds or fixed deposits, where the initial capital is definitely preserved.
An indicative risk-return chart is given below:
Age Risk taking ability Possible investment avenues
Below 30 years High All avenues. Equity (upto 80%)
30 to 45 years Moderate Balanced funds, some equity (upto 40%)
Above 45 years Low Bonds, FDs, Liquid funds, Postal Savings,
only bluechip equity (upto 20%)

4.2 Speculation:
Is the art of investment for generating very high returns in a very short time period by taking
advantage of market imperfections.
Speculation is a very high risk investment avenue, where a person can lose not only his initial
investment, but multiples of the amount investment!!!
Derivatives trading is a very good example of speculation of this type.

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Chapter 5
Liquidity
5.1 What is liquidity?
Liquidity is the ability to meet all financial obligations arising in the short term (a period less than
one year).
Being liquid or having sufficient liquidity is a good sign of financial strength, and it allows you to take
advantage of opportunities that might arise unexpectedly.
Liquidity ensures that you are able to meet your financial obligations on time, which is a very
important business ethic, and has a direct impact on your creditworthiness and market standing.
The liquidity of an asset refers to how quickly the concerned asset can be sold to fetch a
reasonable price in the market.
The liquidity of an asset depends upon the conditions prevailing in the market, and the
demand/supply for the asset.
A booming market will have high demand, whereas in a recessionary period, demand drops even
for some necessities.
A commonly available item will not command a big premium, nor a big discount. But a rare item
may command a premium; conversely, there may not be many buyers for the same at times.
Liquidity includes both the ability to turn an asset into cash and to do so without being required to
significantly reduce the price below its current level.
5.2 Liquidity risk
Refers to the inability to meet financial commitments due to liquidity constraints. It may also refer to
the inability to liquidate an investment to meet the same commitments. Liquidity risk has to be seen
in conjunction with many other factors such as opportunity cost and the disadvantages or
consequences of defaulting on commitments.
Opportunity cost is the cost of the opportunity lost by choosing one option against another.
For example, if you are expecting to gain Rs. 1,00,000 by choosing one investment, but you do not
have the capital to undertake the investment. To raise the capital required, if you sell another
investment at a loss of Rs. 50,000 the net gain would be only Rs. 50,000. You have to analyze
whether it is worth the trouble of going through all this effort for the return likely.
Liquidity risk may also refer to the scenario when your investments (shares, bonds) in a certain
company may become unsaleable due to the impact of negative news or sentiments concerning
that particular company. It may also happen due to a downgrade in the credit rating of the company.
The price of a companys shares or bonds might fall due to a downgrade in the credit rating.
Consequently, there might not be enough buyers for the securities in the market, or the buyers
might demand much lower prices as compensation for the risk premium.

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Chapter 6
Interest
Interest: Interest is the rent that is paid for using borrowed money.
6.1 Simple Interest
The amount of Simple Interest paid each year is a fixed percentage of the Principal Amount only.
The rate of interest is applied ONLY to the initial Principal, even in the subsequent years.
Simple Interest (I) = Principal (P) x Rate of Interest per Period (R) x Number of Periods (N).
I = P x R x N (if R is expressed as a fraction)
I = P x R x N (if R is %)
100
Amount = Principal + Interest
In practice, Simple Interest is rarely used for deposits held for more than one year.
6.2 Compound Interest
The interest rate is applied to the original Principal AND any interest accrued on the Principal (and
not withdrawn). Thus, the Principal with the Accrued Interest for the first Period together become
the Principal for the next Period, and the interest is calculated on this higher base.
A = P [1+(R/100)]
N

For example, if Rs. 1,00,000 is left on deposit to earn a rate = 6% compounded annually, at the end
three years, the deposit will be worth:
A = 1,00,000 x [1+(6/100)]
3
= 1,19,101.60
As before, the Rate of Interest is usually per annum, and the periods are years. If the frequency of
Compounding is higher, i.e., if interest is calculated and compounded for shorter time periods, then
the formula becomes:
A = P [1+(R/t x 100)]
(Nxt)

For semi-annual compounding, t will take a value of 2, for quarterly compounding t will take a value
of 4, and so on.
Compounding the above example on a monthly basis, we will get:
A = 1,00,000 x [1+(6/12 x 1/100)]
(3 x 12)
= 1,19,668.05
All other things being equal, compound interest has a larger effect as the time period increases and
as the interest rate increases.
A higher frequency of compounding (t) results in the interest being calculated more frequently. The
limiting case of this is called continuous compounding where interest is credited on a continuous
basis.

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The distinction is like the difference between getting water from a hand pump and getting water
from a faucet. With the hand pump, the water flow is broken. With the faucet, it is continuous. The
faucet does not necessarily deliver water any faster than the pump. It just delivers it continuously.
With continuous compounding, at any time t, the value of a deposit is given by
A = P x e
(R x t)
Were R is the continuously compounded interest rate and e =2.71828183
For example, if Rs. 1,00,000 is left on deposit to earn a rate = 6% continuously compounded
interest, at the end three years, the deposit will be worth
A = 1,00,000 x e
(6/100) x 3
= 1,19,721.74
Interest is rarely compounded continuously in practice. Continuous compounding is more of a
theoretical notion. It is used frequently in theoretical finance because it simplifies many calculations.
A Comparison of the final amounts using different methods of calculation of interest is given below:
Method of
Calculation Simple Interest
Compounded
Annually
Compounded
Monthly
Continuously
Compounded
Amount (Rs.) 1,18,000.00 1,19,101.60 1,19,668.05 1,19,721.74

Problem: Calculate the Simple Interest and Compound Interest for the following scenario:
Principal: Rs. 3,75,000
Rate of Interest: 7.25% per annum.
Period: 5 years.
For compound interest calculations, calculate for monthly, quarterly and half-yearly compounding.

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Chapter 7
Time Value of Money
Time Value of money: Money has value. The time at which it is received or paid also adds or detracts
from its value, as the case may be. Money also has opportunity cost associated with it. An amount of
money today is more valuable than the same amount of money at a future date. The relationship between
the values of money at different points in time can be found using Time Value of Money calculations.
7.1 Future Value
This is simply the amount to which a sum of money invested today will grow at a given rate of
appreciation. Future value is the same as compounding, and the formula is:
FV = PV (1+r)
n

Here, r is the rate at which the initial amount appreciates and n is the period in years.
Future Value is very similar to Compound Interest that we have looked at earlier.
Consider a sum of Rs. 2,00,000 which is invested to earn a rate of 11% per annum for 5 years. The
FV (at the end of five years) in this case would work out to be
FV = 2,00,000*(1+0.11)^5
FV = Rs.3,37,011.63
7.2 Present Value
This is the value today, assigned to an amount of money due at a date in future. This is done by
using estimates of the rate of return over the concerned period.
If future value is compounding, present value is discounting, or exactly the reverse. The above
formula is used to calculate the present value as:
PV = FV/(1+r)
n

If we try and discount the above FV using the same discount factors, the PV (today) of Rs.
3,37,011.63 five years hence at 11% per annum would be:
PV = 3,37,011.63 / (1+0.11)^5
PV = Rs. 2,00,000.00
7.3 Annuity
Annuities are a series of fixed amounts (paid or received) at a specified frequency over the course
of a fixed period of time. The most common payment frequencies are yearly (once a year), semi-
annually (twice a year), quarterly (four times a year) and monthly (once a month). There are two
basic types of annuities: ordinary annuities and annuities due. Annuities are used in insurance
policies, pension schemes, recurring deposits, etc.

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7.3.1 Ordinary annuity
Payments are made (or received) at the end of each period. For example, straight bonds usually
pay coupon payments at the end of every six months until the bond's maturity date.
For an ordinary annuity, the PV (which is the sum of the PVs of each installment of the annuity
taken separately) is calculated as:
PV = P*[{1-(1+r)
-n
}/r]
Where P is each installment, r is the rate of appreciation and n is the number of installments to be
paid (or received).
Lets try and find out the PV of an ordinary annuity.
Frequency = yearly
Installment = Rs. 1,000
Term = 5 years
Interest rate = 6%
PV = 1,000*[{1-(1+0.06)^-5}/0.06]
PV = 1000*(0.25274/0.06)
PV = Rs. 4,212.33
What this means is that instead of paying (or receiving) the sum of Rs. 1,000 at the end of every
year for five years, one can pay (or receive) an amount of Rs. 4,212.33 today, if the prevailing rate
of interest is 6% per annum.
For an ordinary annuity, the FV is calculated as:
FV = P*[{(1+r)
n
1}/r]
If we try to calculate the FV for the above annuity, we get:
FV = 1,000*[{(1+0.06)^5 1}/0.06]
FV = 1,000*(0.33823/0.06)
FV = 5,637.09
This means that a sum of Rs. 1,000 paid (or received) at the end of every year for five years will
accumulate to Rs. 5,637.09 at the end of five years, if the prevailing rate of interest is 6% per
annum.
7.3.2 Annuity Due
Payments are made (or received) at the beginning of each period. Rent is an example of annuity
due. You are usually required to pay rent when you first move in at the beginning of the month, and
then on the first of each month thereafter.
The formulae for the PV and FV of an annuity due are slightly different. Any handbook on Financial
Management can be referred to for the same.

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7.4 Net Present Value (NPV)
The NPV of a project is the arithmetic sum of the present values of all cash flows associated with
that project. Here, outflows are taken as negative and inflows are taken as positive.
The discount rate used for present valuing the cash flows is generally a reflection of the prevailing
interest rates as well as the risks associated with the project.
NPV is used to evaluate projects and projects having a higher NPV are preferred over those having
a lower NPV. Projects with negative NPV are generally not thought to be viable.
Formulae and examples have been dealt with in detail elsewhere in this program, and hence are
not reproduced here.
7.5 Internal Rate of Return (IRR)
The IRR of a project is that rate of discounting which makes its NPV equal to zero. IRR is that rate
of discounting at which the NPV of the outflows equals the NPV of the inflows.
IRR is also used to evaluate projects and projects having a higher IRR are preferred over those
having a lower IRR.
Formulae and examples have been dealt with in detail elsewhere in this program, and hence are
not reproduced here.

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Chapter 8
Inflation
8.1 Inflation
Inflation is the rate of increase in the generic price level of all goods and services, which results in a
decrease in the purchasing power of money. (This should not be confused with increases in the
prices of specific goods relative to the prices of other goods.)
Inflation is usually measured as a percentage increase in the consumer price index (CPI) or the
wholesale price index (WPI). This percentage increase is calculated every week, and gives us the
change in the index over that of the previous year. Inflation is measured in percentage per year.
The Wholesale Price Index (WPI) and Consumer Price Index (CPI) are indices made up of a basket
of commodities in a fixed ratio. The composition and weights are generally not known to the public.
8.2 Factors
Inflation is dependent on some factors, and at the same time, it influences those factors too. There
exists a cyclical relationship between interest rates and inflation.
Other factors are rising costs, rising demand, reducing supply, interest rates, changes in monetary
policy, etc.

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Chapter 9
Risk & Returns
9.1 Risk
Risk is the degree of uncertainty regarding the rate of return on and/or the principal value of an
investment. It usually refers to an event having an adverse impact on the returns or profitability from
an investment or project.
A measurable possibility of losing capital (or not gaining value). The chance that invested capital
will drop in value can be caused by many factors including but not restricted to inflation, interest
rates, default, politics, liquidity, call provisions, etc.
9.2 Relationship between Risk and Returns
First is the principle that risk and return are directly related. The greater the risk that an investment
may lose money, the greater its potential for providing a substantial return. By the same rule, the
smaller the risk an investment poses, the smaller the potential return it will provide.
A startup business could become bankrupt, or it could become a blue-chip company. If you invest
in the stock of this company, you could lose everything or make a fortune. In contrast, a blue chip
company is less likely to go bankrupt, but youre also less likely to get rich by buying stock in
company with millions of shareholders.
The second principle is that if you can get a better-than-average return on an investment with less
risk, you may be willing to sacrifice potentially greater return to avoid greater risk. Thats sometimes
the case when interest rates go up. Investors pull their money out of stocks, which are more risky,
and put it in bonds, which are less risky, because theyre not giving up much in the way of potential
return and theyre gaining more safety.
The third principle is that you can balance risk and return in your overall portfolio by making
investments along the spectrum of risk, from the most to the least. Diversifying your portfolio in this
way means that some of your investments have the potential to provide strong returns while others
ensure that part of your principal is secure.
9.3 Types of Risk
There are two basic types of risk are:
Market or Systematic Risk: A risk that influences a large number of assets or investments.
An example is political events. It is virtually impossible to protect yourself against this type of
risk if you are restricted to a single market.
Unique or Specific Risk: It is the risk that affects a very small number of assets or
investments, or is specific to a particular asset or investment. An example is news that affects
a specific stock such as a sudden strike by employees.
Diversification is the only way to protect your investments from unsystematic risk.

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9.4 Specific types of risk in connection with investments
Operational Risk: Operational risk is defined as the risk of loss resulting from inadequate or
failed internal processes, people and systems, or from external events.
Operational risk includes legal risk, but excludes strategic risk: i.e. the risk of a loss arising
from a poor strategic business decision. It also excludes reputational risk (damage to an
organization through loss of its reputation or standing).
Non-operational Risk: Non-operational risk would refer to all other risks such as credit (or
default) risk, market risk, liquidity risk, country risk (may be political or currency risk),
catastrophe risk, interest rate risk, etc.
9.4.1 Types of Non operational risks
Credit or Default Risk: This is the risk that a company or individual will be unable to pay the
contractual interest or principal on its debt obligations. This type of risk is of particular concern
to investors who hold bond's within their portfolio. Government bonds, especially those issued
by the Federal government, have the least amount of default risk and least amount of returns
while corporate bonds tend to have the highest amount of default risk but also the higher
interest rates. Bonds with lower chances of default are considered to be investment grade,
and bonds with higher chances of default are considered to be junk bonds. Bond rating
services, such as Moody's, allows investors to determine which bonds are investment-grade,
and which bonds are junk.
Country Risk: This refers to the risk that a country won't be able to honor its financial
commitments. When a country defaults it can harm the performance of all other financial
instruments in that country as well as other countries it has relations with. Country risk applies
to stocks, bonds, mutual funds, options and futures that are issued within a particular country.
This type of risk is most often seen in emerging markets or countries that have a severe deficit.
Foreign Exchange or Currency Risk: When investing in foreign countries you must
consider the fact that currency exchange rates can change the price of the asset as well.
Foreign exchange risk applies to all financial instruments that are in a currency other than your
domestic currency. As an example, if you are a resident of America and invest in some
Canadian stock in Canadian dollars, even if the share value appreciates, you may lose money
if the Canadian dollar depreciates in relation to the American dollar.
Interest Rate Risk: A rise in interest rates during the term of your debt securities hurts the
performance of stocks and bonds.
Political Risk: This represents the financial risk that a country's government will suddenly
change its policies. This is a major reason that second and third world countries lack foreign
investment.
Market Risk: This is the most familiar of all risks. It's the day to day fluctuations in a stocks
price. It is also referred to as volatility. Market risk applies mainly to stocks and options. As a
whole, stocks tend to perform well during a bull market and poorly during a bear market
volatility is not so much a cause but an effect of certain market forces. Volatility is a measure of
risk because it refers to the behavior, or temperament, of your investment rather than the
reason for this behavior. Because market movement is the reason why people can make
money from stocks, volatility is essential for returns, and the more unstable the investment the
more chance it can go dramatically either way.

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Chapter 10
Financial Planning
10.1 Financial Planning
Financial Planning is the organization of financial affairs so as to achieve specific goals or
objectives, keeping in mind the age, risk and returns profile etc. For an individual, it is the process
of process of meeting his (or her) lifes goals through the proper management of finances. These
can include buying a home, saving for childs education, marriages, planning for retirement or
estate planning, as well as unexpected emergencies.
10.2 Steps in Financial Planning
Budgeting, saving, investing, reviewing, retirement allocation, insurance allocation, contingency
planning and taxes.
Some steps for financial planning:
Set measurable goals.
Understand the effect your financial decisions have on other financial issues.
Re-evaluate your financial plan periodically.
Start now dont assume financial planning is for when you get older.
Start with what youve got dont assume financial planning is only for the wealthy.
Take charge you are in control of the financial planning process.
Look at the big picture financial planning is more than just retirement planning or tax-planning.
Dont confuse financial planning with investing.
Dont expect unrealistic returns on investments.
Dont wait until a money crisis to begin financial planning.

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Case Study: Consider a young man who wants to plan his finances:
Married, spouse working, no children.
Combined earnings Rs. 45,000 per month
Expenses Rs. 25,000 per month (including compulsory savings)
Savings Rs. 20,000 per month
How to plan for the future? Age: 27 years.
Income growth > Expense growth
Retire at 55 years.

How would you plan?
There is no fixed solution here; no right solution and no wrong solution either. What can be done is:
Net investible amount is Rs. 2,40,000 per annum.
65% can be invested in equities, either directly, or through SIP in a mutual fund. Break-up of
50% in medium-term assets and 15% in long-term assets (retirement planning)
He can go in for a high risk sectoral fund or an index fund (for the 50%) and a blue-chip equity
fund (for the balance 15%)
20% can be deployed towards life insurance, either a unit-linked plan or a whole-life plan which
offers maximum term coverage along with good returns and tax benefits.
The balance 15% can be put in a bank, on short term deposit, renewed fortnightly, or else put
in a liquid fund. This will take care of liquidity and emergencies, if any.
This can be continued for the next 2 to 3 years, and reviewed.

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Chapter 11
Insurance
11.1 What is Insurance?
Insurance is a form of risk management primarily used to hedge against the risk of potential loss.
It is defined as the equitable transfer of the risk of a potential loss, from one entity to another, in
exchange for a reasonable fee and duty of care.
11.2 Principles of insurance
The timing or occurrence of the loss must be uncertain.
The rate of losses must be relatively predictable: In order to set premiums (charges) insurers
must be able to estimate them accurately. If the coverage is unique, the insured will pay a
correspondingly higher premium.
The losses must be predictable on a macro level: Insurers need to know how much they would
be required to pay when the insured-for event occurs. Most types of insurance have maximum
levels of payouts, but not all do, notably health insurance.
The loss must be significant.
The loss must not be catastrophic: If the insurer is insolvent, it will be unable to pay the insured.
Indemnification
An entity seeking to transfer risk (an individual, corporation, or association of any type) becomes
the 'insured' party once risk is assumed by an 'insurer', the insuring party, by means of a contract,
defined as an insurance 'policy'.
This legal contract sets out terms and conditions specifying the amount of coverage
(compensation) to be rendered to the insured, by the insurer upon assumption of risk, in the event
of a loss, and all the specific perils covered against (indemnified), for the term of the contract.
When insured parties experience a loss for a specified peril, the coverage entitles the policyholder
to make a 'claim' against the insurer for the amount of loss as specified by the policy contract.
The fee paid by the insured to the insurer for assuming the risk is called the 'premium'.
Insurance premiums from many clients are used to fund accounts set aside for later payment of
claims - in theory for a relatively few claimants - and for overhead costs. So long as an insurer
maintains adequate funds set aside for anticipated losses, the remaining margin becomes their
profit.

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11.3 Types of insurances available worldwide:
Any risk that can be quantified probably has a type of insurance to protect it. Among the different
types of insurance are:
Automobile Insurance: may cover both legal liability claims against the driver and loss of or
damage to the vehicle itself.
Casualty Insurance insures against accidents, not necessarily tied to any specific property.
Credit Insurance pays some or all of a loan back when certain things happen to the borrower
such as unemployment, disability, or death.
Financial loss Insurance protects individuals and companies against various financial risks.
For example, a business might purchase cover to protect it from loss of sales if a fire in a
factory prevented it from carrying out its business for a time. Insurance might also cover failure
of a creditor to pay money it owes to the insured.
Health Insurance covers medical bills incurred because of sickness or accidents.
Liability Insurance covers legal claims against the insured. For example, a housing insurance
policy provides the insured with protection in the event of a claim brought by someone who
slips and falls on the property, and brings a lawsuit for her injuries. Similarly, a doctor may
purchase liability insurance to cover any legal claims against him if his negligence
(carelessness) in treating a patient caused the patient injury and/or monetary harm. The
protection offered by a liability insurance policy is two-fold: a legal defense in the event of a
lawsuit commenced against the policyholder, plus indemnification (payment on behalf of the
insured) with respect to a settlement or court verdict.
Life Insurance provides a cash benefit to a decedent's family or other designated beneficiary,
and may specifically provide for burial and other final expenses.
How it works: The investible part of the contribution grows to a corpus which is usually
returned with all accrued bonuses to the person insured on maturity.
The risk cover portion ensures that the nominees of the insured person get the full value of the
insurance sum assured in the case of unforeseen occurrences.
It is possible to have adequate life insurance at an affordable rate if one starts early in life.
Annuities provide a stream of payments and are generally classified as insurance because
they are issued by insurance companies and regulated as insurance. Annuities and pensions
that pay a benefit for life are sometimes regarded as insurance against the possibility that a
retiree will outlive his or her financial resources. In that sense, they are the complement of life
insurance.
Total Permanent Disability Insurance provides benefits when a person is permanently
disabled and can no longer work in their profession, often taken as an adjunct to life insurance.
Locked Funds Insurance is a little known hybrid insurance policy jointly issued by
governments and banks. It is used to protect public funds from tamper by unauthorized parties.
Marine Insurance covers the loss or damage of goods at sea. Marine insurance typically
compensates the owner of merchandise for losses sustained from fire, shipwreck, etc., but
excludes losses that can be recovered from the carrier.
Nuclear Incident Insurance: covers against damages resulting from an incident involving
radioactive materials is generally arranged at the national level.

29
Political Risk Insurance can be taken out by businesses with operations in countries in which
there is a risk that revolution or other political conditions will result in a loss.
Professional Indemnity Insurance is normally a mandatory requirement for professional
practitioners such as Architects, Lawyers, Doctors and Accountants to provide insurance cover
against potential negligence claims. Non licensed professionals may also purchase malpractice
insurance; it is commonly called Errors and Omissions Insurance and covers a service provider
for claims made against them that arise out of the performance of specified professional
services. For instance, a web site designer can obtain E&O insurance to cover them for certain
claims made by third parties that arise out of negligent performance of web site development
services.
Property Insurance provides protection against risks to property, such as fire, theft or weather
damage. This includes specialized forms of insurance such as fire insurance, flood insurance,
earthquake insurance, home insurance, inland marine insurance or boiler insurance.
Terrorism Insurance: as the name suggests, provides for loss of business or property in
incidents occurring from terrorism.
Title Insurance provides a guarantee that title to real property is vested in the purchaser
and/or mortgagee, free and clear of liens or encumbrances. It is usually issued in conjunction
with a search of the public records done at the time of a real estate transaction.
Travel Insurance is an insurance cover taken by those who travel abroad, which covers
certain losses such as medical expenses and theft.
Workers' Compensation Insurance replaces all or part of a worker's wages lost and
accompanying medical expense incurred due to a job-related injury.

11.4 Classification of Insurance Companies
Insurance companies may be classified as
Life insurance companies: who sell life insurance, annuities and pension products.
Non-life or general insurance companies: who sell other types of insurance.
The distinction between the two types of company is that life business is very long term in
nature coverage for life assurance or a pension can cover risks over many decades. By
contrast, non-life insurance cover usually covers a shorter period, such as one year.
Reinsurance companies are insurance companies that sell policies to other insurance
companies, allowing them to reduce their risks and protect themselves from very large losses.
The reinsurance market is dominated by a few very large companies, with huge reserves.

Co r p o r a t e F i n a n c e
M o d u l e - 2

33
Corporate Finance Module 2
TABLE OF CONTENTS

1. FORMS OF BUSINESS ENTERPRISE 1
1.1. Sole Proprietorship ..
1.2. Partnership ....
1.3. Private Limited Company
1.4. Public Limited Company .
1.5. Co-operative Society
2. RAISING FINANCIAL RESOURCES ..
2.1. Equity Capital ...
2.1.1 Companys Perspective
2.1.2 Shareholders Perspective
2.1.3 Raising Equity Capital ...
2.2. Preference Shares .....................
2.2.1 Types of Preference Shares ...................
2.3. Debenture Capital ...................
2.3.2 Investors Perspective
2.4. Term Loan .....
2.5. External Commercial Borrowing (ECB) .
2.6. Internal Sources of Finance ......................
2.6.1 Working Capital Management..
3. CAPITAL STRUCTURE
3.1. Introduction
3.2. Capital Structure Impact ..
3.3. Factory Affecting Capital Structure
4. COST OF CAPITAL ...
4.1. Introduction
4.2. Weighted Average Cost of Capital (WACC)
4.3. Calculating WACC ...
5. CAPITAL BUDGETING .
5.1. Introduction
5.2. Methods ....................
5.2.1 Net Present Value ..
5.2.2 Internal Rate of Return (IRR) ...
5.2.3 Payback Period ..

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Chapter 1
Forms of Business Enterprises
The financial decision of a firm is influenced by legal form of its organization, the regulatory framework
governing it and the tax law applicable to it. Hence it is very important for us to know and understand
different forms of Business
Following are the important forms of business organizations
Sole Proprietorship
Partnership
Private Limited Company
Public Limited Company
Cooperative Society
1.1 Sole Proprietorship
A sole proprietorship is a business that is owned by one individual. It is the simplest form of
business organisation to start and maintain. The business has no separate status apart from the
owner. Owner undertakes the risks of the business for all assets owned, whether used in the
business or personally owned. He realises all the profits, bears all the losses and incur all the
Liabilities of the business. Income earned by sole proprietorship is taxable under personal income
tax. There is no separate firm tax.
1.2 Partnership
A partnership firm is business firm owned by two or more persons who agreed to share profits of
the business. There must be an agreement entered in to orally or in writing by persons desire
specifying capital contribution, profit sharing, rights, duties and liabilities to form a partnership. The
business must be carried on by all the partners or by any of them acting for all of them. As
partnership firm involve two or more people can benefit from expertise of the partners, but the life of
partnership firm is rather limited as Withdrawal, conflict or death of any of the partners may result in
dissolution of the partnership firm.
The Partnership Act does not put any restrictions on maximum number of partners. However,
section 11 of Companies Act prohibits partnership consisting of more than 20 members, unless it is
registered as a company.
1.3 Private Limited Company
A private Limited company can be formed with minimum of two and Maximum of fifty people
subscribing to its share capital. Shares of Private limited company are not freely transferable.
1.4 Public Limited Company
A Public Limited Company is a corporate body that has a Minimum of seven share holders and
does not limit the number of share holders. It issues securities through IPO and which are traded at
the exchange. Ownership of the company represented by equity shares is easily transferable. All

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Public Limited companies need to make disclosure of accounting, financial and other important
information.
1. 5 Cooperative Society
A cooperative Society may be defined as a Society which has its objective the promotion of
economic interests of its members in accordance with cooperative principles. While there is no
maximum limit for membership a minimum of ten members are required to form a Cooperative
society. Member of a cooperative society have right of only one vote, irrespective of the number of
shares held of any denomination.
1.6 Features of a Corporate Body
Corporate form of business organisation (whether it is a Private company or a Public Company)
has following salient features
Distinct Legal Entity: A company is a distinct legal entity separate from its owners.
It can Own assets, incur liability, enter in to contract, sue and can be sued by others.
As company is a separate legal entity there is always a distinction between company and its
owners.
Limited Liability: Unlike in a partnership or sole proprietorship, members of a corporation hold
no liability for the corporation's debts and obligations, As a result their "limited" potential losses
cannot exceed the amount which they contributed to the corporation as dues or paid for shares
Perpetual Lifetime. The assets and structure of the corporation exist beyond the lifetime of any
of its members or agents.

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Chapter 2
Raising Financial Resources

Companies require funds for two important reasons. To invest in capital assets this also referred as
capital investment and to manage working capital finance.
Capital investment require generally require large funds and benefit of capital investment is enjoyed over
longer period of time. Investment bank executing the ambitious plan of computerization of its operations
or a commercial bank setting up a retail branches are some of the examples.
To meet the day to day fund requirement for expenses like salaries, wages, raw material etc this is
termed as working capital finance, generally short term in nature.
Sources of Long term funds
Equity Capital
Preference Capital
Internal Sources of Finance
Debenture Capital
Term Loan
External Commercial Borrowing

2.1 Equity Capital
2.1.1 Company's Perspective
Equity capital represents ownership capital as equity share holders collectively own the company.
Equity capital is permanent in nature. As long as company continues to be in existence company
need not repay capital to its equity share holders, hence no liability for repayment.
It also does not involve any fixed obligation for repayment of dividend. Equity share holders are
entitled to dividend that is declared by the board of directors. Dividend decision is the prerogative of
the board of directors and equity share holders cannot challenge their decision.
Cost of equity capital is high, usually the highest. The rate of return required by equity share
holders is generally higher than rate of return required by other investors.
Issuance of additional equity shares may lead to dilution of management control as every new
share holder will have voting rights proportion to number of shares issued to the new share holder.
2.1.2 Equity Capital - Shareholder's Perspective
Equity share holders as owners of the company elect the board of directors of the company and
have the right to vote on every resolution placed before the company. Board of directors in turn,
selects the management which controls the operations of the firm.

38
The liability of equity share holders is limited to the extent of their capital contributions. In the event
of liquidation they can loose only to the extent of share capital contributed by them.
As equity share investors have residual claim to the income of the firm, income left after satisfying
the claims of all other investors belong to the equity share holders. They can expect returns in
terms of dividend income and capital gains, which can be very high.
But equity share holders also face the risk of not only zero return on their investment but also
capital loss.
Equity shares are traded at the stock exchange hence can be bought or sold at the exchange they
are comparatively very liquid.
2.1.3 Raising Equity Capital
Initial Public Offer (IPO) is a most important way of raising equity capital. This is the first sale of
stock by a company to the public. Both institutional investors and retail investors can
participate in IPO.
Private placements This involves selling securities to small group of investors. Less regulated
as no public offering is involved hence easier to raise funds.
Rights Issue This is a method of raising further funds from existing share / debenture holders

Companies can access global capital Markets through issue of GDR, ADR
American Depository Receipt (ADR) American Depository Receipt is a Negotiable certificate
issued by US bank which represents specified number of shares of an underlying company.
ADRs listed in a American stock exchange.
Global depository Receipt (GDR) - Global Depository Receipt is a Negotiable certificate issued
by an international bank which represents specified number of shares of an underlying
company. GDRs listed in a American or European stock exchange
Foreign Currency Convertible Bonds Issued to foreign investors in foreign currency and
convertible into ordinary shares of the issuing company in any manner, either in whole, or in
part, on the basis of any equity related warrants attached to debt instruments
2.2 Preference Capital
It represents hybrid form of financing with some features of equity and some attributes of debenture.
It resembles equity in the following ways. Preference dividend is payable only out of distributable
profits and it is not a tax deductible expense and like debenture rate of dividend is fixed and no
voting rights to preference share holders under normal circumstances.
2.2.1 Types of preference shares
Cumulative Preference Shares: Preference shares may be cumulative or Non-cumulative with
respect to dividends. Unpaid dividend on cumulative preference shares are carried forward and
payable when the dividend is resumed.
Perpetual preference shares: A perpetual preference shares has no maturity period.
Where as Redeemable Preference Shares has a limited life after which it is suppose to be
retired. Most preference issues are redeemable.

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Callable preference shares: The terms of preference shares may contain a call feature by
which issuing company enjoys the right to call the preference shares, wholly or partly at a
certain price.
Convertible Preference Shares: Preference shares may some times be convertible in to equity
shares. The holders of convertible preference shares enjoy the option of converting preference
shares in to equity shares at a predetermined ratio.
Participating Preference Shares: Preference shares which entitle preference share holders to
participate in surplus profits and residual assets in the event of liquidation according to a
specific formula are called Participating Preference Shares.
Example
Raj buys 10,000 equity shares of XYZ co at Rs. 200 also buys 5,000 pref shares at Rs.101 on
01-Jan-2005.He sells equity shares on 31-dec-2005 at Rs.250. Brokerage paid is 1% each.
XYZ co has issued 1000000 equity shares @ FV of Rs.10 and 10000Pref shares @ FV of Rs.100
What is his voting rights as on 30-jun-2005? What is his return on Investment?
Solution.
As preference shares under normal circumstances not eligible for voting rights,
We calculate voting rights only on the basis of his equity shares holding as on 30-jun-2005
Raj has 10,000 shares as on 30
th
June he has 1% voting rights. (10000/1000000)

Solution.
To calculate return,
Cost of Acquisition of shares is 10000 x 200 = 2000000 + brokerage 20000(2000000 x.01) =
2020000
Sale proceeds = 10000 x 250 = 2500000 brokerage25000 - 2475000
Profit = 455000.
Return = 22.52%

2.3 Debenture capital
Debentures are instruments for raising long term debt capital. Debenture holders are creditors of
the company. Company has an obligation to pay the interest and principal at specified times.
Cost of debt capital represented by debenture capital is lower than the cost of preference or equity
capital. Interest on debenture is also tax deductible and hence effective post tax cost of debenture
is lower. As Debenture holders are not entitled to vote debenture financing does not result in
dilution of control.
Fixed monitory burden associated with debenture financing irrespective of changes in price level
has appeal to many companies.

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2.3.2 Investor's Perspective
Debenture holders earn stable rate of return to a larger extent even if there is a fluctuation in
companys profits. Debenture holders have higher order of priority over equity share holders in the
event of Liquidation .Interest on debenture is fully taxable and debenture share holders do not carry
right to vote.
2.4 Term Loans
Represents source of debt finance which is generally repayable in more than one year.
Term loans are generally employed to finance acquisition of fixed assets and working capital
margin. Interest on term loan is definite obligation that is payable irrespective of the financial
situation of the firm.
2.5 External Commercial Borrowing
ECBs occupy a very important position as a source of funds for Corporate.
ECBs include
Commercial bank loans;
Buyer's credit
Supplier's credit
Securitised instruments (Floating Rates Notes and Fixed Rate Bonds).
Credit from official export credit agencies.
Borrowings from Multilateral Financial Institutions such as International Finance Corporation,
ADB, AFIC, CDC. Etc
As repayment needs to be done in borrowed currency exchange rate risk exists for all the ECBs.
2.6 Internal Sources of Finance
Internal sources are often preferable to a firm as they will usually be cheaper and perhaps easier to
arrange.
Depreciation charges and retained earning represents internal sources of finance.
Although depreciation charges are debited from profit and loss account it does not represent actual
cash out flow. Retained earning represents part of profits which are not distributed as dividend and
which remains with the corporate is used to fund expansion plans.
Working Capital Finance
Equity: New businesses rely on equity funds for short-term working capital needs.
Trade Credit :A company's open account arrangements with its vendor

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Factoring: Factoring is another resource for short-term working capital financing. Once you
have filled an order, a factoring company buys your account receivable and then handles the
collection.
Line of Credit: A line of credit allows you to borrow funds for short-term needs when they arise.
The funds are repaid once you collect the accounts receivable that resulted from the short-term
sales peak.
Commercial Paper: An unsecured, short-term debt instrument issued by a corporation,
typically for the financing of accounts receivable, inventories and meeting short-term liabilities
Letter of Credit :A letter from a bank guaranteeing that a buyer's payment to a seller will be
received on time and for the correct amount
2.6.1 Working Capital Management
Working capital management involves the relationship between a firm's short-term assets and its
short-term liabilities
It ensures 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.
The management of working capital involves managing inventories, accounts receivable and
payable, and cash
In the management of working capital two important characteristics of current assets must be borne
in mind. 1. Short Life span 2. Swift transformation into other forms of asset.
Each current asset is swiftly transformed in to other asset forms within a short period of time. Cash
is used for acquiring raw materials, raw materials through various stages of work in progress
converted in to finished goods. When finished goods are sold on credit are converted in to accounts
receivables and finally accounts receivables on realisation generate cash.
Cash flows in a cycle into, around and out of a business. It is the business's life blood and every
manager's primary task is to help keep it flowing and to use the cashflow to generate profits. If a
business is operating profitably, then it should, in theory, generate cash surpluses. If it doesn't
generate surpluses, the business will eventually run out of cash and expire
The faster a business expands, the more cash it will need for working capital and investment. The
cheapest and best sources of cash exist as working capital right within business. Good
management of working capital will generate cash will help improve profits and reduce risks. Bear
in mind that the cost of providing credit to customers and holding stocks can represent a substantial
proportion of a firm's total profits.
There are two elements in the business cycle that absorb cash - Inventory (stocks and work-in-
progress) and Receivables (debtors owing you money). The main sources of cash are Payables
(your creditors) and Equity and Loans.
Each component of working capital (namely inventory, receivables and payables) has two
dimensions ........ TIME ......... and MONEY. When it comes to managing working capital - TIME IS
MONEY. If you can get money to move faster around the cycle (e.g. collect monies due from
debtors more quickly) or reduce the amount of money tied up (e.g. reduce inventory levels relative
to sales), the business will generate more cash or it will need to borrow less money to fund
working capital. As a consequence, you could reduce the cost of bank interest or you'll
have additional free money available to support additional sales growth or investment.

42
Similarly, if you can negotiate improved terms with suppliers e.g. get longer credit or an
increased credit limit, you effectively create free finance to help fund future sales.

If you ....... Then ......
Collect receivables (debtors)
faster
You release cash from
the cycle
Collect receivables (debtors)
slower
Your receivables soak
up cash
Get better credit (in terms of
duration or amount) from
suppliers
You increase your
cash resources
Shift inventory (stocks) faster You free up cash
Move inventory (stocks) slower You consume more
cash

It can be tempting to pay cash, if available, for fixed assets e.g. computers, plant, vehicles etc. If
you do pay cash, remember that this is now longer available for working capital. Therefore, if cash
is tight, consider other ways of financing capital investment - loans, equity, leasing etc. Similarly, if
you pay dividends or increase drawings, these are cash outflows and, like water flowing down a
plug hole, they remove liquidity from the business
Following are the important terms of Payment
Cash Terms

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Open Account
Consignment
Draft
Letter of Credit
Cash Terms: When goods are sold on cash terms the payment is received either before the
goods are shipped or when the goods are delivered.
Open Account: This happens when the seller first ships the goods and then sends the invoice.
Credit terms are stated in the invoice which is acknowledged by the buyer.
Consignment: The consignment means the transfer of possession of merchandise from the
owner to another person who sells it as the sales agent of the owner
Draft: A draft represents an unconditional order issued by the seller asking the buyer to pay on
demand (demand draft) or at a certain future date (Time draft)
Letter of Credit (L C): A letter of credit is issued by a bank on behalf of its customer (buyer)
to the seller. As per this document bank agrees to honour draft drawn on it for the supplies
made to the customer if the seller fulfills the condition laid down in LC.
LC virtually eliminates credit risk, if the bank has a good standing. It reduces uncertainty as the
seller knows the conditions that should be fulfilled to receive payment. It also offers safety to
the buyer who wants to ensure that payment is made only in conformity with the conditions of
LC

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Chapter 3
Capital Structure

3.1 Introduction
A firm can finance operations through common and preferred stock, with retained earnings, or with
debt. Usually a firm will use a combination of these financing instruments.
The proportion of short and long-term debt is considered when analyzing capital structure. And,
when people refer to capital structure they are most likely referring to a firm's debt-to-equity ratio,
which provides insight into how risky a company is. Usually a company more heavily financed by
debt poses greater risk.
Capital structure explains the proportion of equity and debt capital. Since, the objective of financial
management is to maximize the shareholder wealth, the proportion of the debt and equity capital in
the capital structure is decided accordingly. The key issue in the capital structure decision is: what
is the relationship between capital structure and cost of capital? Since, the value of a firm is
maximized when the cost of capital is minimized and vice versa.
3.2 Capital Structure - Impact
The following example describes how capital structure impacts the shareholders wealth as the
companys revenue change.
Company A with 1,000,000 equity capital of Rs. 10/- each
Company B with 500,000 equity capital of Rs. 10/- each and 12% 500,000 debentures of Rs.
10/- each
Tax rates applicable: 50%, both the companies have same earnings
Company A Company B
PBIT 1,000,000 1,200,000 1,000,000 1,200,000
Interest Nil Nil 600,000 600,000
PBT 1,000,000 1,200,000 400,000 600,000
Tax 500,000 600,000 200,000 300,000
PAT 500,000 600,000 200,000 300,000
EPS 0.5 0.6 0.4 0.6

Company A Company B
PBIT 3,000,000 4,000,000 3,000,000 4,000,000
Interest Nil Nil 600,000 600,000
PBT 3,000,000 4,000,000 2,400,000 3,400,000
Tax 1,500,000 2,000,000 1,200,000 1,700,000
PAT 1,500,000 2,000,000 1,200,000 1,700,000
EPS 1.5 2 2.4 3.4

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The capital structure concerns the proportion of capital that is obtained through debt and equity.
There are tradeoffs involved: using debt capital increases the risk associated with the firm's
earnings, which tends to decrease the firm's stock prices. At the same time, however, debt can lead
to a higher expected rate of return, which tends to increase a firm's stock price. "The optimal capital
structure is the one that strikes a balance between risk and return and thereby maximizes the price
of the stock and simultaneously minimizes the cost of capital."
3.3 Factory Affecting Capital Structure
Capital structure decisions depend upon several factors. One is the firm's business riskthe risk
pertaining to the line of business in which the company is involved. Firms in risky industries, such
as high technology, have lower optimal debt levels than other firms. Another factor in determining
capital structure involves a firm's tax position. Since the interest paid on debt is tax deductible,
using debt tends to be more advantageous for companies that are subject to a high tax rate and are
not able to shelter much of their income from taxation.
A third important factor is a firm's financial flexibility, or its ability to raise capital under less than
ideal conditions. Companies that are able to maintain a strong balance sheet will generally be able
to obtain funds under more reasonable terms than other companies during an economic downturn.
In general, companies that tend to have stable sales levels, assets that make good collateral for
loans, and a high growth rate can use debt more heavily than other companies. On the other hand,
companies that have conservative management, high profitability, or poor credit ratings may wish to
rely on equity capital instead.

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Chapter 4
Cost of Capital

4.1 Introduction
Cost of capital is the required return necessary to make a capital budgeting project worthwhile,
such as building a new factory. Cost of capital would include the cost of debt and the cost of equity.
The cost of capital for any investment, whether for an entire company or for a project, is the rate of
return capital providers would expect to receive if they would invest their capital elsewhere. In other
words, the cost of capital is an opportunity cost.
The cost of capital determines how a company can raise money (through a stock issue, borrowing,
or a mix of the two). This is the rate of return that a firm would receive if they invested their money
someplace else with similar risk.
"Capital is a necessary factor of production and, like any other factor, it has a cost". In the case of
debt capital, the cost is the interest rate that the firm must pay in order to borrow funds. For equity
capital, the cost is the returns that must be paid to investors in the form of dividends and capital
gains. Since the amount of capital available is often limited, it is allocated among various
businesses on the basis of price.
For a proper analysis of capital expenditure decisions, which are the most important decisions
taken by a company, an estimate of the cost of capital is required. Several other decisions like
leasing, long-term financing, and working capital policy require estimates of cost of capital. In
order to maximize the value of the company, costs of all inputs must be minimized and in this
context the firm should be able to measure the cost of capital.
Companies create value for shareholders by earning a return on the invested capital that is above
the cost of capital.
4.2 Weighted Average Case of Capital (WACC)
WACC (Weighted Average Cost of Capital) is an expression of this cost and is used to see if
certain intended investments or strategies or projects or purchases are worthwhile to undertake.
WACC is expressed as a percentage, like interest. So for example if a company works with a
WACC of 12%, than this means that only (and all) investments should be made that give a return
higher than the WACC of 12%.
4.3 Calculating WACC
The easy part of WACC is the debt part of it. In most cases it is clear how much a company has to
pay their bankers or bondholders for debt finance. More elusive however, is the cost of equity
finance. Normally the cost of equity finance is higher than the cost of debt finance, because the
cost of equity involves a risk premium. Calculating the risk premium is one thing that makes
calculating WACC complicated.
Another important complication is which mix of debt and equity should be used to maximize
shareholder value (This is what Weighted means in WACC).
Finally, the corporate tax is also important, as interest payments are generally tax-deductible.

47
Formula:
WACC = Proportion of Equity * Cost of equity + Proportion of Debt * Cost of debt (1-Tax)
Proportion of Equity is derived from Equity / Total Financing**
Proportion of Debt is derived from Debt / Total Financing
** Total financing consists of sum of the market values of debt and equity finance.
Example: Suppose XYZ company has the following costs and values:
Market value of Debt: Rs. 300,000,000
Market value of Equity: Rs. 400,000,000
Cost of debt: 8%
Cost of equity: 18%
Tax: 35%

WACC = [(400/700) * 18%] + [(300/700) * 8% (1-35%)] = 12.5%

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Chapter 5
Capital Budgeting

5.1 Introduction
Capital budgeting is a process of determining investment in a project / asset that is expected to
produce a cash inflow over a period of time.
5.2 Methods
Popular capital budgeting methods are
Net Present Value (NPV)
Internal Rate of Return (IRR)
Pay back period
5.2.1 Net Present Value:
The Net Present Value (NPV) of an investment (project) is the difference between the sum of the
discounted cash flows which are expected from the investment and the amount which is initially
invested. It is a traditional valuation method for a project used in the Discounted Cash Flow
measurement methodology, whereby the following steps are undertaken:
Calculation of expected fresh cash flows per year that result out of the investment
Subtract / discount for the cost of capital (an interest rate to adjust for time and risk)
Subtract the initial investments
The intermediate result is called: Present value
The end result is NPV
So NPV is an amount that expresses how much value an investment will result in. This is done by
measuring all cash flows over time back towards the current point in present time. If the NPV
method results in a positive amount, the project should be undertaken.
In other words, NPV of a project is equal to the sum of the present values of the all the cash flows
associated with it.
C 0 C1 Cn n C t
NPV = --------- + --------- + + ------- = ---------
(1+r)0 (1+r) (1+r)n t=0 (1+r)t

C = cash flow
n = Life of the project
r = discount rate

49
For Example:
ABC Co invested in a project which has following cash flows. Cost of capital is 12%
Year Cash Flow
0 -100000
1 50000
2 50000
3 40000

NPV = - 100000 50000 150000 200000
--------- + --------- + --------- + ---------- = 11583
(1.12)0 (1.12)1 (1.12)2 (1.12)3

5.2.2 Internal Rate of Return (IRR):
The IRR is the discount rate that results in a net present value of zero for a series of future cash
flows. It is a Discounted Cash Flow approach to valuation and investing just as Net Present Value.
Both IRR and NPV are widely used to decide which investments to undertake and which
investments not to make.
NPV is expressed in monetary units and IRR is expressed as a percentage.
In other words, Internal Rate of Return is the discount rate which makes its Net present value of all
cash flows equal to zero.
IRR can be calculated for the earlier example as follows:
50000 12 50000 40000
100000 = --------- + --------- + ------------ = 19.69%
(1+ r)1 (1+r)2 (1+r)3

5.2.3 Payback Period (PP):
The PP method focuses on recovering the cost of investments. PP represents the amount of time
that it takes for a capital budgeting project to recover its initial cost.
The Costs of Project / Investment
PP = -------------------------------------------
Annual Cash Inflows

Payback period is the length of time required to recover the initial cash outflow.
Example of a Payback Period calculation: Take a project costing a total of Rs. 2,000,000. The
expected returns of the project amount to Rs. 400,000 annually. PP would be 2,000,000 / 400,000
= 5 years

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The problems associated with the Payback Period model:
PP ignores any benefits that occur after the Payback Period, and so does not measure total
incomes.
PP ignores the time value of money.
Payback period holds that all other things being equal the better investment is the one with the
shorter payback.

F i n a n c i a l M a r k e t s &
M a r k e t Pa r t i c i p a n t s I
M o d u l e - 3

53
Financial Markets & Market Participants I - Module 3
TABLE OF CONTENTS

1. INTRODUCTION . 1
1.1. Financial System ..
1.2. Purpose of Financial Markets .
1.3. Various Financial Markets ...
2. CAPITAL MARKETS .
2.1. Primary Market ..
2.1.1. Entities which play a role in Primary Markets
2.2. Secondary Market .
2.2.1. Entities which play a role in Secondary Markets ...
2.3. Stock Market ..
2.3.1. Stages of Secondary Market Trading .........................................
2.4. Debt Market ......................
2.4.1. Instruments ............................................................
2.4.2. Various Issuers ......................................................
2.4.3. Various Investors ...................................................
2.4.4. Trading Markets .....................................................

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Chapter 1
Introduction
1.1 Financial System
Financial system refers to a set of complex and closely connected institutions, agents, practices,
markets, transactions and claims in the economy. The financial system consists of financial
institutions, organized and unorganized financial markets, financial instruments and services which
facilitate transfer of funds. Procedures and practices adopted in the markets and financial inter-
relationships are also parts for system.
The financial system in any economy plays the crucial role in allocating resources to productive
uses. It comprises of four principal constituents Financial Institution, Financial market, Financial
Instruments, Financial services. These all together facilitate the process of transforming the savings
into viable and productive investments. The Securities Market or the Financial Market essentially
comprises of three categories of Participants namely,
Issuers of Securities
Intermediaries
Investors in securities
The issuers and investors are the consumers of services rendered by the intermediaries while the
investors are the one who subscribe and trade in the securities issued by the issuers.
Intermediaries, here again enable smooth flow of trading in securities. In pursuit of providing a
product to meet the investors needs the issuers and intermediaries churn out more and better
complicated products.
In economics, a financial market is a mechanism which allows people to trade, normally governed
by the theory of supply and demand, and thereby allocates resources through a price
mechanism.
It typically involves a bid and ask process.
The term financial markets can be a cause of much confusion.
Financial markets could mean:
Organisations that facilitate the trade in financial products. I.e. Stock exchanges facilitate the
trade in stocks, bonds and warrants.
The coming together of buyers and sellers to trade financial products. I.e. Stocks and shares
are traded between buyers and sellers in a number of ways including: the use of stock
exchanges; directly between buyers and sellers etc.
Financial markets can be domestic or they can be international.
Both general markets (where many commodities are traded) and specialised markets (where only
one commodity is traded) exist. Markets work by placing many interested sellers in one "place",
thus making them easier to find for prospective buyers.

56
Financial markets facilitate:
The raising of capital (in the capital markets);
The transfer of risk (in the derivatives markets); and
International trade (in the currency markets).
They are used to match those who want capital to those who have it.
Typically a borrower issues a receipt to the lender promising to pay back the capital. These receipts
are securities which may be freely bought or sold. In return for lending money to the borrower, the
lender will expect some compensation in the form of interest or dividends
1.2 Purpose of Financial Markets
Without financial markets, borrowers would have difficulty finding lenders themselves.
Intermediaries such as banks help in this process. Banks take deposits from those who have
money to save. They can then lend money from this pool of deposited money to those who seek to
borrow. Banks popularly lend money in the form of loans and mortgages.
More complex transactions than a simple bank deposit require markets where lenders and their
agents can meet borrowers and their agents, and where existing borrowing or lending commitments
can be sold on to other parties.
A good example of a financial market for complex transactions is a stock exchange.
A company can raise money by selling shares to investors and its existing shares can be bought
or sold.
The following table illustrates where financial markets fit in the relationship between lenders
and borrowers:
Relationship between lenders and borrowers
Lenders Financial intermediaries Financial markets Borrowers
Individuals
companies
Banks
Banks
Insurance Companies
Pension Funds
Mutual Funds
Interbank
Stock Exchange
Money Market
Bond Market
Foreign Exchange
Individuals
Companies
Central Government
Municipalities
Public Corporations
Banks

Lenders:
Individuals do not think of themselves as lenders but they lend to other parties in many ways.
Lending activities may be:
Putting money in a savings account at a bank;
Contributing to a pension plan;
Paying premiums to an insurance company;

57
Investing in government bonds; or
Investing in company shares.

Companies tend to be borrowers of capital. When companies have surplus cash that is not needed
for a short period of time, they may seek to make money from their cash surplus by lending it via
short term markets called money markets.
There are a few companies that have very strong cash flows. These companies tend to be lenders
rather than borrowers. Such companies may decide to return cash to lenders (e.g. Via a share
buyback.) Alternatively, they may seek to make more money on their cash by lending it (e.g.
Investing in bonds and stocks.)
Banks lend the money to other banks, corporate, retail investors, etc
Borrowers
Individuals borrow money via bank loans for short term needs or longer term mortgages to
help finance a house purchase.
Companies borrow money to aid short term or long term cash flows. They also borrow to fund
modernisation or future business expansion.
Governments often find their spending requirements exceed their tax revenues. To make up
this difference, they need to borrow. Governments also borrow on behalf of nationalised
industries, municipalities, local authorities and other public sector bodies.
Governments borrow by issuing bonds. Its debt seems to be permanent. Indeed the debt
seemingly expands rather than being paid off. One strategy used by governments to reduce
the value of the debt is to influence inflation.
Municipalities and Local authorities may borrow in their own name as well as receiving funding
from national governments.
Public Corporations typically include nationalised industries. These may include the postal
services, railway companies and utility companies.
Banks mobilise the deposits for various lending purposes
Many borrowers have difficulty raising money locally. They need to borrow internationally with the
aid of foreign exchange markets.
1.3 Various Financial Markets
Financial markets can be divided into various subtypes:
a) Capital markets:
Primary market: new issuance of the securities.
Secondary market: allow investors to sell securities that they hold or buy existing securities.
Stock markets: these markets provide financing through the issuance of shares and enable
the subsequent trading thereof.

58
Debt markets: these markets provide financing through the issuance of bonds and enable the
subsequent trading thereof.
Money markets: these markets provide short term debt financing and investment.
Commodity markets: these markets facilitate the trading of commodities.
Derivatives markets: these markets provide instruments for the management of financial risk.
b) Forward / future markets
c) Options markets
d) Foreign exchange markets: facilitate the trading of foreign exchange (currency).

59
Chapter 2
Capital Markets

The capital market is the market for securities, where companies and the government can raise long-term
funds.
The capital market includes the stock market and the bond market. Financial regulators, such as the
securities exchange board of India (SEBI) in India, in the U.S. securities and exchange commission
(SEC) and the financial services authority (FSA)in the UK, oversee the markets, to ensure that investors
are protected against wrong doings.
The capital markets consist of the primary market, where new issues are distributed to investors, and the
secondary market, where existing securities are traded.
The capital market can be compared with other financial markets such as the money market which deals
in short term liquid assets, and derivatives markets which deal in derivative contracts.
2.1 Primary Market
The primary market is that part of the capital markets that deals with the issuance of new
securities. Companies, governments or public sector institutions can obtain funding through the
sale of a new stock or bond issue.
Primary market can be sub divided as follows:
By way of underwriting
Initial public offerings (IPO)
Offer for sale to public at a fixed price
Private placement
Rights issue
Offer for sale to public through book building
Follow on public issue

1. By way of underwriting: a syndicate of banks underwrites the transaction, which means they
have taken on the risk of distributing the securities. Should they not be able to find enough
investors, then they end up holding some securities themselves.
2. Initial public offerings (IPO): a corporate may raise capital in the primary market by way of an
initial public offer, rights issue or private placement. An initial public offer (IPO) is the selling of
securities to the public in the primary market. It is the largest source of funds with long or
indefinite maturity for the company.
Offer for sale to public at a fixed price: initial public offering is the first sale of a
companys securities to investors. Price of the security is already fixed.

60
Private placement: new securities issued to institutional investors including private equity
funds.
Rights issue: offering the existing securities to the existing holders at a price near to the
market quoted price.
3. Offer for sale to public through book building: initial public offering is the first sale of a
companys securities to investors. Price of the security is discovered through a bidding process.
SEBI guidelines defines book building as "a process undertaken by which a demand for the
securities proposed to be issued by a body corporate is elicited and built-up and the price for
such securities is assessed for the determination of the quantum of such securities to be
issued by means of a notice, circular, advertisement, document or information memoranda or
offer document".
Book building is basically a process used in initial public offer (IPO) for efficient price discovery.
It is a mechanism where, during the period for which the IPO is open, bids are collected from
investors at various prices, which are above or equal to the floor price. The offer price is
determined after the bid closing date.
As per SEBI guidelines, an issuer company can issue securities to the public though
prospectus in the following manner:
100% of the net offer to the public through book building process
75% of the net offer to the public through book building process and 25% at the price
determined through book building.
The fixed price portion is conducted like a normal public issue after the book built portion,
during which the issue price is determined.
The concept of book building is relatively new in India. However it is a common practice in
most developed countries.
Difference between book building and IPO: in book building securities are offered at prices
above or equal to the floor prices, whereas securities are offered at a fixed price in case of an
IPO. In case of book building, the demand can be known everyday as the book is built. But in
case of the public issue the demand is known at the close of the issue.
4. Follow on public issue: when an already listed company makes either a fresh issue of
securities to the public or an offer for sale to the public, through an offer document, it is known
as follow on public offering.
2.1.1 Entities which Play Role in Primary Market:
A. Regulators:
As the name suggests, the primary objective of the Regulator is to regulate the markets and all the
participants viz. issuers, intermediaries and the investors. One of the main objectives is protection
of the investor as this would give him confidence to enter the markets and without which the
markets cannot develop.
The regulator develops a fair market practice and regulates the conduct of the issuers of securities
and the intermediaries.

61
The regulator also helps in development of markets by advising the government to enact new laws
and implementing new procedures and systems.
The Indian markets are mainly regulated by two bodies:
1. The Reserve Bank of India (RBI)
2. The Securities and Exchange Board of India (SEBI)
1. The Reserve Bank of India (RBI)
RBI is the central bank of India. It was established on April 1, 1935 in accordance with the
Reserve Bank of India Act, 1934.
The main functions of the Reserve Bank are:
Functions as bankers bank The RBI prescribes broad parameters of banking
operations within which the country's banking and financial system functions. It also
maintains public confidence in the financial system, protect depositors' interest and provide
cost-effective banking services to the public.
Formulates monetary and credit policies The RBI controls the money supply and
circulation in the economy by formulating the monetary and credit policy. This in turn helps
RBI keep in the inflation under control.
Maintains exchange value of rupee and manages the Foreign Exchange
Management Act, 1999 RBI regulates the flow of foreign exchange to and from the
country. This helps RBI maintain a healthy exchange rate of the rupee against foreign
currencies.
Facilitates external trade and payment RBI ensures that the foreign trade is carried out
smoothly and also ensures that the exporters and importers obligations interests are
protected. It also promotes orderly development and maintenance of foreign exchange
market in India. It also regulates the functioning of the participants in the foreign exchange
market.
Issues currency as a Central Bank of the country, it also issues currency notes and
coins. The RBI also exchanges and destroys currency and coins not fit for circulation.
Banker to the Government performs merchant banking functions for the central and
state governments especially handling the issue of Government Securities, Treasury bills,
State Development Loans etc.
Banker to banks maintains banking accounts of all scheduled banks in India.

2. Securities Exchange Board of India
In 1988 the Securities and Exchange Board of India (SEBI) was established by the Government
of India through an executive resolution, and was subsequently upgraded as a fully
autonomous body (a statutory Board) in the year 1992 with the passing of the Securities and
Exchange Board of India Act (SEBI Act) on 30th January 1992. In place of Government Control,
a statutory and autonomous regulatory board with defined responsibilities, to cover both
development & regulation of the market, and independent powers have been set up.

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The Securities and Exchange Board of India (SEBI) is the regulatory authority for regulating the
securities markets and its participants. The primary objectives of SEBI are:
Protecting the interests of investors in securities
Promoting the development of the securities market
Regulating the securities market
SEBI has powers for
Regulating the business in stock exchanges and securities markets.
Registering and regulating the working of stock brokers, sub brokers etc
Promoting and regulating self-regulatory organizations
Prohibiting fraudulent and unfair trade practices
Calling for information from, undertaking inspection, conducting Inquiries and audits of the
stock exchanges, intermediaries, self regulatory organizations, mutual funds and other
persons associated with the securities market.
Since its inception SEBI has been working targeting the securities and is attending to the
fulfillment of its objectives with commendable zeal and dexterity. The improvements in the
securities markets like capitalization requirements, margining, establishment of clearing
corporations etc. reduced the risk of credit and also reduced the market.
SEBI has introduced the comprehensive regulatory measures, prescribed registration norms,
the eligibility criteria, the code of obligations and the code of conduct for different
intermediaries like, bankers to issue, merchant bankers, brokers and sub-brokers, registrars,
portfolio managers, credit rating agencies, underwriters and others. It has framed bye-laws,
risk identification and risk management systems for Clearing houses of stock exchanges,
surveillance system etc. which has made dealing in securities both safe and transparent to the
end investor.
Securities Exchange Commission (SEC) USA
The Markets in USA are regulated by SEC
The mission of the U.S. Securities and Exchange Commission is to protect investors,
maintain fair, orderly, and efficient markets, and facilitate capital formation
SEC oversees the key participants in the securities world, including securities exchanges,
securities brokers and dealers, investment advisors, and mutual funds
SEC expects that all the investors should have access to accurate information before
investing
It regulates the self regulatory organisations like stock exchanges, national association of
securities dealers, etc
It also oversees the securities investor protection corporation which insures the securities
& cash of the investors maintained with brokers
It reviews and approves proposed new rules and changes to the existing rules

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B. Issuers:
Most companies are usually started privately by their promoter(s). However, the promoters capital
and the borrowings from banks and financial institutions may not be sufficient for setting up or
running the business over a long term. So companies invite the public to contribute towards the
equity and issue shares to individual investors. The way to invite share capital from the public is
through a Public Issue. Simply stated, a public issue is an offer to the public to subscribe to the
share capital of a company. Once this is done, the company allots shares to the applicants as per
the prescribed rules and regulations laid down by SEBI.
The three major Issuers of Securities in India, are Government, Public sector Undertakings and the
Corporate.
1. Government Central, State and Local Bodies
RBI acts as the investment banker to the central government and raises funds to fund
budgetary deficits, short term and long term fund requirements of the govt.
RBI issues Treasury bills (short term), Government dated securities (long term) and relief
bonds (Tax free).
State governments and other local bodies issue debt securities to fund their developmental
activities and to finance the budgetary deficit
Over 70% of all borrowings in the primary market are by governmental bodies
Over 90% of the secondary market volumes are in government securities
RBI regulates the issuance of government securities
2. Public Sector undertakings
Public Sector undertakings bonds are treated as surrogates of government securities
PSUs raise funds to meet the financing requirements and working capital needs
3. Corporate
Corporates issue equity and preference shares when they wish to divest their stakes
They also issue commercial papers, secured and non secured debentures
Generally interest rate on corporate debt is more than the governmental bodies as they are
less secured in nature
SEBI regulates the corporate debt
C. Merchant bankers:
In the pre-issue process, the Merchant Banker takes up the due diligence of companys operations/
management/ business plans/ legal etc. Other activities of the Merchant Banker include drafting
and design of Offer documents, Prospectus, statutory advertisements and memorandum containing
salient features of the Prospectus. The Merchant Banker shall ensure compliance with stipulated
requirements and completion of prescribed formalities with the Stock Exchanges, RoC and SEBI
including finalization of Prospectus and RoC filing. Appointment of other intermediaries viz.,
Registrar(s), Printers, Advertising Agency and Bankers to the Offer is also included in the pre-issue
processes. The Merchant Banker also draws up the various marketing strategies for the issue. The

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post issue activities including management of escrow accounts, coordinate non-institutional
allocation, intimation of allocation and dispatch of refunds to bidders etc are performed by the
Merchant Banker. The post offer activities for the offer will involve essential follow-up steps, which
include the finalization of trading and dealing of instruments and dispatch of certificates and demat
of delivery of shares, with the various agencies connected with the work such as the Registrar(s) to
the Offer and Bankers to the Offer and the bank handling refund business. The merchant banker
shall be responsible for ensuring that these agencies fulfill their functions and enable it to discharge
this responsibility through suitable agreements with the Company.
D. Lead Managers:
Lead Managers play the most vital role amongst all intermediaries during public issues.
Assist the company right from preparing prospectus to the listing of securities at the stock
exchanges.
Satisfy themselves about the correctness and propriety of all the information provided in the
prospectus.
It is mandatory for them to carry due diligence for all the information provided in the prospectus
and they must issue a certificate to this effect to SEBI.
They appoint other intermediaries viz., Registrars, Bankers to the issue, underwriters, printers,
advt. agencies, etc in consultation with the issuer.
It is Lead Managers role to ensure that all the intermediaries fulfill their responsibilities.
They follow-up with bankers to the issue to get quick estimates of collection and advise the
issuer about the subscription.
A Company may appoint more than one Lead Manager provided Inter-Se Allocation of
responsibilities between the Lead Managers are properly structured.
E. Underwriters:
Underwriters are intermediaries who underwrite the securities offered to the investors.
The underwriters are appointed by the issuers.
They commit to shoulder the liability and subscribe to the shortfall in case the issue is under-
subscribed (i.e. if the company does not receive full response from public and amount
received from is less than the issue size).
Underwriters subscribe to the unsubscribed amount so that the issue is successful.
For this commitment they are entitled to a commission on the amount underwritten.
F. Bankers to the issue:
As name suggests, they carry out all the activities of ensuring that the funds are collected and
transferred to the Escrow accounts.
Bankers along with their branch network act as the collecting agencies for the issuers during
the public issues.
Accept applications from the investors on behalf of the company.

65
These applications are then forwarded to Registrar & Share Transfer Agent for further
processing.
Process the funds procured during the public issue.
These Banks provide temporary loans to the issuers for the period between the issue date and
the date the issue proceeds becomes available after allotment, which is referred to as a bridge
loan
G. Registrars and share transfer agents:
The Registrar finalizes the list of eligible allottees after deleting the invalid applications and ensures
that the corporate action for crediting of shares to the demat accounts of the applicants is done and
the dispatch of refund orders to those applicable are sent. The Lead manager coordinates with the
Registrar to ensure follow up so that that the flow of applications from collecting bank branches,
processing of the applications and other matters till the basis of allotment is finalized, dispatch
security certificates and refund orders completed and securities listed.
Processes all applications received from the public and allot the shares to the applicants as per
the allotment basis
Allotment of shares to the applicants DP accounts
Dispatch of refund orders
Handles allotment related queries
Maintains the shareholders data
Dispatch of securities / funds in case of any corporate actions declared
Registration of physical securities on the purchasers name
Karvy share registry, MCS Ltd, Cameo Services, Intime Share Registry etc are the major R & T
agents in India
H. Depositories & Depository Participants:
A Depository is an intermediary where the securities are held in the electronic form which also
performs the function of dematerializing securities and enabling their transactions in book-entry
form.
It provides service connected with recording of allotment of securities or transfer of ownership
of securities in the record of a depository.
A depository cannot directly open accounts and provide services to clients. Persons willing to
avail services can do so by entering into an agreement with the depository through its
Depository Participants.
A depository can be compared to a bank. Cash is kept deposited in a bank and shares in a
depository in the electronic mode.

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BANK DEPOSITORY
Holds funds in an account Hold securities in an account
Transfers funds between accounts
on the instruction of the account
holder
Transfers securities between accounts
on the instruction of the account holder
Facilitates transfer without having
to handle money
Facilitates transfer of ownership
without having to handle securities
Facilitates safekeeping of money Facilitates safekeeping of securities

Services offered by a Depository
Dematerialization: Converting the holdings from physical format to electronic format
Corporate Actions: All non monetary corporate actions can be directly credited to the
investors account in electronic form
Electronic settlement of trades in stock exchanges: Trades are settled in a normal way
Electronic credit of securities allotted in public issues, rights issue: Securities are
received in electronic form directly into the investors account
Pledge: Depositories allow investors to pledge their securities
In India, we have two depositories namely National Securities Depository Ltd. (NSDL) and Central
Depository Services Ltd. (CDSL).
Depository Participant (DP)
The agent through which Depository interfaces with the investor is known as Depository
Participant (DP).
It is compared with a branch of a bank like Depository with a bank
A Depository Participant has to be registered with SEBI.
Investors need to open an account with the DP to avail the services; procedures followed for
opening an account is similar to opening a bank account (personal identification and details
need to be provided).
The services typically offered by a DP are:
Dematerialisation and rematerialisation of securities to the investor on behalf of the Depository
Settlement Processing transferring and receiving securities on instruction of the account
holder (based on his settlement obligation)
Enabling book-entry transfer of securities between accounts.
Securities lending and borrowing
Creating lien on Securities when securities are pledged against a loan
Non-monetary Corporate actions (e.g. direct credit of Bonus, Rights, and Splits etc.)

67
Benefits of Holding Securities in a Dematerialized Form
A safe, convenient way to hold securities; eliminates risks associated with physical security
such as bad delivery , fake securities, delays, thefts etc.
Instant transfer of securities.
Shorter settlement cycles.
Stamp duty is not required on transfer of securities
Reduction in paperwork involved in transfer of securities
Reduction in the cost of transaction
Flexibility of the number of shares to be moved; even one share can be bought/ sold or moved
across accounts.
Facility of nomination
Easy to create lien on securities, thereby enabling quicker disbursement of loans against
shares.
Change in address recorded with DP gets registered with all companies in which investor holds
securities electronically eliminating the need to correspond with each of them separately
Transmission of securities is done by DP eliminating correspondence with companies
Automatic Credit of securities Bonus, Rights, Splits, IPO allotments, etc.
Easy and convenient monitoring on holdings.
2.2 Secondary Market
The secondary market is the financial market for trading of securities that have already been
issued in an initial private or public offering. Alternatively, secondary market can refer to the market
for any kind of used goods. Once a newly issued stock is listed on a stock exchange, investors
and speculators can easily trade on the exchange, as market makers provide bids and offers in
the new stock.
In the secondary market, securities are sold by and transferred from one investor or speculator to
another. It is therefore important that the secondary market be highly liquid and transparent.
Before electronic trading started, the only way to create this liquidity was for investors and
speculators to meet at a fixed place regularly. This is how stock exchanges originated.
2.2.1 Entities which play role in Secondary Market:
A. Regulators:
Regulators protect the interests of the investors in securities and also promotes the development of,
and regulates, the securities market and related matters.

68
B. Stock exchanges:
A group of individuals, whether incorporated or not, constituted for the purpose of assisting,
regulating or controlling the business of buying and selling of securities.
Provides a trading platform to the members of the exchange for the securities listed.
In India, Stock exchanges are regulated by SEBI.
Major Stock exchanges of India are the National Stock Exchange (NSE) and the Bombay
Stock Exchange (BSE).
Trading traditionally took place through open out cry system till NSE launched online fully
automated screen based trading in 1994 through out India.
This resulted in better efficiency, liquidity and transparency and also better surveillance of the
brokers.
Revolutionized the stock trading by extending footprint across the nation.
Have one of the finest systems for trading and settlements in the world; withstood the test of
times without any major crisis.
The National Stock Exchange of India Ltd. (NSE)
Largest Stock Exchange in India in terms of daily turnover. Currently around Rs.9000 crores in
the Equity Cash Segment and around Rs.25,000 crores in the Derivatives segment.
Promoted by leading Financial Institutions, Banks, Insurance Companies and other Financial
Intermediaries in India.
First to launch online automated trading system in India in November, 1994.
Has presence in Capital Market (Equities Cash), Wholesale Debt Market & Derivatives
segment.
Has 922 members (as on Jan 31, 2006) across the 3 segments. Additionally, there are 8835
sub-brokers attached to these members.
The Stock Exchange, Mumbai (BSE)
Oldest Stock Exchange in Asia; was established as The Native Share & Stock Brokers
Association in 1875.
First stock exchange in the country to obtain permanent recognition from Government of India
in 1956 under Securities Contract (Regulation) Act, 1956.
Average Daily Turnover in Equities Cash Market Segment was about Rs.4,000 crores.
C. Custodians:
Custodians are those entities who take care of Post-trading activities on behalf of their clients such
as Financial Institutions, Asset Management Companies, Pension Funds, Foreign Institutional
Investors, etc.

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Activities of a custodian include:
Trade processing services: Ensuring smooth trade confirmations to Stock Exchanges,
reporting and resolving the mismatches with Clients, etc.
Settlement Services:
Ensure timely settlement of Funds and Securities with the Clearing Houses/ Brokers/
Counter Parties on behalf of client.
Maintain clearing accounts with Depository Participants and Clearing Corporations to settle
the electronic trades.
For physical trades, ensure prompt scrutiny, processing and lodgment of securities with the
respective Company / Registrar and Transfer Agent, with the objective of final transfer to
the purchaser, thus facilitating delivery of securities to the parties concerned on sale.
Safekeeping of securities (Physical custody): Transferred physical securities, when
received, are held in vaults on behalf of the clients. Custodians track these securities and
ensure their availability at short notices.
Institutional DP services: Maintain accounts with the depositories to offer various services to
their clients such as
Dematerialization (Conversion of physical holdings into electronic form)
Settlement of trade instructions
Re-materialization (Conversion of holding from electronic to physical form)
Corporate actions follow-up
Saleable holding reports
Monitoring of Redemptions & pre-payments
Holding and transaction statements
The dedicated Corporate Actions team ensures:
Calculation of entitlements, reconciling with companies/registrars prior to due date, etc. on
the client holdings.
Timely collection of monetary and non-monetary benefits on behalf of the client.
Corporate Actions, Primary markets and related services:
The Primary Markets team handles:
Applications on behalf of clients for primary market issues,
Calculates Rights entitlements
Follow up on allotments or refunds and sends customised reports to clients.
Leading custodians In India are SHCIL, CIL, ICICI, HSBC, DB, Citibank, SBI Custodial services, etc.

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D. Brokers / sub-brokers:
Broker
Broker is a member of the stock exchange who is licensed to buy or sell securities on his own
or on behalf of his client.
Membership is for each segment of the stock exchange e.g. Capital Markets, Debt or
Derivatives.
Can be an individual, registered partnership firm or a corporate;
Admitted as member of the exchange usually by bidding process after satisfying eligibility
criteria as stipulated by the exchange.
Acts as intermediary between the exchange and the investor
Registered with and regulated by SEBI; follows the Code of Conduct as per SEBI for day to
day operations especially relations with investors. Also governed by the Stock Exchange Rules
and Regulations.
Is free to open branches across country and operate in any area with exchange permission.
Investors trade through a trading account; personal details and identity proofs need to be
provided apart from adequate margin collection upfront.
Typically has Front office which executes the trades on the exchange and Back office which
handles settlement of trades.
Sub Broker
A Sub Broker is an agent of a broker (member of the exchange).
Has to be registered with SEBI as well as Exchange of which his broker is the Member. Non-
registered sub-brokers cannot be an agent of a broker.
Broker is responsible for the acts and dealings of his sub-broker.
Helps in improving the reach of the broker and client coverage.
Clients of sub-brokers are to be registered with the main broker.
Not authorized to issue a contract or a confirmation note to his investor or the client; contracts,
trade confirmations issued by the main broker.
Cannot settle trade on behalf of his clients; this is done by the main broker or his clearing agent
who would be a member of the clearing house of the exchange.
Trading and other margins are maintained by the main broker for clients of the sub-broker.
Earnings are by way of brokerage earned by the main broker shared with the sub-broker.
E. Clearinghouses & Clearing Banks:
Clearinghouses:
Clearing is the process of setting off payables and receivables and settling the net balances.

71
Clearing Houses typically undertakes the following functions:
In the securities markets, match settlement obligation of each broker i.e. netting off securities
or funds payable vis--vis securities or funds receivable.
Handle the securities movement through Depositories and funds through Clearing Banks.
As an Exchange Clearing House:
Matches and reconciles daily trades
Monitors risk, exposures of each member and collects any shortfall in margin requirements.
Maintains margin account of members
Handles shortfalls in clearing members obligation i.e. shortage or non-delivery of securities
or funds, thus preventing any settlement failure.
Guarantees settlement dues, thereby eliminating counter-party risk.
National Securities Clearing Corporation Ltd. Clearing House for NSE and BOI Shareholding
Ltd. Clearing House for BSE.
Clearing Banks
The Clearing houses have a set of designated banks to carry out the settlement of funds
Fund transfer to and receipt from the Clearing Members (CM) a/c takes place through these
clearing banks
CM has to open the account with the clearing bank to facilitate the funds transfer
The CM is required to authorise their clearing banks to access their clearing accounts for
debiting, crediting, reporting of balances and any other information in accordance with the
advice received from the clearing corporation
Clearing corporation forwards the fund obligation report to the respective clearing bank of the
CM
The clearing banks debit the account of the member and credit the account of the clearing
corporation for settlement
The funds are transferred on the pay out by the clearing banks from the account of the
clearing corporations to CMs account
F. Depositories & depository participants:
2.3 Stock Market
It is a market (stock exchange) for the trading of company stock and derivatives of same.
Initially companies sell the stocks via primary market
Later, stocks are bought and sold in the secondary market
Stock has to be listed* on the exchange before it is traded in the secondary market
*listing means admission of securities of an issuer to trading privileges on a stock exchange
through a formal agreement. The prime objective of admission to dealings on the exchange is to

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provide liquidity and marketability to securities, as also to provide a mechanism for effective
management of trading.
2.3.1 Stages of secondary market trading
Stage-1: Trading in this stage buy and sell orders match and the trade is confirmed
Components of trading activity are as below.
A. Various markets:
Normal market: all orders which are of regular lot size or multiples thereof are traded in the
normal market. In the dematerialized segment the market lot of these shares is one. Normal
market consists of various book types wherein orders are segregated as regular lot orders,
special term orders, negotiated trade orders and stop loss orders depending on their order
attributes.
Odd lot market: all orders whose order size is less than the regular lot size are traded in the
odd-lot market. An order is called an odd lot order if the order size is less than regular lot size.
These orders do not have any special terms attributes attached to them. In an odd-lot market,
both the price and quantity of both the orders (buy and sell) should exactly match for the trade
to take place. Currently the odd lot market facility is used for the limited physical market as per
the SEBI directives.
Auction market: stocks are sold on basis of auctioning. In the auction market, auctions are
initiated by the exchange on behalf of trading members for settlement related reasons.
There are 3 participants in this market.
Initiator: the party who initiates the auction process is called an initiator
Competitor: the party who enters orders on the same side as of the initiator
Solicitor: the party who enters orders on the opposite side as of the initiator
B. Order books:
Order books show the entire buy and sell orders which are pending for matching as of that time.
Orders are first numbered and time-stamped on receipt and then immediately processed for
potential match. Every order has a distinctive order number and a unique time stamp on it. If a
match is not found, then the orders are stored in different 'books'. Orders are stored in price-time
priority in various books in the following sequence:
best price
within price, by time priority.
Price priority means that if two orders are entered into the system, the order having the best price
gets the higher priority. Time priority means if two orders having the same price are entered, the
order that is entered first gets the higher priority.
C. Order matching:
Always the best buy order is matched with the best sell order. An order may match partially with
another order resulting in multiple trades. Best buy is with the highest price & best sell is with the

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lowest price. (the system views all buy orders available from the point of view of a seller and all sell
orders from the point of view of the buyers in the market. So, of all buy orders available in the
market at any point of time, a seller would obviously like to sell at the highest possible buy price
that is offered. Hence, the best buy order is the order with the highest price and the best sell order
is the order with the lowest price.) Orders would be displayed till the time the full quantity is
matched
D. Order conditions:
A trading member can enter various types of orders depending upon his/her requirements. These
conditions are broadly classified into three categories:
Time related conditions
Price related conditions
Quantity related conditions
1) Time related conditions:
Day: a day order, as the name suggests, is an order which is valid for the day on which it is
entered. If the order is not matched during the day, the order gets cancelled automatically at
the end of the trading day.
Good till cancelled (GTC): a good till cancelled (GTC) order is an order that remains in the
system until it is cancelled by the trading member. It will therefore be able to span trading days
if it does not get matched. The maximum number of days a GTC order can remain in the
system is notified by the exchange from time to time.
Good till date/day (GTD): a good till days/date (GTD) order allows the trading member to
specify the days/date up to which the order should stay in the system. At the end of this period
the order will get flushed from the system. The maximum number of days a GTD order can
remain in the system is notified by the exchange from time to time.
Immediate or cancel (IOC): an immediate or cancel (IOC) order allows a trading member to
buy or sell a security as soon as the order is released into the market, failing which the order
will be removed from the market. Partial match is possible for the order, and the unmatched
portion of the order is cancelled immediately.
2) Price related conditions:
Limit price/order: an order that allows the price to be specified while entering the order into
the system.
Market price/order: an order to buy or sell securities at the best price obtainable at the time of
entering the order.
Stop loss (SL) price/order: the one that allows the trading member to place an order which
gets activated only when the market price of the relevant security reaches or crosses a
threshold price. Until then the order does not enter the market.
A sell order in the stop loss book gets triggered when the last traded price in the normal market
reaches or falls below the trigger price of the order. A buy order in the stop loss book gets triggered
when the last traded price in the normal market reaches or exceeds the trigger price of the order.
E.g. If for stop loss buy order, the trigger is 93.00, the limit price is 95.00 and the market (last
traded) price is 90.00, then this order is released into the system once the market price reaches or

74
exceeds 93.00. This order is added to the regular lot book with time of triggering as the time stamp,
as a limit order of 95.00
3) Quantity related conditions:
Disclosed quantity (DQ): an order with a DQ condition allows the trading member to disclose
only a part of the order quantity to the market. For example, an order of 1000 with a disclosed
quantity condition of 200 will mean that 200 is displayed to the market at a time. After this is
traded, another 200 is automatically released and so on till the full order is executed. The
exchange may set a minimum disclosed quantity criteria from time to time.
Mf: minimum fill (mf) orders allow the trading member to specify the minimum quantity
by which an order should be filled. For example, an order of 1000 units with minimum
fill 200 will require that each trade be for at least 200 units. In other words there will be
a maximum of 5 trades of 200 each or a single trade of 1000. The exchange may lay
down norms of mf from time to time.
Aon: all or none orders allow a trading member to impose the condition that only the
full order should be matched against. This may be by way of multiple trades. If the full
order is not matched it will stay in the books till matched or cancelled.
Stage-2: Clearing and settlement clearing is the process of determination of obligations, after
which the obligations are discharged by settlement.
Clearing corporations generally have two categories of clearing members
Trading members: responsible for clearing and settlement of the trades of his own or of
individual investors (his clients).
Custodian members: the trading members pass on its obligation to the custodians if the trades
are of institutional clients and custodians in turn confirm/affirm the same to the clearing
corporation.

Clearing Corporation
Custodian
Broker
Accounting Concepts

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Clearing & settlement cycle:
At the end of each trading day, concluded trades are received from the exchanges by
clearinghouses. Clearing house determines the cumulative obligations of each member and
electronically transfers the data to clearing members (CMs).
All trades concluded during a particular trading period are settled together. A multilateral netting
procedure is adopted to determine the net settlement obligations (delivery/receipt positions) of CMs.
Clearinghouse then allocates or assigns delivery of securities inter se the members to arrive at the
delivery and receipt obligation of funds and securities by each member.
Settlement is deemed to be complete upon declaration and release of pay-out of funds and
securities.
On the securities pay-in day, delivering members are required to transfer the securities to
clearinghouse. On pay out day the securities are delivered to the respective receiving members.
Exceptions may arise because of short delivery of securities by CMs on the pay-out day.
Each CM would communicate to the clearinghouse on the pay-in day the securities that the cm
would be delivering and those that the cm is unable to deliver. Clearinghouse identifies short
deliveries and conducts a buying-in auction on the day after the pay-out day.
The CM is debited by an amount equivalent to the securities not delivered and valued at a valuation
price (the closing price as announced by the exchange on the day previous to the day of the
valuation). If the buy-in auction price is more than the valuation price, the cm is required to make
good the difference. This amount is credited to the receiving member's account on the auction pay-
out day.
Settlement cycle in India
Rolling settlement:
In a rolling settlement, each trading day is considered as a trading period and trades executed
during the day are settled based on the net obligations for the day.
In India, trades in rolling settlement are settled on a t+2 basis i.e. On the 2nd working day.
Typically trades taking place on Monday are settled on Wednesday, Tuesdays trades settled
on Thursday and so on.
A tabular representation of the settlement cycle for rolling settlement is given below:
Activity Day
Trading Rolling settlement trading T
Clearing Custodial confirmation T+1 working days
Delivery generation T+1 working days
Settlement Securities and funds pay in T+2 working days
Securities and funds pay out T+2 working days
Valuation debit T+2 working days
Post settlement Auction T+3 working days
Bad delivery reporting T+4 working days

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Auction settlement T+5 working days
Rectified bad delivery pay-in and pay-out T+6 working days
Re-bad delivery reporting and pickup T+8 working days
Close out of re-bad delivery and funds pay-in & pay-out T+9 working days

Securities settlement
The securities obligations of members are downloaded to members / custodians by
clearinghouse after the trading period is over. The members / custodians make available the
required securities in the pool accounts with the depository participants.
The delivering member should have clear balances of securities in his delivery account within
his cm clearing account with the depository on or before 10:00 a.m. On the pay-in day. The
depository would debit the delivering members account on or after 10:00 a.m. The depository
would credit the receiving members' receipt account within his cm clearing account with the
depository on or after 2:30 p.m. On the pay-out day.
Funds settlement
Members are informed of their funds obligation for various settlements through the daily
clearing data download.
The member account may be debited for various types of transactions on a daily basis. The
member is required to ensure that adequate funds are available in the clearing account
towards all obligations, on the scheduled date and time. Members may refer to their obligation
statements and provide for funds accordingly.
The members with a funds pay-in obligation are required to have clear funds in their account
on or before 10.30 a.m. On the settlement day. The payout of funds is credited to the clearing
account of the members on or after 1.30 p.m. On the settlement day.
2.4 Debt Market
It refers to people and entities involved in buying and selling of debt and the quantity and prices of
those transactions over time. Participants in the market trade bonds issued by companies and
various government bodies
There is no single location or exchange where debt market participants interact for common
business. Participants talk to each other, conclude deals, send confirmations etc. On the telephone,
with clerical staff doing the running around for settling trades. In that sense, the debt market is a
virtual market
The market is best understood by being aware of the below elements and their mutual
interaction:
Instruments i.e. The instruments that are being traded in the debt market.
Issuers i.e. Entities which issue these instruments.
Investors i.e. Entities which invest in these instruments or trade in these instruments.
Regulators i.e. The regulators and the regulations governing the market.

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2.4.1 Instruments
Debt instruments are basically obligations undertaken by the issuer of the instrument as regards
certain future cash flows representing interest and principal, which the issuer would pay to the legal
owner of the instrument. Debt instruments are of various types.
Key terms that distinguish one debt instrument from another:
Issuer of the instrument
Face value of the instrument
Interest rate
Repayment terms (and therefore maturity period/tenor)
Security or collateral provided by the issuer

Various instruments based on the above factors:
Money market instruments: by convention, the term "money market" refers to the market for
short-term requirement and deployment of funds. Money market instruments are those
instruments, which have a maturity period of less than one year. (CPs, CDs, treasury bills,
short-term debentures, bills exchange)
Long term securities: by convention, these are instruments having a maturity exceeding one
year. (govt. Securities, public sector bonds, corporate debentures)
2.4.2 Various Issuers
Government and other sovereign bodies: the largest volumes of instruments issued and
traded in the debt market fall in this category. Issuers within this category include the
government, some statutory bodies. Instruments issued by the government carry the highest
credit rating because of the ability of the government to tax and repay its obligations.
Banks and development financial institutions: instruments issued by DFIS and banks carry
the highest credit ratings amongst non-government issuers primarily because of their linkage
with the government.
Public sector units: PSUs issue PSU bonds. These PSU bonds are approved securities for
investment by various trusts, provident funds etc.
Private sector companies: private sector companies issue commercial papers (cps) and
short and long term debentures.
Quasi government owned non-corporate entities: the origin of these issuers lies in the
inability of state governments to execute large infrastructure projects through budgetary
allocations. Consequently, these state governments have created special purpose vehicles
(SPVs) for executing these projects. These SPVs issue bonds/debentures. Typical maturity of
the instruments ranges from 3-7 years.

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2.4.3 Various investors
In addition to retail investors, the institutional investors are divided as below
Banks: collectively, all the banks put together are the largest investors in the debt market.
They invest in all instruments ranging from t-bills, cps and CDs to government securities,
private sector debentures etc. Due to regulations, banks have to invest part of their deposits
into government securities.
Insurance companies: the second largest category of investors in the debt market is the
insurance companies.
Provident funds: the total incremental investment by provident funds every year makes them
the third largest investors in the debt market.
Mutual funds: mutual funds represent an extremely important category of investors. World
over, they have almost surpassed banks as the largest direct collector of primary savings from
retail investors and therefore as investors in the debt market.
Trusts: trusts include religious and charitable trusts as well as statutory trusts formed by the
government and quasi government bodies. There are very few instruments in which trusts are
allowed to invest. Most of the trusts invest in CDs of banks and bonds of financial institutions.
Corporate treasuries: corporate treasuries have become prominent investors only in the last
few years. Treasuries could be either those of the public sector units or private sector
companies or any other government bodies or agencies.
Foreign investors (FIIs):
Credit Rating Agencies:
Organizations which provide the service of evaluating the credit worthiness of issues are known as
Rating Agencies. Some of the rating symbols are as below:

R a t i n g
S y m b o l
D e f i n i t i o n
I n v e s t m e n t G r a d e s
A A A H i g h e s t S a f e t y
A A H i g h S a f e t y
A A d e q u a t e S a f e t y
B B B M o d e r a t e S a f e t y
S p e c u l a t i v e G r a d e s
B B I n a d e q u a t e S a f e t y
B H i g h R i s k
C S u b s t a n t i a l R i s k
D D e f a u l t

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Credit rating agencies assign ratings to debt issues to educate the investors about the
creditworthiness of the security
Good credit rating refers to ones corporate reputation within the financial community
Major Credit Rating Agencies:
CRISIL: The oldest rating agency in India was originally promoted by ICICI
Standard & Poor and Moody: are the global leaders in credit ratings
ICRA: Promoted by IFCI
CARE: Promoted by IDBI
Index:
It is a statistical measure of change in a securities market.
It is essentially an imaginary portfolio of securities representing a particular market.
Each index has its own calculation methodology and is usually expressed in terms of a change
from a base value.
For example, knowing that a stock exchange is at, say, 5,000 doesn't tell you much. However,
knowing that the index has risen 30% over the last year to 5,000 gives a much better demonstration
of performance.
The index is calculated based on a free-float capitalization method when weighting the effect of
a company on the index.
For example, if a company has a float of 10M shares and outstanding shares of 12M, the percent of
float to outstanding is 85% or 0.85, which is then multiplied by its market cap {e.g., 120M (12M
shares x 10/share) x 0.85 = $102M free-float capitalization}.
BSE Sensex Components as on 31-Mar-2006
ONGC 12.61 TATASTL 1.87
NTPC 8.22 Maruti Udyog 1.84
RIL 7.85 HDFC Bank 1.73
TCS 6.64 Hindalco 1.36
InfosysTechn 5.89 Grasim Inds 1.31
Wipro 5.60 Hero Honda 1.31
BhartiTeleve 5.27 Cipla 1.28
ITC Ltd 4.83 Ranbaxy Labs 1.08
Hind Lever 4.02 ACC 1.02
ICICI Bank 3.90 GujAmbujaCem 0.96
SBI 3.70 BHEL 3.74
Tata Motors 2.56 HDFC 2.41
L&T 2.40 REL 0.93
Bajaj Auto 2.02 TataPowerCom 0.81
Satyam Compu 1.92 DrReddysLab 0.75

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2.4.4 Two important Trading Markets for debt instruments
1) Dealer network market / over the counter (OTC):
It is a very popular way of trading.
Instruments such as bonds generally do not trade on a formal exchange and are, therefore,
traded in this segment.
In the OTC market, trading occurs via a network of middlemen, called dealers, who carry
inventories of securities to facilitate the buy and sell orders of investors, rather than providing
the order matchmaking service seen in specialist exchanges.
Participants talk to each other, conclude deals, send confirmations etc. On the telephone.
Most debt instruments are traded by investment banks making markets for specific issues.
If an investor wants to buy or sell a bond, he or she must call the bank that makes the market
in that bond and asks for quotes.
2) Exchange: like any other stock trading, debt securities trading also runs on the same principles
and mechanism
F i n a n c i a l M a r k e t s &
M a r k e t Pa r t i c i p a n t s I I
M o d u l e - 4

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Financial Markets & Market Participants II - Module 4
TABLE OF CONTENTS
1 MONEY MARKET.... 75
1.1 The most common instruments under money market ...................................................... 75
1.2 Primary issuance of the money market instruments......................................................... 86
1.3 Secondary market activities of money market instruments .............................................. 88
1.4 Regulators role in the money market ............................................................................... 88
2 COMMODITIES MARKET 89
2.1 Commodities Exchange: ............................................................................................... 89
2.2 Regulators: .................................................................................................................... 80
3 DERIVATIVES MARKET. 81
3.1 Types of Derivatives:......................................................................................................... 81
3.1.1 Forward Contracts........................................................................................... . 81
3.1.2 Futures................................................................................................................. 81
3.1.3 Options.................................................................................................................. 82
3.1.4 Swaps ................................................................................................................... 82
3.2 Overview of futures trading: .............................................................................................. 83
3.2.1 Futures Exchanges:.............................................................................................. 83
3.2.2 Futures Clearinghouses:....................................................................................... 84
3.2.3 Futures Brokers: ................................................................................................... 84
3.2.4 Futures Market Participants:................................................................................. 84
3.2.5 Regulators:............................................................................................................ 85
3.3 Overview of Options Trading: ............................................................................................ 87
3.3.1 About options trading at NSE: .............................................................................. 87
4 FOREIGN EXCHANGE MARKETS.. 90
4.1 Regulatory Role: ............................................................................................................... 91
5 INVESTORS .. 93
5.1 Mutual Funds: ................................................................................................................... 93
5.1.1 Types of Schemes: ............................................................................................... 94
5.2 Banks & Financial Institutions: .......................................................................................... 95
5.3 Foreign Financial Institutions: ........................................................................................... 96
5.4 Hedge Funds:.................................................................................................................... 96
5.4.1 Prime Brokers: ...................................................................................................... 96

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Chapter 1
Money Market
Money market is the financial market for short term borrowing and lending, typically up to one year.
In the money market banks lend to, and borrow from each other, short term instruments like certificate of
deposits (CDs) or enter into agreements such as repurchase agreements (Repos)
1.1 The most common instruments under money market
1. Call / notice / term money market:
The most active part of the money market is the market for overnight and term money between
banks and institutions. This is a form of loan and not traded in the markets
The call money market is an integral part of the Indian money market, where the day-to-day surplus
funds (mostly of banks) are traded. The loans are of short-term duration varying from 1 to 14 days.
The money that is lent for one day in this market is known as "call money", and if it exceeds one
day (but less than 15 days) it is referred to as "notice money".
Term money refers to money lent for 15 days or more in the inter bank market.
Banks borrow in the money market for the following purpose:
To fill the gaps or temporary mismatches in funds
To meet the CRR & SLR mandatory requirements as stipulated by the central bank
To meet sudden demand for funds arising out of large outflows
Call money market participants:
Those who can both borrow as well as lend in the market - RBI (through LAF) banks, PDs.
Those who can only lend - financial institutions LIC, UTI, GIC, IDBI, NABARD, ICICI and
Mutual Funds etc.
2. Repo transactions (market ready forwards / re-purchase agreements):
Re-purchase agreements between banks and institutions. Short-term loansnormally for less than
two weeks and frequently for one dayarranged by selling securities to an investor with an
agreement to repurchase them at a fixed price on a fixed date. This is a form of sale and buyback
and not traded in the markets.
Reverse repo: reversal to the above transaction. buying and selling back.
3. Commercial papers (cp):
Commercial papers are short-term unsecured borrowings by reputed companies that are financially
strong and carry a high credit rating.

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These are sold directly by the issuers to the investors or else placed by borrowers through agents /
brokers etc.
Commercial papers are issued in the form of discount to the face value.
These are issued in denominations of Rs 2.5mn and usually have a maturity 15 days to 1 year but,
the most active market is for 90 day cps. These are unsecured and backed by credit of the issuing
company
The key regulation govern the issuance of cps; cps have to be compulsorily rated by a recognized
credit rating agency and only those companies can issue cps which have a short term rating of at
least p1 (degree of safety regarding timely payment is strong). Companies have to meet certain
eligibility criteria as decided by the central bank to issue cps.
4. Certificate of deposits (CD):
CDs are short-term borrowings having a maturity of not less than 15 days up to a maximum of one
year. CD is subject to payment of stamp.
They are like bank term deposits accounts. Unlike traditional time deposits these are freely
negotiable instruments and are often referred to as negotiable certificate of deposits
Features of CD:
Issued at discount to face value
These are issued by banks in denominations of Rs 0.5mn and have maturity ranging from 30
days to 3 years
Banks are allowed to issue CDs with a maturity of less than one year while financial institutions
are allowed to issue CDs with a maturity of at least one year to 3 years.
5. Treasury bills (t-bills):
These are issued by the Reserve Bank of India on behalf of the government of India and are thus
actually a class of government securities
Treasury bills (or t-bills) mature in one year or less. They are like zero coupon bonds in that they do
not pay interest prior to maturity and are sold at a discount of the par value. Treasury bills are
considered by many the most risk free investment. Treasury bills are commonly issued with
maturity dates of 91 days, and 182 days. Treasury bills are sold weekly at an auction held on
Mondays. Banks and financial institutions, especially primary dealers, are the largest purchasers of
t-bills.

1.2 Primary issuance of the money market instruments
1. Government securities:
Central banks are responsible for issuance of the government securities
Securities are issued to primary dealers through auction mechanism
French auction: after all bids are received, a particular price is decided as cut-off price. All
bids that are higher than the cut-off are given full allotment at their bid price.

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Dutch auction: after all bids are received, a particular price is decided as cut-off price. All bids
that are higher than the cut-off are given allotment at the cut-off price.
2. Private Placement:
After having discovered the coupon through the auction mechanism, if on account of some
circumstances the government / RBI decide to further issue the same security to expand the
outstanding quantum, the government usually privately places the security with RBI. The RBI in
turn may sell these securities at a later date through their open market window albeit at a different
yield
On-tap issue: under this scheme of arrangements after the initial primary placement of a
security, the issue remains open to yet further subscriptions. The period for which the issue
remains open may be sometimes time specific or volume specific
3. Commercial papers:
Commercial papers are generally issued via private placement.
CPs are issued in electronic form.

4. Certificate of deposits:
Banks can issue certificate of deposits.
Certificate of deposits are issued via private placement.
At present CDs are issued in physical form.
Primary Dealers:
Primary Dealers in India are the authorized dealers appointed by the Reserve Bank of India to
deal in Government Securities.
The objectives of Primary Dealers are:
To strengthen the infrastructure in the government securities market in order to make it
vibrant, liquid and broad based.
To ensure development of underwriting and market- making capabilities for government
securities outside the RBI
To improve secondary market trading system, which would contribute to price discovery,
enhance liquidity and turnover and encourage voluntary holding of government securities
amongst a wider investor base
To make PDs an effective conduit for conducting open market operations Primary dealers
have played a critical role in widening and deepening the Government Securities in India.
Primary Dealers in US are banks or brokerage firms who may directly trade with the Federal
Reserve.
Make bids and offers when Fed conducts open market operations and actively participate in
US Treasury security auctions.

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1.3 Secondary market activities of money market instruments
Treasury bills are mostly held to maturity by a majority of the buyers.
364 days treasury bill is comparatively more actively traded.
Markets for government securities are pre-dominantly wholesale markets, with trades done on
telephonic negotiations.
Traders have to report their trades within 24 hours of the trade to the central bank.
Central bank (PDO) updates books with the trades.
Generally these trades are settled on the same day or the next day.
Exchange traded CPs, CDs are settled in the same procedure followed for stock market.
1.4 Regulators role in the money market
In India the Reserve Bank of India is the main regulator for the money market. The RBI also
regulates the market through the control of the investment policy followed by banks. As an example
RBI has allowed banks to invest in debentures of private sector companies.

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Chapter 2
Commodities Market
Commodity markets are markets where raw or primary products are exchanged.
The modern commodity markets have their roots in the trading of agricultural products. While wheat and
corn, cattle and pigs, were widely traded using standard instruments in the 19th century in the united
states, other basic foodstuffs as soybeans were only added quite recently in most markets.
List of traded commodities:
Food stuff: coffee, sugar, rice, soybeans, wheat, sunflower oil, orange juice, etc.
Fuels: crude oil, gasoline, diesel, petrol, etc.
Precious metals: gold, platinum, silver, etc.
Industrial metals: copper, lead, zinc, aluminium, nickel, steel, etc.
Rare metals: indium, silicon, germanium, cobalt, etc.
Others: cotton, rubber, wool, etc.
Commodity markets are organized traders' exchange in which standardized, graded products are
bought and sold.
Worldwide, there are 48 major commodity exchanges that trade over 96 commodities, ranging from
wheat and cotton to silver and oil.
Most trading is done in futures contracts, that is, agreements to deliver goods at a set time in the
future for a price established at the time of the agreement.
Commodity futures trading allows both hedging to protect against serious losses in a declining
market and speculation for gain in a rising market.
For example, a seller may sign a contract agreeing to deliver grain in two months at a set price.
If the grain market declines at the end of two months, the seller will still get the higher price,
quoted in the futures contract. If the market rises, however, speculators buying grain stand to
profit by paying the lower contract price for the grain and reselling it at the higher market price.
Commodity spot contracts, a less widely used form of trading, call for immediate delivery of a
specified commodity and are often used to obtain the goods necessary to fulfill a futures
contract.
2.1 Commodities Exchange:
An entity, usually an incorporated non-profit association that determines and enforces rules and
procedures for the trading of commodities and related investments, such as commodity futures.
Commodities exchange also refers to the physical center where trading takes place.
Modern commodity markets began with the trading of agricultural products, such as corn, cattle,
wheat and pigs in the 19th century.

90
Modern commodity markets trade many types of investment vehicles, and are often utilized by
various investors from commodity producers to investment speculators.
For example, a corn producer could purchase corn futures on a commodity exchange to lock in a
price for a sale of a specified amount of corn at a future date, while at the same time a speculator
could buy and sell corn futures with the hope of profiting from future changes in corn prices
Multi Commodity Exchange of India ltd (MCX) and National Commodity & Derivatives Exchange
India (NCDEX) are the two commodity exchanges in India.
2.2 Regulators:
The Commodity Futures Trading Commission (CFTC) is the federal agency that regulates
the futures markets in the US. The mission of the CFTC, which was created by congress in
1974, is to protect commodities market participants against manipulation, abusive trade
practices and fraud; to guarantee the integrity of commodity market pricing; and to assure the
financial solvency of commodity brokerage firms, exchanges, and clearinghouses. The CFTC's
oversight and regulation help assure that commodities markets provide effective price
discovery and risk-transfer opportunities
The Forward Markets Commission (FMC) is the regulator for the commodities market in
India. The FMC functions under the administrative control of the union ministry of food and
consumer affairs and the law governing commodity forward and futures trading in commodities
is the forward contracts regulation act 1952.

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Chapter 3
Derivatives Market
A financial instrument whose characteristics and value depend upon the characteristics and value of an
underlying instrument or asset, typically a commodity, bond, equity or currency is known as derivative.
3.1 Types of Derivatives:
3.1.1 Forward Contracts
It is an over-the-counter obligation to buy or to sell a financial instrument or to make a payment at
some point in time in the future. Details of which were settled privately between the two
counterparties.
For example: forward foreign exchange contracts in which one party is obligated to buy foreign
exchange from another party at a fixed rate for delivery on a pre-set date.
3.1.2 Futures
An exchange-traded obligation to buy or sell a financial instrument or to make a payment at one of
the exchange's fixed delivery dates, the details of which are transparent publicly on the trading floor
and for which contract settlement takes place through the exchange's clearinghouse
Or
A futures contract is an obligation (that is, a legally binding agreement between a buyer and seller)
to receive (in the case of a long position) or deliver (in the case of a short position) a commodity or
financial instrument sometime in the future, but at a price that's agreed upon
Types of futures:
Commodity futures: the underlying instrument is commodity which can be grains, coffee beans
for example an orange-juice future contract, gives one person the obligation to take delivery of
some huge amount of orange juice at a fixed price on some date. Alternately, who wrote (i.e., sold)
the contract, has the obligation to deliver that orange juice
Stock index futures
Currency futures
Stock futures
Bond futures
Interest rate futures
3.1.3 Options
The right but not the obligation to buy (sell) some underlying cash instrument at a pre-determined
rate on a pre-determined expiration date in a pre-set notional amount
An option contract gives the buyer or owner (also called the "holder") the right, but not the
obligation, to buy (in the case of a call option) or sell (in the case of a put option) the underlying

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commodity, stock at an agreed upon price (known as the "strike price"), on or before the option
expiration date
Call option: a call option is a financial contract giving the owner the right but not the obligation to
buy a pre-set amount of the underlying financial instrument at a pre-set price with a pre-set maturity
date
Put option: a put option is a financial contract giving the owner the right but not the obligation to sell
a pre-set amount of the underlying financial instrument at a pre-set price with a pre-set maturity
date
Types of options:
Stock options
Index options
Interest rate options
3.1.4 Swaps
It is an agreement between two entities to exchange a stream of payments without transferring
underlying debt.
Interest rate swap: is an agreement to exchange fixed interest payments for floating rate
payments calculated for an agreed notional amount. There is no exchange of principal. By usage,
fixed-rate payer has sold swap, floating-rate payer has bought swap
For example, take the case of a fixed-to-floating interest rate swap.
Here party A makes periodic interest payments to party B based on a floating interest rate of LIBOR
+50 basis points.
Party B in turn makes periodic interest payments based on a fixed rate of 3%. The payments are
calculated over the notional amount. The first rate is called floating, because it is reset at the
beginning of each interest calculation period to the then LIBOR.
A B
Rating Rate
LIBOR + 50bps
Fixed Rate: 3.00%
3.2 Overview of futures trading:
Futures trades take place at any of a number of centralized exchanges, often in open-outcry,
auction-style trading pits and electronic trade-matching platforms (such as the Chicago
mercantile exchange's globex system, for example).
In every transaction, the exchange clearinghouse is substituted as the buyer to the seller and
the seller to the buyer, thereby guaranteeing performance and eliminating counterparty risk.

93
Customers who trade futures are required to post margin deposits with an exchange member
firm which, in turn, must deposit margin with the exchange. Margins are not payment against
the market value of the commodity represented by the futures contract, but rather, are a
performance bond -- a good-faith deposit -- to ensure the ability of market participants to honor
their financial commitments and cover any obligations which might arise out of their trading
activities.
Buying a futures contract is called taking a "long" position. Selling a futures contract is referred
to as taking a "short" position.
A long futures position profits when the futures price goes up, and a short futures position
profits when the futures price goes down. Maturing futures contracts expire on specific dates,
usually during the contract month.
At any time before the contract matures, the trader may offset, or close out, his or her
obligation by selling what was previously bought or buying what was previously sold.
By offsetting an open futures contract, a trader is relieved of any obligation to make or take
delivery of the underlying commodity or financial instrument. This is made possible by the fact
that futures contracts have standardized terms and trade on centralized exchanges. The vast
majority of futures contracts, in fact, are closed out by offsetting market transactions prior to
their maturity, rather than through the delivery process.
3.2.1 Futures Exchanges:
Worldwide futures exchanges typically operate with a trading floor where traders and brokers
compete on equal footing in an auction-style, open-outcry market and where they communicate by
voice and hand signals with others in the pit.
In the recent times the electronic trading has become more commonplace, though futures trading in
some of the old markets continue to be dominated by the open-outcry, auction-style pit trading
during normal business hours.
3.2.2 Futures Clearinghouses:
Each futures exchange has its own clearinghouse that acts as the master bookkeeper and
settlement agent.
In every matched transaction executed through the exchanges facilities, the clearinghouse is
substituted as the buyer to every seller and the seller to every buyer.
The clearinghouse deals exclusively with clearing members and holds each clearing member
responsible for every position it carries on its books, regardless of whether the position is being
carried for the account of a non-member public customer or for the clearing member's own account.
The clearinghouse makes the clearing member sole responsible for carrying and guaranteeing an
account to secure all margin requirements and payments.
3.2.3 Futures Brokers:
They are intermediary between public customers and an exchange.
Maintain records of each customer's open futures positions, margin deposits, money balances and
completed transactions.

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A futures broker is the only entity, outside a futures clearinghouse, that can hold the funds of
futures customers.
In return for providing these services - and for guaranteeing the accounts carried on its books to the
exchange clearinghouse - broker earns commissions.
3.2.4 Futures Market Participants:
Futures market participants may be divided into two broad categories:
Hedgers: who actually deal in the underlying commodity or financial instrument and seek to
protect themselves against adverse price fluctuations.
Speculators (including professional floor traders): who seek to profit from price swings.
Hedgers:
The futures markets exist to facilitate the management of risk and are thus used extensively by
hedgers.
Individuals or businesses who have exposure to the price of an agricultural commodity, or currency,
or interest rates, for instance, and take futures positions designed to mitigate their risks.
This requires the hedger to take a futures position opposite to that of his or her position in the
actual commodity or financial instrument. For example, a soybean farmer is at risk should the price
of the commodity fall before he harvests and sells his crop. A short position in the futures market
will return a profit when the price of soybeans declines, and the hedger's profit on the short futures
position compensates for the loss on the physical commodity.
Speculators:
Speculators are attracted to futures trading purely and simply because they see the opportunity to
profit from price swings in commodities and financial instruments.
Speculators take advantage of the fact that the futures markets offer them access to price
movements; the ability to offset their obligations prior to delivery.
In pursuit of trading profits, speculators willingly take risks that hedgers wish to transfer.
In this process, speculators provide the liquidity that assures low transaction costs and reliable
price discovery, market characteristics which, in turn, make futures markets attractive to hedgers.
3.2.5 Regulators:
In the US, the commodity futures trading commission (CFTC) is the federal agency that regulates
the futures markets. The mission of the CFTC, which was created by congress in 1974, is to protect
futures market participants against manipulation, abusive trade practices and fraud; to guarantee
the integrity of futures market pricing; and to assure the financial solvency of futures brokerage
firms, exchanges, and clearinghouses Securities exchange commission (sec) is the regulator for
options in the US
In India derivatives and derivative markets come under SEBI regulation

95
Gold February futures performance on multi commodity exchange of India (MCX)

Silver march futures performance on multi commodity exchange of India (MCX)

Soyabean February futures performance on NCDEX

Guar gum February futures performance on CDEX

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3.3 Overview of Options Trading:
The holder may exercise the options, sell the options or may allow it to expire
The option holder may exercise the option any time after purchasing it, right up to the last
trading day
Whenever an option holder exercises an option, somewhere an option seller (or "writer") is
"assigned" the obligation to fulfill the terms of the option contract
A call option is said to be "out-of-the-money" if the underlying asset is trading below the strike
price of the option
A call option is "in-the-money" if the underlying security is trading above the call option's strike
price
Put options work in the exact opposite fashion
The trading mechanism of options is same as futures.
3.3.1 About options trading at NSE:
The option markets in particular are not easily accessible to retail investors/traders. For example,
the minimum value for an index/stock option contract at the NSE is of the order of 200,000
(~$4400). Margin requirements in the 10-20% range do help to some extent, but retail investors
with limited capital would be playing with fire if they traded fully on margin. Also, the retail
participants lack of familiarity with option writing, combined with higher margin requirements for
option sellers led to relatively higher option premia in the early days.
But there is hope the trends show the remarkable growth in derivatives trading since 2000. The
NSE now ranks among the top exchanges for single stock futures! Here are charts that show the
rapid growth in index & stock option contract volumes:

97
Volumes of futures & options trading in dec05 on NSE

source: NSE India

98

Source: NSE India

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Chapter 4
Foreign Exchange Markets
Foreign exchange trading is the simultaneous buying of one currency and selling of another

With a daily average turnover of approximately U.S. $1.9 trillion, the foreign exchange market,
also known as the "forex" or "fx" market, is the largest financial market in the world
Traditionally, forex market participants have always included major international commercial
and investment banks, large multinational corporations, global money managers, currency
dealers, and international money brokers
Three main reasons to participate in the forex market:

One is to facilitate an actual currency exchange, whereby an international corporation, for
instance, may convert profits earned in foreign currencies back into its domestic currency
Hedging is another common commercial use of the forex market -- corporate treasurers
and money managers routinely use the fx market in order to hedge against unwanted
exposure to future price movements in the currency market
And finally, speculation for profit represents the most popular use of the forex market -- in
fact, estimates suggest that more than 95% of all forex trading represents speculative
activity
Fx trading is not centralized on an exchange and conducted between two counterparts over the
telephone or via an electronic network (over the counter market)
It is a 24 hour market. Trading begins each day at Sydney and moves to other financial centers
as the business opens
The world's currencies are on a fluctuating exchange rate and are always traded in pairs
For example Euro/Dollar or U.S. dollar/yen
U.S. dollar, Japanese yen, Euro, British pound, Swiss franc, Canadian dollar and the Australian
dollar cover 85% of the forex trade
Forex transactions always involve the simultaneous purchase of one currency and sale of
another
Fx traders express a market position in terms of the first currency in the pair -- for example, a
trader who has bought dollars and sold yen (USD/JPY) at 103.99 is considered to be long U.S.
dollars and short yen
Quoting convention is to display 1 unit of the first currency in the pair expressed in terms of the
second currency in the pair by way of example, if the USD/CHF pair is quoted as 1.6433, this
means that $1 is the equivalent of 1.6433 Swiss francs
Currency prices are affected by a variety of economic and political conditions, most importantly
interest rates, inflation and political stability
Moreover, the central banks of various governments occasionally intervene in the forex market
to influence the value of their currencies, either by flooding the market with their domestic
currency in an attempt to lower the price, or conversely, by buying in order to raise the price

100
Any of these factors, as well as large market orders, can cause high volatility in currency prices.
However, the size and depth of the forex market makes it virtually impossible for any single
market participant to drive the market in one direction or the other for any length of time
Currency traders make decisions using both technical factors and economic fundamentals
Technical traders use charts, trend lines, support and resistance levels, and numerous patterns
and mathematical analyses to identify trading opportunities
Fundamentalists predict price movements by interpreting a wide variety of economic
information, including news, government-issued indicators and reports, and even rumor
The most dramatic price movements, however, occur when unexpected events happen
The event can range from a central bank raising domestic interest rates to the outcome of a
political election or even an act of war
Nonetheless, more often it is the expectations surrounding an event that drives the market
rather than the event itself
4.1 Regulatory Role:
In the US the commodity futures modernization act of 2000 (CFMA) placed responsibility for
overseeing and regulating the foreign exchange market with the commodity futures trading
commission (CFTC). Generally, if a brokerage company is to offer over-the-counter (OTC) foreign
exchange trading to retail customers, it must be registered as a futures commission merchant
(FCM) and as such, is subject to strict capital requirements
In India, RBI is the regulator for the foreign exchange market

Indian rupee vs us dollar $ for the period aug05 to feb06

101
Indian rupee vs British pound for the period aug05 to feb06

Indian rupee vs Euro for the period aug05 to feb06

Indian rupee vs Japanese yen for the period aug05 to feb06

102
Chapter 5
Investors
5.1 Mutual Funds:
A mutual fund is a financial intermediary that facilitates a group of investors to pool their money
together with a predetermined investment objective. The pooled funds are managed by a fund
manager who invests into specific securities (usually stocks or bonds) in line with the pre-
determined objective.
Mutual fund issues units to the investors in accordance with quantum of money invested by
them. Investors of mutual funds are known as unit holders.

Investors
pool their
money with
passed
back to
Invest in
Generates
Fund
Manager
Returns
Securities

Structure of a Mutual Fund
There are many entities involved and the diagram below illustrates the organisational set up of a
mutual fund:

103

Fund Sponsor: Establishes the MF as a Trust, appoints Trustees and Promoter of the Asset
Management Company (AMC).
Trustee: Holds Mutual Funds property for the benefit of the unit holders; vested with the
general power of superintendence and direction over AMC. Monitor the performance and
compliance of SEBI Regulations by the mutual fund.
AMC: Floats new schemes and manages the funds collected in the scheme by investing in
various types of securities in line with the investment objective of the Mutual Fund. Governed
by AMC Agreement and manages funds in tune with SEBI guidelines.
Mutual Fund: Hold unit holders funds collected through various schemes in Trust. Is governed
by SEBI and managed by the Trustees.
Custodian: Responsible for safekeeping of investments of the Fund and monitors all benefits
due to the Fund.
Registrar & Transfer Agent: Performs record keeping functions, and investor servicing which
includes managing investors purchases, redemptions, etc.
Distributors: Marketing funds to the investors. They are typically Banks, Broking Houses,
Brokers Corporate & Retail and Financial Advisors
SEBI: Regulatory body; Protects the investors interests. Regulates & promotes growth of
Mutual Funds

Net Asset Value (NAV)
Net Asset Value is the market value of the assets of the scheme minus its liabilities. The per unit
NAV is the net asset value of the scheme divided by the number of units outstanding on the
Valuation Date.
Entry Load: Entry load is the commission that an investor has to pay while purchasing units of a
mutual fund. This is a certain percentage that the mutual fund charges to meet its expenses.
Exit Load means a similar kind of commission but its charged when the investor exits the scheme.
5.1.1 Types of Schemes:
By Structure
Open Ended: Always open for re-purchase (even after the closure of NFO) and for
redemption. Repurchase price pegged to the NAV.
Closed Ended: It is not open for re-purchase after the NFO period and can be traded on
stock exchanges
By Investment Objective
Growth: Typically invest in instruments which will grow faster such as equities. More riskier.
Income: Invests in fixed income securities for regular income and less riskier.
Balanced: Invests in both the type of securities.

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Index: Invests in securities which are part of the index. Performance is very near to the
indexs performance.
By Investment option
Growth: The returns on the investment will be automatically re-invested in the market and
the value is just the reflection of the underlying
Dividend: Some of the returns on investments are distributed in the form of cash to the unit
holders
Bonus: Some of the returns on investments are distributed in the form of further units to the
unit holders
Dividend Re-Investment: The fund re-invests the dividend into the mutual fund and allots
more units to the unit holders as per the NAV
Equity Linked Saving Scheme / Tax scheme: These are equity funds and have a lock in
period (3 years) to avail the tax benefit.
Investment Options
Systematic Investment Plan (SIP): Fixed amount invested in MF at regular intervals for a
fixed period. Typically for investors who would like to invest a small portion of their income
every month.
Systematic Withdrawal Plan (SWP): A large amount invested in a MF being withdrawn at
regular intervals for a fixed period in such a way that the investment becomes nil at the end
of the period.

5.2 Banks & Financial Institutions:
Banks as Investors
Banks invest in Government Securities and SLR Bonds as a part of the statutory requirement
of maintaining a certain portion of their deposits this form.
Banks invest in Equities, Money Markets, Bond Markets and Forex Markets to take positions or
to hedge their positions.
Banks invest with various time horizons to maximize returns on their assets
Financial Institutions
FIs invest their surplus typically into bond and equity markets to maximize their returns.
Insurance companies invest based on market conditions and insureds appetite (option
chosen) in either equity or debt markets.
FIs usually adopt a long term view while taking an exposure in the markets.

105
5.3 Foreign Financial Institutions:
Foreign Institutional Investors (FIIs) are typically pension funds, mutual funds, hedge funds,
investment trusts, foundation or charitable trusts etc. established or incorporated outside India
who are allowed to invest in the Indian securities.
FIIs are first cleared by RBI and then registered with SEBI before they take up exposure in
Indian markets.
RBI monitors FII exposure in Indian companies and SEBI regulates their functioning in the
Indian markets.
First allowed to invest in 1992-93, FIIs are today major players on the Indian stock markets;
No. of FIIs registered with SEBI increased from 496 in 1997-98 to 823 as on December 31,
2005; was 685 in 2004-05.
Net investments in calendar year 2005 was at a record high of US $ 10.11 billion; was US
$ 8.52 b in 2004, US $ 6.6 b in 2003 and modest US $ 4.3 million in 1992-93
Investments for Calendar month Jan 06 was US $ 603 million.

5.4 Hedge Funds:
An investment vehicle wherein the investment manager is allowed the freedom and flexibility to
invest in a variety of markets and to utilize investments and strategies with variable long/short
exposure and degrees of leverage
Features
Hedge funds target absolute returns versus mutual funds which target returns relative to a
benchmark
Hedge funds styles and strategies fit into three broad categories: Relative Value (capturing the
spread in two relative securities), Event-Driven (Exploit pricing inefficiencies that have been
caused by corporate events, such as a mergers) and Opportunistic (Taking long or short
positions by correctly predicting the direction of the security)
Hedge funds typically charge an asset management fee of 1-2 % of assets and levy a 20%
performance or incentive fee on the profits
Hedge funds are meant for High Net worth Individuals hence have high minimum investment
criteria
Hedge funds are subject to very few regulatory controls and required to register with the local
regulators
5.4.1 Prime Brokers:
Specialized Brokerage services provided by brokers to special clients who need non-standard
services e.g. clients who place orders for large trades.
Term attributed more with the US markets.
Prime Brokers typically offer following services:
Global Custody (incl. clearing, custody and asset servicing)

106
Securities Lending
Financing (facilitating leverage to clients assets)
Operational Support (act as primary contacts to the clients counterparties)
Also offer Value Added Services like:
Funds Mobilization: Introducing Hedge Funds clients to prospective investors.
Office Space and Leasing: Provide and sub-lease commercial real estate office space to
hedge funds clients.
Risk Management Advisory Services Providing Risk Analytic Technology.
Consulting Services Any other service including regulatory advisory services.

F i n a n c i a l A c c o u n t i n g
M o d u l e - 5

109
Financial Accounting Module 5
TABLE OF CONTENTS

1. INTRODUCTION .. 101
2. ACCOUNTING PRINCIPLES, POLICIES AND STANDARDS ... 102
2.1. Nature of Accounting Principles........................................................................................ 102
2.2. Classification of Accounting Principles ............................................................................. 103
2.3. Accounting concepts........................................................................................................ 103
2.4. Accounting Conventions ...................................................................................... 105
3. FINANCIAL STATEMENTS 107
3.1. Balance sheet ................................................................................................................... 107
3.1.1. Components of the balance sheet: ...................................................................... 108
3.1.2. Some Concepts arise out of balance sheet: ........................................................ 110
3.2. Profit and Loss / Income statement ..................................................................... 111
3.2.1. Items highlighted in P& L Statement ................................................................... 124
3.2.2. Some Concepts arise out of balance sheet: ........................................................ 124
3.3. Cash / Funds flow statement ............................................................................................ 115
3.3.1. Operations............................................................................................................ 124
3.3.2. Investing............................................................................................................... 124
3.3.3. Financing ............................................................................................................. 124
4. VALUATION OF THE BALANCE SHEET 131
4.1. Why should anyone analyse a balance sheet: ................................................................. 131
4.2. Accounting standards followed for valuation .................................................................... 132
5. FINANCIAL RATIOS .. 134
5.1. Liquidity Ratios:................................................................................................................. 134
5.1.1. Current ratio: ........................................................................................................ 134
5.1.2. Quick ratio (Acid-test ratio): ................................................................................. 135
5.1.3. Cash ratio:............................................................................................................ 135
5.2. Leverage Ratios: ............................................................................................................... 135
5.2.1. Debt-equity ratio:.................................................................................................. 136
5.2.2. Debt ratio:............................................................................................................. 136
5.2.3. Debt service coverage ratio: ................................................................................ 128
5.2.4. Interest coverage ratio (Times interest earned ratio):.......................................... 136
5.3. Turnover Ratios / Asset management ratios: ................................................................... 129
5.3.1. Inventory / stock turnover ratio:............................................................................ 129
5.3.2. Receivables turnover ratio: .................................................................................. 129
5.3.3. Fixed Assets turnover ratio: ................................................................................. 129
5.4. Profitability Ratios: ............................................................................................................ 130
5.4.1. Profit margin ratios: .............................................................................................. 137
5.4.2. Rate of return ratios: ............................................................................................ 139

110
5.5. Valuation Ratios: ............................................................................................................... 139
5.5.1. Price to Earnings ratio (P/E ratio): ........................................................................ 139
5.5.2. Earnings per share (EPS) ..................................................................................... 139
5.5.3. Yield ...................................................................................................................... 139

111
Chapter 1
Introduction
The stakeholders of a firm are interested in knowing about how the company is doing and what is
its financial condition though their specific interests may differ from each other.
Following are broadly considered as stake holders of the company;
Shareholders
Creditors
Suppliers
Managers
Employees
Tax authorities
And others

Trade creditors and short-term lenders are interested primarily in the short-term liquidity of the
company and its ability to pay its dues.
Long-term bond holders are concerned about the ability of the company to service the debt till
the maturity.
Long-term shareholders, managers and employees who want to make a career with the
company are interested in the profitability and growth of the firm.
Stakeholders look at three financial statements, viz. the balance sheet, the profit and loss
statement, and the funds flow statement to understand the financial performance and condition
of a company.
The balance sheet shows the financial position or condition of the company at a given point of
time.
The profit and loss or income statement reflects the financial performance of the company
over a period of time.
The cash / funds flow statement portrays the flow of funds through the business during a
given accounting period. It answers, what are the sources of funds? and how did the company
utilized the funds?

112
Chapter 2
Accounting Principles, Policies and Standards

The accounting information of a company is studied and relied on by a greater number of persons
than its owners or management. This implies two aspects
The financial statements are to be prepared with greater care towards completeness and
clarity, as the users do not have the facility of seeking clarification and have to rely solely on
the published information; and
The information furnished by different companies should, as far as possible, use common
terms, apply common principles and adopt common approach in the presentation of data so
that the comparison is facilitated.
2.1. Nature of Accounting Principles
The term principles is used in accounting to mean a general law or rule adopted or professed as a
guide to action.
In drawing up accounting statements, whether they are external financial accounts or internal-
focused management accounts, a clear objective has to be that the accounts fairly reflect the true
substance of the business and the results of its operation.
The theory of accounting has, therefore, developed the concept of a true and fair view. The true
and fair view is applied in ensuring and assessing whether accounts do indeed portray accurately
the business activities.
There is general agreement that, before it can be regarded as useful in satisfying the needs of
various user groups, accounting information should satisfy the following criteria; understandability,
comparability, relevance, objectivity and feasibility.
Understandability implies the expression, with clarity, of accounting information in such a way
that it will be understandable to users who are generally assumed to have a reasonable
knowledge of business and economic activities.
Comparability implies the ability for users to be able to compare similar companies in the
same industry group and to make comparisons of performance over time.
Relevance means that it should be able to influence the decision taken when alternatives are
available. In other words, it should provide meaningful and useful information about the
organization to those who want to know something about it.
Objectivity implies that it should not be influenced by the personal prejudices of the complier.
The information should be reliable and can be verified from some documentary evidence.
Feasibility is that it should be capable of being implemented without undue complexity or cost.

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2.2. Classification of Accounting Principles
The accounting principles are variously known as concepts, conventions, postulates, theories and
assumptions. However, the general trend is to accept Principles as the comprehensive term to
include the sub-divisions Concepts and Conventions.

Accounting principles relate to the recording of data and preparation of financial statement. They
constitute the basic accounting postulates, i.e. necessary assumptions and ideas on which the
accounting practice is based. They have received widespread, though not universal, acceptance by
accountants.
2.3 Accounting concepts
1) Entity concept:
This concept requires that the business be treated separate from (a) its owners and (b) other units
owned by the same owners. For the purpose of accounting, the business firm is regarded as a
separate entity as distinct from the persons who are connected with it. Any profit earned by the
business is the amount due from the business to the owner. The accountant records transactions
as they affect this entity and regards owners, creditors, suppliers, employees, customers and the
government as parties transacting with this entity.
Accounting Principles
Accounting Concepts Accounting Conventions
Entity
Money
measurement
Stable Monetary
unit
Going concern
Cost
Duel aspect
Accounting
period
Accrual
Realisation
Matching
Conservatism
Consistency
Disclosure
Materiality

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2) Money / monetary measurement concept:
Accounting is concerned with only those facts which are expressible in monetary terms.
For example if a company has cash Rs. 5,000, building 2,500 sq.ft. and land of 5,000 sq.ft. 20
numbers of furniture and 200 kgs of goods, it would be shown as cash Rs. 5,000, buildings Rs.
1,000,000, land Rs. 200,000, furniture Rs. 50,000 and goods Rs. 60,000. Therefore, this concept
provides a uniform basis of accounting, making their recording and summarizing easy.
3) Stable monetary unit concept:
Monetary unit remains stable and values recorded at that time that events occur are not changed.
In other words, changes in the purchasing power (due to inflation) of money are not considered.
4) Going concern concept:
It assumes that the company will remain in business for an indefinitely long period.
5) Cost concept:
All the assets of the company are recorded at their cost value and this is used for all subsequent
accounting purposes. For example, depreciation is charged on the basis of the original cost.
6) Dual aspect concept:
Regarded as the most distinctive and fundamental concept of accounting. Accounting recognizes
that every transaction has two aspects. For instance, when the proprietor introduces Rs. 10,000 as
capital, the company acquires Rs. 10,000 as an asset in the form of cash. At the same time, the
transaction creates a liability for the company as the amount repayable to the owner. If the
company purchases machinery for Rs. 6,000 by paying cash, there is addition to the machinery
owned by the company, but the cash is depleted. In accounting, both the aspects are recorded.
This gives rise to the accounting equation
Assets = Liabilities

After first transaction of introduction of capital, the equation would appear as
Assets Liabilities
Cash Capital
Rs. 10,000 = Rs. 10,000

After the second transaction, the equation would appear as:
Assets Liabilities
Cash + Machinery Capital
Rs. 4,000 + Rs. 6,000 = Rs. 10,000

The recognition of the dual aspect of transaction is the basis of the Double Entry System which
forms the foundation of the modern accounting practice.
7) Accounting period concept:
In order to know the results of business operations and financial position of the firm periodically,
time is divided into segments referred to as Accounting periods. In India generally companies
adopt the financial year as April to March, although there are variations. However, listed companies
may have to prepare various statements in every quarter or every half year to meet the exchange
regulations.

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8) Accrual concept:
Under this concept, an expense is to be provided for when it is due, whether it is actually paid or
not. For example, if rent of March may be paid in April. However, if the profit and loss account is
prepared covering period up to March, the rent for March has to be included although it is unpaid.
Similarly, income which has accrued, but not yet received can also be included, provided it is
certain.
The accounting system based on the accrual concept is known as Mercantile system of
accounting or Accrual basis of accounting. The accounting system based on actual cash receipts
and payments is known as Cash basis accounting which may suit some social service
organizations. There is one more system Hybrid system of accounting which follows both the
concepts. As per the income tax guidelines companies have to follow Mercantile system of
accounting only.
9) Realisation concept:
According to this concept, revenue is deemed to be earned only when it is realised. For example,
revenue is realised when goods are shipped or delivered to the customer, and not when a sales
order is received or a contract is signed. Raw material is getting value added during the process of
manufacture. Though there is a profit added at every stage, the realization will not happen until the
finished goods are sold.
10) Matching concept:
Once revenues for an accounting period are recognized, expenses incurred in generating these
revenues are matched against them. When sales are accounted in a year, all expenses needed to
manufacture the goods and sell them should be included in the same year. If the expenses have
not been paid, they should be accounted as outstanding expenses.
2.4 Accounting Conventions
1) Conservatism:
The purpose of conservatism is not to project a better picture about the company than what it really
is. Caution should be exercised in recognizing the unrealised income, but all expected expenses
have to be provided for. The idea is not to mislead the users of the information with an optimistic
estimate which may not realise. Anticipate no profit but provide for all possible losses. Accordingly
current assets are generally valued at cost or market value, whichever is lower.
2) Consistency:
The methods adopted to value the assets should not be changed during the life of the asset
concerned. If, for any reason, the method is changed, the fact should be revealed in the financial
statements.
3) Disclosure:
All relevant factors about the operations and financial position of the company that would have an
impact on the decision making by the users of the information should be reported in the financial
statements. These reports should not conceal any material fact about the companys financial
status.

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4) Materiality:
This convention moderates the convention of disclosure. There may be cases where the effect of
non-adherence to the concepts would be negligible and bring no material change in the position as
revealed at the same time a strict adherence to the concepts may increase the cost of accounting
without adding any value. These cases can be ignored. For example, instead of keeping an
elaborate record of individual items of stationery, the closing stock may be estimated and the
balance written off as expense. It also means that in the financial statements certain items may be
shown in groups rather than as individual items.

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Chapter 3
Financial Statements

As discussed earlier, the financial statements are largely divided into three. The balance sheet, the profit
& loss statement and the cash / funds flow statement.
These three are the most important financial statements produced by a company. While each is important
in its own right, they are meant to be analyzed together.
3.1 Balance sheet
A balance sheet is a snapshot of the company at a given point in time. The date of the balance
sheet is always recorded because the balance sheet changes over time. The balance sheet of a
company could be given at the fiscal year end, end of the month, or end of the quarter. Most
companies produce a balance sheet on a monthly basis for financial reporting purposes.
It shows the financial condition of a business at a given point of time. As per the companies act, the
balance sheet of a company shall be in either horizontal form or the vertical form.
Horizontal form

Liabilities and Equity Assets
Share Capital
Reserves and surplus
Secured loans
Unsecured loans
Current liabilities and provisions
Fixed assets
Investments
Current assets, loans & advances
Miscellaneous expenses
Vertical Form

I. Liabilities & Capital
(1) Shareholders funds
a) Share capital
b) Reserves and surplus
(2) Loan funds
a) Secured loans
b) Unsecured loans

II. Assets
(1) Fixed assets
(2) Investments
(3) Net current assets, loans and advances
(4) Miscellaneous expenses

3.1.1 Components of the balance sheet:
Liabilities: Liabilities defined very broadly represent what business entity owes others. The
companies act classifies them as follows:
1. Share capital

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2. Reserves and surplus
3. Secured loans
4. Unsecured loans
5. Current liabilities and provisions
Share Capital: This is divided into two types; equity capital and preference capital. Equity
capital represents the contribution of equity shareholders who are technically the owners of the
company. It does not carry any fixed rate of dividend. Preference capital represents the
contribution of preference shareholders and the dividend rate payable on it is fixed.
Reserves and Surplus: These are profits which have been retained in the firm. There are two
types of reserves; revenue reserves and capital reserves. Revenue reserves represent
accumulated retained earnings from the profits of normal business. Capital reserves arise out
of non operational gains such as premium on issue of shares or gain on revaluation of assets.
Surplus is the balance in the profit and loss account which has not been appropriated to any
particular reserve account. Reserves and surplus + equity capital represent owners equity (net
worth).
Secured loans: Borrowings of the company against which specific securities have been
provided. Bonds, loans from financial institutions and loans from commercial banks are
components of these loans.
Unsecured loans: Borrowings of the company against which no security has been provided.
Major components are fixed deposits, loans and advances from promoters, unsecured loans
from banks, etc.
Current liabilities and provisions: Current liabilities are obligations which are expected to
mature in the next twelve months. Loans which are payable within a year from the date of
balance sheet, amounts due to the suppliers of goods & services bought on credit for which
payment has to be made within a year, advance payments received for goods or services to be
supplied in the future, unclaimed dividends, provisions for taxes, and accruals for salaries,
wages, rentals, interest expenses, etc
Assets: Assets represent resources which are of some value to the firm. They have been
acquired at a specific monetary cost by the company for the conduct of its operations.
Under the companies act, the assets are classified as follows:
1. Fixed assets
2. Investments
3. Current assets, loans and advances
4. Miscellaneous expenditures and losses
Fixed assets: These assets have two characteristics; they are acquired for use over relatively
long periods for carrying on the operations of the company and they are generally not meant
for resale. Examples are land, buildings, plant, machinery, etc.
Investments: These are financial securities owned by the company. Some of the investments
like equity shares of other companies held for income and control represent long term

119
commitment of funds. Some may be short term in nature but they have to be shown under
investments heading as per the companies act.
Current Assets, Loans and Advances: This category consists of cash and other resources
which get converted into cash during the operating cycle of the company. The major
components of current assets are: cash, inventories, pre-paid expenses.
Loans and advances are amounts loaned to employees, advances given to suppliers, and
deposits made with governmental and other agencies.
Miscellaneous expenditures and losses: Miscellaneous expenditures represent certain
outlays such as preliminary expenses and pre-operative expenses which have not been written
off. According to accounting a loss represents a decrease in owners equity. Hence, when a
loss occurs, the owners equity should be reduced by that amount. However as per company
law, the share capital can not be reduced when loss occurs. Hence, the loss is shown in the
assets side.
A sample balance sheet has been depicted below for the reference.
Balance sheet of XYZ Ltd as on March 31, 2005
(Rs. in millions)
Liabilities 2005 2004 Assets 2005 2004
Share Capital
Equity
Preference

Reserves & Surplus

Secured loans
Term loans
Cash credit

Unsecured loans
Bank credit
Inter-Corporate
deposits

Current liabilities &
provisions
Trade credit
Advances
Provisions
15.00
15.00
---

11.20

14.30
7.00
7.30

6.90
2.50
4.40

10.50

7.50
2.00
1.00
15.00
15.00
---

10.60

13.10
5.80
7.30

2.50
2.50
---

8.10

6.00
1.30
0.80
Net fixed Assets
Gross Assets
Depreciation(-)

Investments

Current Assets, loans &
advances
Cash & bank
Debtors
Inventories
Advances
Misc. exp & losses
33.00
50.00
17.00

1.00

23.40

1.00
11.40
10.50
0.50
0.50

32.20
46.20
14.00

1.00

15.60

0.60
6.80
7.20
1.00
0.50
57.90 49.30 57.90 49.30

Conclusion
Since balance sheets present the health of a company as of one point in time, valuable information
will be lost if managers do not take the opportunity to compare the progress and trend of a business
by regularly evaluating and comparing balance sheets of past time periods. Information is power.
The information that can be gleaned from the preparation and analysis of a balance sheet is one
financial management tool that may mean the difference between success and failure.

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3.2.2 Some Concepts arise out of balance sheet:
a) Intangible Asset:
An asset that is not physical in nature. Corporate intellectual property (items such as patents,
trademarks, copyrights, business methodologies), goodwill and brand recognition are all common
forms of intangible assets. Intangible assets can often be considered to have indefinite useful lives,
while tangible assets such as factories and equipment generally have defined useful lives, after
which they are of little to no value to a firm.
While intangible assets don't have the obvious physical value of a factory or equipment, they can
prove very valuable for a firm and can be critical to its long-term success or failure. For example, a
company such as Coca-Cola would not be nearly as large if it were not for the high value obtained
through its brand-name recognition. Although brand recognition is not a physical asset you can see
or touch, its positive effects on bottom-line profits can prove extremely valuable to firms such as
Coca-Cola, whose brand strength drives global sales year after year.
For Example: Goodwill is the excess of the purchase price over the fair market value of an asset.
The market sets the price of what a business is worth. In mergers and acquisitions, goodwill arises
when more amount was paid for the business than you'd expect from just looking at the value of its
assets and liabilities. This difference can have a number of reasons, including a happy workforce,
customer loyalty, a good location, and so on.
b) Tangible Asset:
An asset that has a physical form such as machinery, buildings and land.
c) Amortisation:
The paying off of debt in regular installments over a period of time.
The deduction of capital expenses over a specific period of time. Similar to depreciation, it is a
method of measuring the consumption of the value of long-term assets like equipment or
buildings.
For example: Amortization is a way to claim the decrease in value on your car every year. If you
bought your car new for Rs. 400,000 and after the first year it is worth Rs. 350,000, theoretically,
you could amortize the Rs. 50,000 for tax.
3.2 Profit and Loss / Income statement
A Profit and Loss (P & L) statement measures a company's sales and expenses during a specified
period of time. The function of a P & L statement is to total all sources of revenue and subtract all
expenses related to the revenue. It shows a company's financial progress during the time period
being examined.
It summarizes the revenues, costs and expenses incurred during a specific period of time - usually
a fiscal quarter or year. These records provide information that shows the ability of a company to
generate profit by increasing revenue and reducing costs. The P&L statement is also known as a
"statement of profit and loss", an "income statement" or an "income and expense statement".
There is no standard format provided for the profit and loss account however, the companies act
requires that the information provided in the statement should be adequate to reflect a true and fair
picture of the operations of the company for the accounting period.

121
It may be presented in the vertical form or in the horizontal form. Generally companies follow the
vertical form.
The vertical form statement may be a single-step statement or multi-step statement. In a single step
statement all revenues are recorded first then the expenses are shown and finally the net profit is
given. In a multi-step statement, the statement is divided into stages and profit will be calculated at
the end of each stage.
3.2.1 Profit and loss statement highlights the following items:
Net Sales
Cost of goods sold
Gross profit
Operating expenses (Including Depreciation)
Operating profit
Non-operating surplus
Non-operating deficit
Profit before Interest and tax (PBIT)
Interest
Profit before tax (PBT)
Tax
Profit after tax (PAT)
Dividend payout
Net Income
Net Sales: Net Sales are the total revenue generated from the sale of all the company's products
or services minus an allowance for returns, rebates, etc. Sometimes on an income statement, you
might see the terms "gross sales" and "returns," "rebates" or "allowances." Gross sales are the total
revenue generated from the company's products or services before returns or rebates are deducted.
Net sales on the other hand have all these expenses deducted.
Net Sales of XYZ Ltd: Rs. 70.1 millions
Cost of goods sold: It is the sum of costs incurred for manufacturing the goods sold during the
accounting period. It consists of direct material cost, direct labour cost. It is different from cost of
production. (This represents the cost of goods produced during the accounting year and not the
cost of goods sold during the same period)
Cost of goods sold of XYZ Ltd: Rs. 55.2 millions
(Stocks + Salaries + Manufacturing Expenses = 42.1 + 6.8 + 6.3)

Gross profit: Subtract all the money a company spent in the production of its goods and services
(cost of goods sold) from the money made from selling them (net sales).
Gross profit of XYZ Ltd: Rs. 14.9 millions

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(Net Sales Cost of goods sold = 70.1 55.2)

Gross profit on sales is important because it reveals the profitability of a company's core business.
A company with a high gross profit has more money left over to pump into research and
development of new products, a big marketing campaign, or better yet - to pass on to its investors.
Investors should also monitor changes in gross profit percentages. These changes often indicate
the causes of decreases or increases in a company's profitability. For instance, a decrease in gross
profit could be caused by an industry price war that has forced the company to sell its products at a
lower price. Poor management of costs could also lead to a decreased gross profit.
Operating expenses: Consist of general administrative expenses, selling and distribution
expenses and depreciation.
Operating expenses of XYZ Ltd: Rs. 5.6 millions
(Depreciation + General Admn. exp. + Selling exp. = 3.0 + 1.2 + 1.4)

Operating profit: It is a company's earnings from its core operations after it has deducted its cost
of goods sold and its general operating expenses. Operating income does not include interest
expenses or other financing costs. Nor does it include income generated outside the normal
activities of the company, such as income on investments or foreign currency gains.
Operating profit of XYZ Ltd: Rs. 9.3 millions
(Gross profit - Operating exp. = 14.9 + 5.6)

Operating income is particularly important because it is a measure of profitability based on a
company's operations. In other words, it assesses whether or not the foundation of a company is
profitable. It ignores income or losses outside of a company's normal domain. It also excludes
extraordinary events, such as lawsuits or natural disasters, which in a typical year would not affect
the company's bottom line.
Non-operating surplus: It represents gains arising from sources other than normal operations of
the business. Income from investments, profit from disposal of assets.
Non-operating surplus of XYZ Ltd: Nil
Non-operating deficit: It represents losses from activities unrelated to the normal operations of the
company.
Non-operating deficit of XYZ Ltd: Rs. 0.4 millions
Profit before Interest and tax (PBIT) / Earnings before interest and taxes (EBIT): It is the sum
of operating profit and non-operating surplus non-operating deficit. This represents a measure of
profit which is not influenced by interest and tax factors.
PBIT of XYZ company: Rs. 8.9 millions
(Operating profit + Non-operating surplus Non-operating deficit = 9.3 0.4)

Interest: It is the expense incurred for borrowed funds.
Interest of XYZ Ltd: Rs. 2.1 millions
Profit before tax (PBT) / Earnings before taxes (EBT): It is obtained by deducting interest from
profits before interest and taxes.
PBT of XYZ company: Rs. 6.8 millions

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(PBIT Interest = 8.9 2.1)
Tax: It represents the income tax payable on the taxable profit of the year.
Tax of XYZ Ltd: Rs. 3.5 millions
Profit and Loss statement of XYZ Ltd for the year ending March 31, 2005
(Rs. in Millions)
Particulars 2005 2004
Net Sales
Cost of goods sold
Stocks 42.1
Wages and salaries 6.8
Other manufacturing expenses 6.3
______
Gross profit
Operating expenses
Depreciation 3.0
General administration 1.2
Selling 1.4
______
Operating profit
Non-operating surplus/deficit
Earnings before interest and tax
Interest
Profit before tax
Tax
Profit after tax
Dividends
Retained earnings
70.1
55.2

14.9
5.6

9.3
(0.4)
8.9
2.1
6.8
3.5
3.3
2.7
0.6
62.3
47.5

14.8
4.9

9.9
0.6
10.5
2.2
8.3
4.1
4.2
2.7
1.5

Profit after tax (PAT): It is the difference between the profit before tax and tax for the year.
PAT of XYZ company: Rs. 3.3 millions
(PBT Tax = 6.8 3.5)

Dividend: It represents a portion of the companys earnings marked for distribution to the
shareholders.
Dividend of XYZ Ltd: Rs. 2.7 millions
Net Income / Retained earnings: It is the difference between profit after tax and dividends.
Net Income of XYZ company: Rs. 0.6 millions
(PAT Dividend = 3.3 2.7)

Five simple calculations to find out the net profit/loss of a company
1. Net Sales Cost of Goods sold = Gross Profit
Gross profit of XYZ Ltd: Rs. 14.9 millions (70.1 55.2)
2. Gross Profit Operating (Selling & Admn.) expenses = Operating Profit
3. Operating profit of XYZ Ltd: Rs. 9.3 millions (14.9 + 5.6)

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Operating profit + Other Income Other expenses = Profit before
Interest and taxes
4. PBIT of XYZ company: Rs. 8.9 millions (9.3 0.4)
5. Profit before Interest & taxes Interest = Profit before taxes / Net Loss
PBT of XYZ company: Rs. 6.8 millions (8.9 2.1)
6. Profit before taxes Income taxes = Net Profit
PAT of XYZ company: Rs. 3.3 millions (6.8 3.5)

Conclusion
The creation of a profit and loss statement is an important event for a small business. At one glance,
it provides a summary of the most important activities of the company.
A P & L statement is the record of the good news of sales and the less propitious news of
expenses. It provides valuable information to managers and owners including the costs of
goods sold, gross margin, selling and administrative expenses, and net profit. Compiled
on a regular basis, the P & L statement is one of the most important tools for a small
business owner to use to evaluate and make adjustments to operations.
3.2.2 Some Concepts arise out of balance sheet:
EBITDA (Earnings before Interest, Tax, Depreciation & Amortisation): An indicator of a
company's financial performance. EBITDA can be used to analyze and compare profitability
between companies and industries because it eliminates the effects of financing and
accounting decisions.
EBIT (Earnings before Interest & Tax): An indicator of a company's profitability, calculated as
revenue minus expenses, excluding tax and interest. By excluding both taxes and interest
expenses, the figure hones in on the company's ability to profit and thus makes for easier
cross-company comparisons.
An important factor contributing to the widespread use of EBIT is the way in which it nulls the
effects of the different capital structures and tax rates used by different companies. By
excluding both taxes and interest expenses, the figure hones in on the company's ability to
profit and thus makes for easier cross-company comparisons.
EBT (Earnings before Tax): An indicator of a company's financial performance. EBT provides
a level measure to compare companies in different tax jurisdictions.
3.3 Cash / Funds flow statement
Complementing the balance sheet and income statement, the cash flow statement (CFS), a
mandatory part of a company's financial reports. The CFS allows investors to understand how a
company's operations are running, where its money is coming from, and how it is being spent.
The cash flow statement is designed to convert the accrual basis of accounting used to prepare the
income statement and balance sheet back to a cash basis. This may sound redundant, but it is
necessary. The accrual basis of accounting generally is preferred for the income statement and
balance sheet because it more accurately matches revenue sources to the expenses incurred
generating those specific sources.

125
However, it also is important to analyze the actual level of cash flowing into and out of the business.
Like the income statement, the statement of cash flow measures financial activity over a period of
time. It also tracks the effects of changes in balance sheet accounts. It is one of the most useful
financial management tools.
The cash flow statement is distinct from the income statement and balance sheet because it does
not include the amount of future incoming and outgoing cash that has been recorded on credit.
Therefore, cash is not the same as net income, which, on the income statement and balance sheet,
includes cash sales and sales made on credit.
Cash flow is determined by looking at three components by which cash enters and leaves a
company: core operations, investing and financing,
3.3.1 Operations
Measuring the cash inflows and outflows caused by core business operations, the operations
component of cash flow reflects how much cash is generated from a company's products or
services. Generally, changes made in cash, accounts receivable, depreciation, inventory and
accounts payable are reflected in cash from operations.
Cash flow is calculated by making certain adjustments to net income by adding or subtracting
differences in revenue, expenses and credit transactions (appearing on the balance sheet and
income statement) resulting from transactions that occur from one period to the next. These
adjustments are made because non-cash items are calculated into net income (income statement)
and total assets and liabilities (balance sheet). So, because not all transactions involve actual cash
items, many items have to be reevaluated when calculating cash flow from operations.
For example, depreciation is not really a cash expense; it is an amount that is deducted from the
total value of an asset that has previously been accounted for. That is why it is added back into net
sales for calculating cash flow. The only time income from an asset is accounted for in CFS
calculations is when the asset is sold.
Changes in accounts receivable on the balance sheet from one accounting period to the next must
also be reflected in cash flow. If accounts receivable decrease, this implies that more cash has
entered the company from customers paying off their credit accounts - the amount by which AR has
decreased is then added to net sales. If accounts receivable increase from one accounting period
to the next, the amount of the increase must be deducted from net sales because, although the
amounts represented in AR are revenue, they are not cash.
An increase in inventory, on the other hand, signals that a company has spent more money to
purchase more raw materials. If the inventory was paid with cash, the increase in the value of
inventory is deducted from net sales. A decrease in inventory would be added to net sales. If
inventory was purchased on credit, an increase in accounts payable would occur on the balance
sheet, and the amount of the increase from one year to the other would be deducted from net sales.
The same logic holds true for taxes payable, salaries payable and prepaid insurance. If something
has been paid off, then the difference in the value owed from one year to the next has to be
subtracted from net income. If there is an amount that is still owed, then any differences will have to
be added to net earnings.

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3.3.2 Investing
Changes in equipment, assets or investments relate to cash from investing. Usually cash changes
from investing are a "cash out" item, because cash is used to buy new equipment, buildings or
short-term assets such as marketable securities. However, when a company divests of an asset,
the transaction is considered "cash in" for calculating cash from investing.
3.3.3 Financing
Changes in debt, loans or dividends are accounted for in cash from financing. Changes in cash
from financing are "cash in" when capital is raised, and they're "cash out" when dividends are paid.
Thus, if a company issues a bond to the public, the company receives cash financing. However,
when interest is paid to bondholders, the company is reducing its cash.
Funds flow statement of XYZ Ltd for the year ended March 31, 2005 (Rs. in Millions)
Cash Inflows
Operations
Net profit 3.3
Depreciation 3.0
Issue of share capital
Long term borrowings
Sale of fixed assets
Increase in Current Liabilities & provisions
Inter-corporate deposits 4.4
Trade credit 1.5
Advances 0.7
Provisions 0.2
Decreases in current assets other than cash
Advances 0.5
Total Cash generated
Cash outflows
Payment of dividends
Purchase of fixed assets
Repayment of long-term borrowings
Decreases in current liabilities & provisions
Increases in current assets other than cash
Debtors 4.6
Inventories 3.3
Total cash used

Net Change in Cash position

6.3

----
1.2
----
6.8

0.5
____
14.8

2.7
3.8
----
----
7.7

____
14.2

0.4

Tying the CFS with the Balance Sheet and Income Statement
As we have already discussed, the cash flow statement is derived from the income statement and
the balance sheet. Net earnings from the income statement is the figure from which the
information on the CFS is deduced. As for the balance sheet, the net cash flow in the CFS from one
year to the next should equal the increase or decrease of cash between the two consecutive
balance sheets that apply to the period that the cash flow statement covers. For example, if the
calculation is made for a cash flow for the year 2000, the balance sheets from the years 1999 and
2000 should be used.

127
Conclusion
A company can use a cash flow statement to predict future cash flow, which helps with matters in
budgeting. For investors, the cash flow reflects a company's financial health: basically, the more
cash available for business operations, the better. However, this is not a hard and fast rule.
Sometimes a negative cash flow results from a company's growth strategy in the form of expanding
its operations.
By adjusting earnings, revenues, assets and liabilities, the investor can get a very clear picture of
what some people consider the most important aspect of a company: how much cash it generates
and, particularly, how much of that cash stems from core operations.
Problem 1:
From the following particulars of ABC Club, prepare the P & L account and funds flow statement for
the year ended 31-Dec-2005:
Particulars Rs.
Subscription received (including Rs. 4,000 for 2004) 30,000
Donation received 2,000
Subscription outstanding at the end of year 6,000
Rent paid 1,800
Purchase of furniture (life 10 years) at the beginning of the year 1,000
Purchase of sports equipment 2,500
Purchase of Magazines and Newspapers 1,200
Sale of old furniture at the beginning of the year (book value: Rs. 300) 500
Opening cash 6,800
Investments in this year 4,000
Interests received 1,000
Bank charges 20
Postage & Telephone exp. 1,800
Printing & stationary (Including last years Rs. 300) 1,000
Printers bill outstanding 500
Entrance fee 2,700
Honorary secretarys allowances (including last years Rs. 200) 1,800
Honorary secretarys outstanding allowances 300

Solution: Funds flow statement
Particulars Rs. Rs. Rs.
Opening Cash 6,800
Subscription 30,000
Donations 2,000
Sale of Old furniture 500
Interest received 1,000
Entrance fee 2,700
Total 36,200 43,000
Rent 1,800
Furniture 1,000
Sports Equipment 2,500
Magazines & News papers 1,200
Investments 4,000
Bank Charges 20
Postage & Telephone exp 1,800
Printing & Stationery 1,000

128
Honorary Secretarys allowance 1,800
Total 15,120
Closing Cash 27,880

Profit & Loss statement
Subscription
Outstanding
(-) Last years
30,000
6,000
(4,000)
Donations 2,000
Profit on sale of old furniture 200
Interest received 1,000
Entrance fee 2,700
Total 37,900 37,900
Rent 1,800
Depreciation on furniture 100
Magazines & News papers 1,200
Bank Charges 20
Postage & Telephone exp 1,800
Printing & Stationery
Outstanding
(-) Last year payment
1,000
500
(300)

Honorary Secretarys allowance
Outstanding
(-) Last year payment
1,800
300
(200)

Total 8,020 (8,020)
Profit for the year 29,880

Problem 2:
The balance sheet of Public library showed as follows on 31-Mar-2005:
Liabilities Rs. Rs.
Outstanding expenses 700
Creditors 4,300
Reserves 70,000
Total 75,000
Assets
Cash 4,000
Subscription outstanding 1,000
Lecture hall rent outstanding 400
Investments 6,000
Library books 20,000
Furniture & fittings 3,500
Building 40,000
Prepaid Insurance 100
Total 75,000

Rs.1,200 collected as advances to be paid back and Rs.12,500 have been received as subscription
fee. Interest on investments received Rs. 200, Rs. 450 has been received due to sale of news
papers & Rs. 100 due to sale of old furniture. Proceeds from entertainment: Rs. 4,500, Lecture hall
rent received Rs. 1,500. Payment to creditors Rs. 4,300, Books purchased Rs. 1,400. Electricity &
water paid Rs. 1,400, Building repairs Rs. 800, and Insurance paid Rs. 350.

129
Electric installation exp Rs.2,000 and outstanding expenses paid Rs.700. Printing & stationery Rs.
500, Rs. 250 sundry expenses. Postage: Rs. 450, Magazine subscription costs Rs. 1,400. New
investments made Rs. 3,000, Salaries paid Rs. 3,600.
Insurance was prepaid to the extent of Rs. 75 and outstanding subscriptions Rs. 1,800, Rs. 250
were outstanding for use of lecture hall and Rs. 300 for interest on investments had accrued due.
There were creditors outstanding for new steel shelves acquired during the year amounting to Rs.
1,750. Salaries pending to be paid Rs.500 and stationery pending to be paid Rs.75.
Prepare funds flow statement, Profit & Loss statement and Balance sheet for the year ended 31-
Mar-2006, after providing 2% depreciation on building, 5% on furniture & fittings. And 10% on
library books, such depreciation has to be calculated on the opening balances of the assets in
question.
Solution:
Funds flow statement
Opening Cash 4,000
Receipts
Entrance fee
Subscriptions
Interest on Investments
Sale of old news papers
Sale of old furniture
Entertainment proceeds
Lecture hall rent
Total

1,200
12,500
200
450
100
4,500
1,500
20,450

20,450
Payments
To creditors
Books purchased
Electricity & water exp
Repairs to buildings
Insurance
Electric Installation exp
Last years outstanding expenses paid
Printing & stationery
Sundry expenses
Postage
Magazine subscriptions
New Investments
Salaries
Total

4,300
1,400
1,400
800
350
2,000
700
500
250
450
1,400
3,000
3,600
20,150

(20,150)
Closing cash balance 4,300

Profit & Loss statement
Subscription
Outstanding
(-) Last years
12,500
1,800
(1,000)
Proceeds from entertainment 4,500
Lecture hall rent
Outstanding
1,500
250

130
(-) Last years (400)
Interest received
Interest accrued
200
300
Sale of news paper 450
Total 20,100
Electricity & Water exp 1,400
Building repairs 800
Insurance
Paid Insurance during last year
Prepaid for next year
350
100
(75)

Printing & Stationery
Stationery to be paid
500
75

Sundry expenses 250
Postage 450
Magazine subscription costs 1,400
Salaries
Outstanding salaries
3,600
500

Depreciation
Building
Furniture & Fittings
Library books

800
175
2,000

Total 12,325
Profit for the year 7,775

Balance Sheet as on 31-Mar-2006
Liabilities Rs. Rs. Assets Rs. Rs.
Reserves
Profit for the year

Advances
New creditors
Outstanding exp:
Salaries
Stationery

70,000
7,775

77,775
1,200
1,750

500
75

Closing Cash balances
Investments
New Investments

Library books
New books
Depreciation

Furniture & Fittings
+ New shelves
+ Electric Installations
- Sale of old furniture
- Depreciation

Buildings
-Depreciation

Insurance pre-paid
Outstandings:
Subscription
Lecture hall
Interest on Investments

6,000
3,000

20,000
1,400
(2,000)

3,500
1,750
2,000
(100)
(175)

40,000
(800)

4,300

9,000

19,400

6,975

39,200
75

1,800
250

300
81,300 81,300

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Chapter 4
Valuation of the balance sheet
4.1 Why should anyone analyse a balance sheet:
The analysis of a balance sheet can identify potential liquidity problems. These may signify the
company's inability to meet financial obligations. An investor could also spot the degree to which a
company is leveraged, or indebted. An overly leveraged company may have difficulties raising
future capital. Even more severe, they may be headed towards bankruptcy. These are just a few of
the danger signs that can be detected with careful analysis of a balance sheet.
The balance sheet will be prepared utilising a variety of valuation methodsthe selection
is normally based on the nature of the item and the relevance and reliability of the method
of accounting for that item. The different methods give the same value at initial recognition. The
most common valuation methods are:
1. Historical Cost/Historical Proceeds Method/Book Value method. For an asset: the amount
of cash, or its equivalent, paid to acquire the item, commonly adjusted for depreciation or other
allocation. For a liability: the amount of cash, or its equivalent, received when the obligation
was incurredsometimes adjusted for amortization or other allocations.
For Example the assets of XYZ Ltd are valued as net fixed assets (Rs. 33 millions) which is
Cost of the assets (Rs. 50 millions) depreciation (Rs. 17 millions)
2. Current Market Value Method. The amount of cash, or its equivalent, that could be obtained
by selling an asset in an orderly liquidation.
For Example the assets of XYZ Ltd can be valued as per the market value at that point of time
instead valuing at book value
3. Net Realizable Value Method. The amount of cash, or its equivalent, into which an asset is
expected to be converted in the due course of business, less any direct costs necessary to
make that conversion.
4. Discounted Future Cash Flows Method. For an asset: the present value of future cash
inflows into which an asset is expected to be converted in the due course of business, less
present values of cash outflows necessary to obtain those inflows. For a liability: the present
value of future cash outflows expected to be required to satisfy the liability in the due course of
business.
The key issues in determining the appropriate method are relevance and reliability. The following
comments on these criteria should be useful:
Relevance: To be relevant, information about an item must have feedback value and/or
predictive value for users and must be timely. Information is relevant if it has the capacity to
make a difference in the decisions of owners, investors, creditors, or other interested parties.
Reliability: To be reliable, information about an item must be faithful, verifiable, and neutral.
Information is reliable if it is sufficiently consistent in its representation of the underlying
resource, obligation, or effect of events; and sufficiently free of error and bias to be useful to
owners, investors, creditors, and others in making decisions.
If two methods are equally relevant and reliable, then the method with the lowest cost to the
preparer would probably be chosen.

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The three alternatives most often cited are: depreciated historical cost, estimated
market value, or a combination of depreciated historical cost and estimated market
value.
4.2 Accounting standards followed for valuation
1. Valuation of Securities:
Held-to-maturity debt securities, that the Company intend to hold to maturity, are stated at cost after
accounting for premium or discount on acquisitions, which are amortized (reduce the amount in
installments) over the period to maturity.
Other securities for which market quotations are available are stated at fair value. Net unrealised
gains or losses on these securities are reported as a separate item in shareholders equity at a net-
of-tax amount.
Other securities for which market quotations are unavailable are stated at cost, which is determined
by the moving-average method.
2. Valuation of Inventories
Goods in progress are stated at cost, which is determined on an individual situation basis.
Supplies are valued at cost, which is principally determined by the first-in, first-out method.
3. Depreciation:
The term used to describe the process of allocating the cost of a long lived asset to expense over
its life
Methods used to determine depreciation are:
Straight Line Method
The straight line method spreads the net cost of an asset (initial investment less estimated future
salvage value) evenly over the estimated life of the asset.
For Example:
Original Cost (C) Rs.1,00,000
Estimated Salvage Value (S) Rs.10,000
Estimated Life (N) 10 years
Depreciation Charge = (C-S)/N = (Rs. 1,00,000- Rs. 10,000)/10 = Rs. 9,000/year

Declining Balance Method
In the declining balance method, instead of spreading the cost of an asset evenly over its life, the
asset is expensed at a constant rate, resulting in successively declining depreciation charges each
period.
For Example:
Original Cost (C) Rs. 1,00,000
Depreciation rate 20%

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Depreciation Charge Net Book Value Year End
Year 1 Rs. 20,000 Rs. 80,000
Year 2 Rs. 16,000 Rs. 64,000
Year 3 Rs. 12,800 Rs. 51,200

Depreciation is considered while valuing fixed assets like plant, machinery, buildings, furniture, etc.
**Salvage Value: The estimated value that an asset will realize upon its sale at the end of its useful
life. The value is used in accounting to determine depreciation amounts and in the tax system to
determine deductions. The value can be a best guess of the end value or can be determined by a
regulatory body.
4. Deferred Charges
Expenses that are already paid but are expected to perform positively in the future periods may be
carried over to the future period as deferred charges. Entities are able to choose whether they defer
those expenses as deferred charges in the balance sheets or recognize immediately as expenses.
Bond issue costs are expensed when incurred.
Start up costs and Research & development costs are deferred
5. Reserves
The allowance for Bad Debts account is principally provided, in amounts considered to be
appropriate, based primarily upon the Company past credit loss experience and an evaluation of
potential losses in the receivables outstanding.

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Chapter 5
Financial Ratios
A ratio is an arithmetical relationship between two figures. Financial ratio analysis is the calculation and
comparison of ratios which are derived from the information in a company's financial statements. The
level and historical trends of these ratios can be used to make inferences about a company's financial
condition, its operations and attractiveness as an investment.
Financial ratios are broadly divided into five categories:
Liquidity ratios
Leverage ratios
Turnover ratios
Profitability ratios
Valuation ratios
5.1 Liquidity Ratios:
Liquidity refers to the ability of a firm to meet its obligations in the short run, usually one year.
Companies will generally pay their interest payments and other short-term debts with current assets.
Therefore, it is essential that a firm have an adequate surplus of current assets in order to meet
their current liabilities. If a company has only illiquid assets, it may not be able to make payments
on their debts. To measure a firm's ability to meet such short-term obligations, various ratios have
been developed. Liquidity ratios are generally based on the relationship between current assets
(the sources for meeting short-term obligations) and current liabilities.
5.1.1 Current ratio:
The current ratio is also known as the working capital ratio. It measures the ability of the firm to
meet its current liabilities. The greater extent to which current assets exceed current liabilities, the
easier a company can meet its short-term obligations.
CR: Current Assets / Current Liabilities
Current ratio of XYZ Ltd: 23.4/17.4 = 1.34

Short-term creditors prefer a high current ratio since it reduces their risk.
Shareholders may prefer a lower current ratio so that more of the companys assets are
working to grow the business.
Typical values of the current ratio vary by company and industry.
A ratio lower than that of the industry average suggests that the company may have liquidity
problems.
However, a significantly higher ratio may suggest that the company is not efficiently using its
funds.
A satisfactory Current Ratio for a company will be within close range of the industry average.

135
Main drawback of the current ratio is that inventory (part of current assets) may include many items
that are difficult to liquidate quickly and that have uncertain liquidation values.
5.1.2 Quick ratio (Acid-test ratio):
This is an alternative measure of liquidity that does not include inventory in the current assets
(quick Assets). For this reason, it's also a more conservative ratio.
Quick ratio: (Current Assets Inventory) / Current Liabilities
Quick ratio of XYZ Ltd: (23.4 - 10.5)/17.4 = 12.8/17.4 = 0.74

The current assets used in the quick ratio are cash, account receivables, etc inventory.
Inventory is excluded in this ratio because, in many industries, inventory cannot be quickly
converted to cash.
If this is the case, inventory should not be included as an asset that can be used to pay off
short-term obligations.
Like the Current Ratio, to have an Acid Test Ratio within close range to the industry average is
desirable.
5.1.3 Cash ratio:
The most conservative liquid ratio. It excludes all current assets except the most liquid: cash & cash
equivalents.
Cash ratio: (Cash + Marketable Securities) / Current Liabilities
Quick ratio of XYZ Ltd: 1.0/17.4 = 12.8/17.4 = 0.058

Working Capital: Working Capital is simply the amount that current assets exceed current
liabilities. Here it is in the form of the equation:
Working Capital = Current Assets - Current Liabilities
This formula is very similar to the current ratio. The only difference is that it gives you a rupee
amount rather than a ratio.
It too is calculated to determine a firm's ability to pay its short-term obligations.
Working Capital can be viewed as somewhat of a security blanket.
The greater the amount of Working Capital, the more security an investor can have that they
will be able to meet their financial obligations.
5.1 Leverage Ratios:
Leverage refers to the use of debt finance. These ratios measure a company's capital structure. In
other words, they measure how a company finances their assets. Do they rely strictly on equity? Or,
do they use a combination of equity and debt? The answers to these questions are of great
importance to investors. While debt is a cheaper source of finance, it is also a riskier source of
finance. Leverage ratios help in assessing the risk arising from the use of debt capital. Unlike
liquidity ratios that are concerned with short-term assets and liabilities, financial leverage ratios
measure the extent to which the company is using long term debt.

136
A firm that finances its assets with a high percentage of debt is risking bankruptcy should it be
unable to make its debt payments. This may happen if the economy of the business does not
perform as well as expected. A firm with a lower percentage of debt has a bigger safety cushion
should times turn bad.
A related side effect of being highly leveraged is the unwillingness of lenders to provide more debt
financing. In this case, a firm that finds itself in a jam may have to issue stock on unfavorable terms.
All in all, being highly leveraged is generally viewed as being disadvantageous due to the increased
risk of bankruptcy, higher borrowing costs, and decreased financial flexibility.
On the other hand, using debt financing has advantages. Stockholder's potential return on their
investment is greater when a firm borrows more. Borrowing also has some tax advantages.
Two types of ratios are commonly used to analyse financial leverage. Structural ratios are based on
the proportions of debt and equity in the financial structure of the company. Coverage ratios show
the relationship between debt servicing commitments and the sources for meeting these burdens.
5.2.1 Debt-equity ratio:
This ratio shows the relative contributions of creditors and owners (net worth + pref. Capital). Lower
the ratio better the protection for creditors
Debt-equity ratio: Debt / Equity
Debt-Equity ratio of XYZ Ltd: 31.7/26.2 = 1.21
5.2.2 Debt ratio:
This ratio measures the extent to which borrowed funds support the firms assets
Debt ratio: Debt / Assets
Debt ratio of XYZ Ltd: 31.7/57.9 = 0.55
5.2.3 Debt service coverage ratio:
Financial institutions calculate the average debt service coverage ratio for the period during which
the loan is repayable. Normally, lending institutions regard a debt service coverage ratio of 1.5 to
2.0 as satisfactory.
Debt service coverage ratio: (PAT + Depreciation + Other non cash charges +Interest on loan) /
(Interest on loan + Repayment of loan)
5.2.4 Interest coverage ratio (Times interest earned ratio):
This ratio indicates how well the companys earnings can cover the interest payments on its debt.
Interest Coverage ratio: EBIT / Interest Charges
Interest Coverage ratio of XYZ Ltd: 8.9/2.1 = 4.23
The optimal capital structure for a company you invest in depends on which type of investor you are.
A bondholder would prefer a company with very little debt financing because of the lower risk
inherent in this type of capital structure. A stockholder would probably opt for a higher percentage
of debt than the bondholder in a firm's capital structure. Yet, a company that is highly leveraged is
also very risky for a stockholder.
When a firm becomes over leveraged, bankruptcy can result.

137

5.3 Turnover Ratios / Asset management ratios:
These ratios also known as Asset management ratios, measure how efficiently the assets are
utilized by a firm. These ratios are also known as Efficiency ratios.
5.3.1 Inventory / stock turnover ratio:
It measures how fast the inventory is moving through the firm and generating sales. It reflects the
efficiency of inventory management. The higher the ratio, the more efficient the management of
inventories and vice versa.
Cost of goods sold / average inventory
Inventory turnover ratio of XYZ Ltd: 55.2/{(10.5+7.2)/2} = 6.24
5.3.2 Receivables turnover ratio:
It is an indication of how quickly the company collects its accounts receivables and is defined as
follows:
Annual Credit Sales / Average Accounts Receivables
Receivable turnover ratio of XYZ Ltd: 70.1/{(11.4+6.8)/2} = 7.70
It is often reported in terms of the number of days that credit sales remain in accounts
receivable before they are collected. This number is known as collection period.
5.3.3 Fixed Assets turnover ratio:
It measures sales per rupee of investment in fixed assets. This ratio is supposed to measure the
efficiency with which fixed assets are employed. A high ratio indicates a high degree of efficiency in
asset utilisation and vice versa.
Net sales / average net fixed assets
Fixed assets turnover ratio of XYZ Ltd: 70.1 + {(33.0+32.2)/2} = 2.15
5.4 Profitability Ratios:
Profitability ratios reflect the final result of business operations. There are two types of profitability
ratios; Profit margin ratios show the relationship between profit and sales and Rate of return
ratios - reflect the relationship between profit and investment.
5.4.1 Profit margin ratios:
(a)Gross profit margin ratio:
This ratio shows the margin left after meeting manufacturing costs, it measures the efficiency of
production and pricing
Gross profit / Net Sales
Gross profit margin ratio of XYZ Ltd: 14.9/70.1 = 0.21

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The gross profit margin ratio tells us the profit a company makes on its cost of sales, or cost of
goods sold. It is a very simple idea and it tells us how much gross profit per $1 of turnover our
business is earning.
Gross profit is the profit we earn before we take off any administration costs, selling costs and so
on. So we should have a much higher gross profit margin than net profit margin.
Leisure
&
Hotels
International
Airlines
Manufacturing Retailing Domestic
Airline
Refining Pizza
Restaurants
Accounting
software
Gross
Profit
9.64% 5.62% 35.14% 11.41% 27.46% 11.99% 47.52% 89.55%

See how the gross profit margins vary from business to business and from industry to industry. For
example, the international airline has a gross profit margin of only 5.62% yet the accounting
software business has a gross profit margin of 89.55%.
If a company's raw materials and factory wages go up a lot, the gross profit margin will go down
unless the business increases its selling prices at the same time.
(b)Net profit margin ratio:
This ratio shows the earnings left for shareholders and it measures the overall efficiency in all fields
Net profit / Net Sales
Net profit margin ratio of XYZ Ltd: 3.3/70.1 = 0.047
The net profit margin ratio tells us the amount of net profit per $1 of turnover a company has earned.
That is, after taking account of the cost of sales, the administration costs, the selling and
distributions costs and all other costs, the net profit is the profit that is left, out of which they will pay
interest, tax, dividends, etc
Leisure
&
Hotels
International
Airlines
Manufacturing Retailing Domestic
Airline
Refining Pizza
Restaurants
Accounting
software
Net
Profit
7.36% 4.05% -10.48% 1.63% 10.7% 12.63% 7.55% 27.15%

Just like the gross profit margins, the net profit margins also vary from business to business and
from industry to industry. When we compare the gross and the net profit margins we can gain a
good impression of their non-production and non-direct costs such as administration, marketing and
finance costs.
We saw that the international airline's gross profit margin was the lowest of this group of eight
businesses at only 5.62%; but look, its net profit margin is 4.05%, only a little bit lower than its
gross profit margin. On the other hand, the domestic airline's gross profit margin is 27.46% but its
net profit margin is a lot less than that at 10.87%. As we just said, these comparisons give us a
great insight into the cost structure of these businesses.
Look at the software business too, a very high gross profit margin of 89.55% but a net profit margin
of 27.15%. This is still high, but we can now see that the administration and similar expenses are
very high whilst its cost of sales and operating costs are relatively very low.

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Gross & Net profit ratios together provide a valuable understanding of the cost and profit structure
of the firm.
5.4.2 Rate of return ratios:
(a) Return on Equity / Return on net worth:
It measures the profitability of equity funds invested in the firm. It reflects the productivity of the
ownership (risk) capital utilised in the company.
PAT Pref. dividends /Avg. of (paid-up capital + reserves & surplus)
Return on equity ratio of XYZ Ltd: 3.3/{(26.2+25.6)/2} = 0.127
Leisure
&
Hotels
International
Airlines
Manufactu
ring
Retailing Domestic
Airline
Refining Pizza
Restaurants
Accounting
software
ROCE 5.56% 3.16% -12.12% -0.12% 33.63% 16.17% 16.14% 16.29%

ROE values demonstrate that not everyone can get the same results for the same ratio at the same
time: it depends on the industry, the management, the economy and so on.
The domestic airline has the highest ROCE value. The international airline's ROCE is extremely low
at just over 3%. Wouldn't the shareholders be better off selling the business and putting the money
in the bank as it would earn more than that?
(b) Return on assets ratio:
It is a measure of how effectively the companys assets are being used to generate profits.
Net profit / Average of total assets
Return on assets ratio of XYZ Ltd: 3.3/[(57.9 + 49.3)/2] = 0.062
Sometimes an increase in company earnings can disguise an operating loss. If a company's
operating expenses exceed its operating income, it has an operating loss. If it also has income from
investments and tax benefits, this income can offset the loss and show an increase in earnings per
share. However, if these other sources of non-operating income are not recurring, the unsuspecting
investor may come to an erroneous conclusion about the company's overall financial health. The
lesson to be learned here is to carefully scrutinize the financials especially when operating income
is negative.
5.5 Valuation Ratios:
These ratios indicate how the equity stock of the company is assessed in the capital market. Since,
the market value of equity reflects the combined influence of risk and return, valuation ratios are the
most comprehensive measures of a companys performance.
5.5.1 Price to Earnings ratio (P/E ratio):
The most popular financial statistic in stock market analysis. The P/E is a performance benchmark
that can be used as a comparison against other companies or within the stock's own historical
performance. For instance, if a stock has historically run at a P/E of 35 and the current P/E is 12,

140
you will want to explore the reasons for the drastic change. If you believe that the ratio is too low,
you may want to buy the stock. It is a summary measure which primarily reflects the growth
prospects, risk, corporate image, degree of liquidity, etc of the company.
P/E ratio = Market value per share / EPS*

5.5.2 Earnings per share (EPS):
It is a traditional method used for determining corporate value. In other words, it is the portion of a
company's profit allocated to each outstanding share of common stock. EPS serves as an indicator
of company's profitability.
Net Income Dividends on preferential stock / outstanding shares
Those worried about lofty valuations for Indian stocks should note that the P/E ratios of key stocks
(specifically, those that constitute the S&P CNX Nifty Index) arent even close to levels seen during
the 1999-2000 boom. Heres a chart I created using historical data from the NSE:

Source: NSE India

As you can see, P/E ratios for the Nifty-50 stocks crossed 28 back in Q1 2000, and then collapsed
below 12 in 2003. Since then, P/E expansion has certainly contributed to Niftys rise from 1300 to
2900. But even today, the combined P/E ratio stands at ~18, much lower (and reasonable?) than
the 2000 peak. The implication: The E denominator, which stands for earnings, has remained
very strong as most of the Nifty-50 companies have experience 20-30% earnings growth since
2003.
Note: There are companies currently in the Nifty-50 (such as TCS, L&T, etc.) that werent part of
the index back in 1999. Similarly, several companies (such as HCL-Infosys, NIIT, etc.) that
contributed to the high P/E have since been dropped from the index.

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5.5.3 Yield:
It is a measure of the rate of return earned by shareholders
Dividend + Price change / Initial price
It can be split as:
Dividend yield: Dividend/Initial price
Capital gains (losses) yield: Price change / initial price
Generally companies with low growth prospects offer a high dividend yield and a low capital gains
yield. On the other hand, companies with high growth prospects offer a low dividend yield and a
high capital gain yield.
Conclusion:
Analyzing a balance sheet is fundamental knowledge for anyone who wishes to carefully select
solid and profitable investments. The balance sheet is the basic report of a firm's possessions,
debts and capital. The composition of these three items will vary dramatically from firm to firm. As
an investor, you need to know how to examine and compare balance sheets of different companies
in order to select the investment that meets your needs.

B F S I Do m a i n
M o d u l e - 6

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BFSI Domain - Module 6
TABLE OF CONTENTS
1 END TO END SOLUTIONS IN THE BFSI SPACE. 138
2 PRODUCT OFFERINGS 139
2.1 BPD -FLEXCUBE:............................................................................................................. 139
2.1.1 FLEXCUBE Universal Banking Solution........................................................... 139
2.1.2 FLEXCUBE Corporate Banking Solution.......................................................... 139
2.1.3 FLEXCUBE - Core Banking Solutions ................................................................. 139
2.1.4 FLEXCUBE - Private Banking Solutions.............................................................. 140
2.1.5 FLEXCUBE for Mutual Funds Solutions .............................................................. 141
2.1.6 FLEXCUBE for Brokerage solutions.................................................................... 141
2.1.7 FLEXCUBE @...................................................................................................... 141
2.2 Reveleus ........................................................................................................................... 142
2.2.1 Pre-built Business Analytics................................................................................. 143
2.2.1.1 Risk Analytics - Credit, Operational Risk, Asset Liability Management for Basel II
compliance and beyond. . 143
2.2.1.1.1 Reveleus Credit Risk Analytics .. 143
2.2.1.1.2 Reveleus Operational Risk Suite .. 143
2.2.1.1.3 Reveleus Asset Liability Management .. 143
2.2.1.2 Customer Relationship Customer Profitability & Channel Analytics. 152
2.2.1.2.1 Reveleus Customer Profitability .. 144
2.2.1.2.2 Reveleus Channel Analytics 144
2.2.1.3 Performance Measurement Analytics . 144
2.2.1.3.1 Enterprise Financial Performance . 144
2.2.1.3.2 Reveleus Funds Transfer Pricing .. 145
2.2.1.4 Specialized Analytics Mortgage Analytics, Credit Card Analytics 145
2.2.1.4.1 Credit Card Analytics .. 145
2.2.1.4.2 Reveleus Mortgage Analytics 146
2.3 Reveleus ORTOS.. ........................................................................................................ 146
2.4 Daybreak. .......................................................................................................................... 147
2.4.1 Daybreak Modules............................................................................................ 148
2.5 Castek ............................................................................................................................. 148
2.5.1 Castek - Solutions offered:................................................................................... 148
2.5.1.1 Insure
3
Policy 148
2.5.1.1.1 Insurance Customer Information 149
2.5.1.1.2 Product Configuration .. 149
2.5.1.1.3 Policy Administration 149
2.5.1.2 Insure
3
Billing 158
2.5.1.3 Insure
3
Claims .. 158
2.5.1.4 ClaimsPath 150
3 I-FLEX CONSULTING . 151
3.1 Business and IT Strategy Consulting................................................................................ 151
3.1.1 IT Strategy and Plan ............................................................................................ 151
3.1.2 e-Business and Internet Strategy......................................................................... 151
3.1.3 Customer Relationship Management................................................................... 152
3.1.4 Business Intelligence ........................................................................................... 152
3.2 Business and Technology Consulting............................................................................... 152

146
3.2.1 Requirements and Functional Specification ........................................................ 153
3.2.2 Business Process Redesign ................................................................................ 153
3.2.3 Risk Management ................................................................................................ 153
3.2.4 Technology Architecture ...................................................................................... 154
3.2.5 Software Package Evaluation and Selection....................................................... 154
3.2.6 IT Securities Policies and Procedures ................................................................. 155
3.2.7 Project Management ............................................................................................ 156
3.2.8 Basel II Offerings.................................................................................................. 156
3.3 Process and Quality Consulting........................................................................................ 157
4 PRIMESOURCING THE SERVICES OFFERING 158
4.1 PrimeSourcing Retail Banking ....................................................................................... 158
4.2 PrimeSourcing Corporate Banking ................................................................................ 159
4.2.1 Treasury Management Solutions......................................................................... 159
4.2.2 Cash Management Solutions............................................................................... 159
4.2.3 Trade Finance Solutions...................................................................................... 160
4.3 PrimeSourcing Private Banking ..................................................................................... 160
4.3.1 Wealth Management Solutions............................................................................ 160
4.3.2 Mutual Funds and Portfolio Management ............................................................ 161
4.4 PrimeSourcing Investment Banking............................................................................... 161
4.4.1 Portfolio Management Solutions.......................................................................... 168
4.4.2 Capital Markets Solutions .................................................................................... 168
4.4.3 Risk Management Solutions ................................................................................ 168
4.5 PrimeSourcing Insurance............................................................................................... 169
4.6 Center of Excellence Payment Solutions....................................................................... 169
5 COMPLIANCE SOLUTIONS . 170
5.1 Anti Money Laundering..................................................................................................... 164
5.2 Basel II ............................................................................................................................. 165
5.2.1 Need for Basel Accord......................................................................................... 165
5.2.2 The New Basel Capital Accord Basel II ............................................................ 165
5.3 Sarbanes Oxley Act .......................................................................................................... 167
5.3.1 Genesis of Sarbanes Oxley Act, 2002................................................................. 167
5.3.2 Highlights of Sarbanes Oxley Act ........................................................................ 167
5.3.3 i-flex offerings for Section 404 compliance.......................................................... 168

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Chapter 1
End to End solutions in the BFSI space
i-flex provides comprehensive IT solutions exclusively to the financial services industry worldwide. The
range of solutions include packaged applications (encompassing consumer banking, corporate
banking, investor servicing and asset management for mutual funds, internet delivery of financial
services, and business analytics and risk management), custom application software development,
deployment, maintenance and support services (both onsite and offshore), and, business and IT
consulting services.

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Chapter 2
Product Offerings
i-flex can today be considered as the largest IT products company in India. It has a large basket of
products catering to various segments of the BFSI industry. Based on the product classification, they are
structured accordingly within i-flex.
2.1 Banking Products Division (BPD) Offers FLEXCUBE:
FLEXCUBE is a complete banking product suite for retail, consumer, corporate, investment and
internet banking, and asset management and investor servicing. Since its launch in 1997, more
than 250 financial institutions in 100 countries have chosen FLEXCUBE. FLEXCUBE has been
ranked the world's No. 1 selling core banking solution for three consecutive years -2002, 2003 and
2004 - by the UK-based International Banking Systems (IBS).
2.1.1 FLEXCUBE Universal Banking Solution
FLEXCUBE UBS offers a mix of institutional and retail banking business for broad-based financial
institutions. It offers:
a single application for retail, corporate and investment banking needs
support for diverse delivery channels like ATM, Internet, etc
integrated with business intelligence and Internet banking solutions
2.1.2 FLEXCUBE Corporate Banking Solution
FLEXCUBE offers a scalable, flexible and secure transaction processing platform for corporate
banking operations. A multi-currency, multi-branch system, FLEXCUBE provides a wide array of
functional modules to choose from, each addressing various aspects of corporate banking business.
It also enables straight-through processing and online tracking of exposures.
2.1.3 FLEXCUBE - Core Banking Solutions
FLEXCUBE Core banking solutions helps large and growing retail banks succeed in improving
their profitability and extending their customer reach. It offers solutions in the following areas:
Customer Information
Checking and Savings Accounts
Time Deposits
Loan Application processing
Loan Operations
Product Marketing
Signature Module
ATM Interface
Internet Banking Interface

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EFTPOS (Electronic Fund Transfer Point of Sale)/ Debit Cards
Tele-banking Interface
General Ledger Voucher Entry
Clearing Module
Overall Branch Operations
2.1.4 FLEXCUBE - Private Banking Solutions
i-flexs private banking and wealth management solutions endow customers with the ability to
streamline asset allocation processes, automate complex portfolio modeling, analyze performance
management and attribution and generate comprehensive reports. i-flex has an alliance with
Odyssey Group to provide front-middle office and back office functionalities for Wealth
Management. Odyssey Group is a leader in Wealth Management solutions with 15 out of Top 25
European banks as customers.
Following functionalities are offered as part of Front Office Middle Office Solutions:
Advisory functionality (via mobile, e-mail etc.)
Portfolio analysis, trade and order management
Compliance checking
Performance measurement covering positions history, return analysis etc.
Client reporting
Risk management
Back Office Functionalities include:
Messaging advices and confirmations
Settlements SWIFT and clearing
Statutory reporting
Corporate Actions
General Ledge, Fee and Tax Accounting
Securities Reconciliation
Nostro Reconciliation
Clearing of Exchanges
Custodial services

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2.1.5 FLEXCUBE for Mutual Funds Solutions
FLEXCUBE for Mutual Funds provide solutions in the areas of asset management and investor
services.
The investor service solution offers an end-to-end functionality for a transfer agent through the
following components: fund configuration, shareholder servicing and accounting, dividend
processing and reporting. This includes all types of funds including index, equity, bond and money
market funds. Functionalities include:
real-time online information; anywhere-anytime transacting
comprehensive load, fee and commission-definition; efficient intermediary management
multi-currency, multi-entity system with Euro compliance
hierarchical set up of intermediaries and processing of commissions at hierarchy-level
flexible frequencies for payment of broker commission, and currency and modes
support for different dividend declaration and payment frequencies
complete support to LOI (Letter Of Intent) concept
multiple payment options for dividends including partial reinvestment in multiple funds and
partial payout
2.1.6 FLEXCUBE for Brokerage solutions
FLEXCUBE supports Interest Rate Futures, Currency Futures, Commodity Futures, Equity and
Index Futures, Currency Options, Interest Rate Options, Equity and Index Options, Commodity
Options, and Brokers/Clearing Members/Clearing Houses.
The Exchange Traded Derivatives (ETD) capability of FLEXCUBE
is an automated and flexible

back-office system for processing transactions in exchange traded options and futures. It captures
details of long-, short- and liquidation-type deals entered by the front-office and processes them.
The Securities capability in FLEXCUBE is a back-office system for processing securities deals and
events in the life cycle of a portfolio of securities. It manages processing for events such as booking,
money settlement, security settlement, counterparty confirmation, broker confirmation,
delivery/receipt confirmation, settlement message generation, amendment, extension, reversal,
cancellation and corporate actions.
2.1.7 FLEXCUBE @
FLEXCUBE @ is an integrated e-Finance Platform, providing Financial Institutions a ready suite of
web applications in areas of Retail Banking, Corporate Banking, Brokerage, Mutual Funds,
Payments, Mobile Banking etc.
Following are the FLEXCUBE @ modules:
FLEXCUBE @ Business Application Packs - are a ready suite of solutions that deliver
exhaustive set of banking functions over the Web.

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FLEXCUBE @ Retail provides comprehensive range of retail banking services; accessing
accounts, fund transfers between accounts, loan repayments and customer service
transactions such as stop checks, order demand drafts and statements.
FLEXCUBE @ Corporate provides range of Corporate banking facilities such as initiating
Global Payments over SWIFT and Telex networks, execute Trade Finance transactions,
manage Foreign Exchange contracts, and facilities for managing Loans and Deposits.
FLEXCUBE @ Broker solution for internet trading in Equities, Fixed Income Securities,
Options and Futures catering to typical Investment Banks and Broker requirements.
FLEXCUBE @ Investor Services for performing Mutual Fund transactions over the Web such
as Buy, Sell and Switch Funds, Transaction activity and standing instructions.
FLEXCUBE @ EBPP a comprehensive solution that covers e-billing, bill presentment and
payment solution. It supports Automated Clearing House (ACH) and Electronic Clearing
System (ECS) networks for payments.
FLEXCUBE @ Pay caters to wide range of payment systems including retail, corporate and
investor payments. Settlements can be carried through ACH, RTGS, SWIFT and Credit
Networks.
FLEXCUBE @ PKI offers Public Key Infrastructure (PKI) services providing Certificate based
authentication mechanism in form of APIs for digital signing and enveloping data.
FLEXCUBE @ Portal provides interactive interface between Financial Institutions and
customers providing one-stop repository for all financial services.
FLEXCUBE @ Connect acts as platform to integrate disparate applications and multiple
channels into a uniform data view across the enterprise.
2.2 Reveleus
Reveleus is a suite of analytical applications for the financial services industry focused in the
areas of risk management, customer insight, and enterprise-wide financial performance. Reveleus'
Risk Analytics product solves the most complex global challenges facing the financial industry
today, including multi-jurisdictional Basel II compliance and operational risk management. Reveleus
is positioned in Gartner's 'Leaders Quadrant' in its Basel II Risk Management Application Software
Magic Quadrant and Tower Group has ranked Reveleus' Basel II solution amongst the best in this
domain.
Solutions offered by Reveleus:
2.2.1 Pre-built Business Analytics
Pre-built Business Analytics is a complete business solution providing a full set of business
dimensions and performance metrics designed for financial services along with pre-defined reports,
baseline analysis, key performance indicators and event alerts.
Business Analytics comprises of:
Risk Analytics
Customer Relationship
Performance Measurement

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2.2.1.1 Risk Analytics - Credit, Operational Risk, Asset Liability Management for Basel II
compliance and beyond.
The Reveleus Basel II Solution includes capital computations for Credit, Market and Operational
Risk. [More information about Basel II norms and i-flex solution is provided later]
2.2.1.1.1 Reveleus Credit Risk Analytics
Credit risk analytics provides information about banks lending activities in ways that enable judging
opportunities and risks rapidly yet safely. Credit Risk Analytics offers solutions both for Retail and
Corporate Banking. It allows credit risk professionals to improve business practices based on:
Regulatory Capital analysis
Customer Concentration analysis
Facility Concentration analysis
Risk Mitigation analysis
Rating Migration analysis
Aging, Classification and Default analysis
2.2.1.1.2 Reveleus Operational Risk Suite
Operational Risk Suite maps Operational Risk to Organizational Structure. This suite is either
bundled under Reveleus solution or offered separately. Either ways, this is suite has its own identity
and is known as Reveleus Operational Risk Tool Suite (ORTOS). [Covered under Reveleus
ORTOS product suite]
2.2.1.1.3 Reveleus Asset Liability Management
Asset Liability Management application empowers management to understand and better manage
risks. The risk managers can generate different scenarios to identify the most suitable strategy to
reset the existing risk exposure to the desired one given the risk appetite and the risk return
framework of the organization. Asset Liability Management application enables its users to define
and segment the various business dimensions be it time buckets, products, business lines or
geography as best suited to their realities. This provides risk managers the analytical flexibility they
need to take charge of ALM.
What is ALM or Asset Liability Management? (Refer Appendix I)
2.2.1.2 Customer Relationship Customer Profitability & Channel Analytics
Reveleus CRM analytics delivers targeted and actionable customer analytics that enable informed
and timely business decisions. It allows improvement in business practices based on customer
profitability analysis, customer transaction analysis, customer satisfaction and retention analysis
and targeted campaign management.
2.2.1.2.1 Reveleus Customer Profitability
Customer Profitability provides answers to all the profitability related strategic questions and helps
the bank in architecting effective strategies to enhance revenues and reduce costs.

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Reveleus Customer Profitability facilitates the computation and evaluation of profitability across
multiple dimensions consistently. It is based on an account level profitability estimation module,
which it shares with Reveleus Enterprise Financial Performance. With the use of both these
products the users can understand profitability dimensioned on products, customers or as an
outcome of the interaction between customers and banks through products in a consistent and fair
manner.

Reveleus Customer Profitability helps to highlight the behavior of profitable customers across time
for insights into the changing profile and dynamics of customer interactions and profitability. The
solution by integrating with product level profitability of each customer is able to provide an
understanding of what kind of customer bank relationships have yielded profits in the past and
hence what should be expected in the future.
2.2.1.2.2 Reveleus Channel Analytics
Channel Analytics provides insight into customer interaction across channels. It allows optimizing
service delivery, based on cross channel performance analysis, transaction load analysis, branch
specific analysis, electronic channel analysis, and POS (Point of sale) merchant category analysis.
2.2.1.3 Performance Measurement Analytics
Performance Measurement Analytics help managers get an early and accurate insight into their
data to make informed decisions.
2.2.1.3.1 Enterprise Financial Performance
Enterprise Financial Performance enables comprehensive analysis of enterprise performance
through business metrics across responsibility centers. Some of the benefits derived are:
Helps management to cut costs by analyzing processes that generate costs.
Enables pro-active budget analysis through multiple scenario budgets and variance analysis
Integrates information from around the enterprise to enable accurate and flexible reporting and
analysis
Information on the performance of the Organization through the various Key Performance Ratios
like Return on Investments, Return on Capital, Return on Asset Balances, Profit Center Earnings
etc. can be viewed. The user-defined and multiple reporting lines enable different Divisions to
analyze their data as best suited for their specific business imperatives and geographical locations,
while maintaining accuracy and consistency at the organizational level.
2.2.1.3.2 Reveleus Funds Transfer Pricing
Reveleus Funds Transfer Pricing provides the basis for accurately estimating the profits made from
product offerings; in terms of dealing with certain customers, and from conducting business in
certain geographical areas as well as broad lines of business.
Banking businesses face a problem of accurately estimating the profits earned from their various
fundraising and deployment activities. The mismatch between the source of the funds and the
deployment raises issues of interest rate risk that cloud accurate profitability measurement. This
involves the costs of managing the interest rate risk as a bank-wide activity, and delineating the
benefits and costs of this activity is important for accurate performance measurement. The Funds
Transfer Pricing module is designed to help both manage risk effectively and to accurately measure
performance in various divisions of the bank.

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2.2.1.4 Specialized Analytics Mortgage Analytics, Credit Card Analytics
2.2.1.4.1 Credit Card Analytics
Reveleus Credit Cards Analytics enables the monitoring and action on issues critical to the Credit
Cards business. Some of the features are:
Provides a comprehensive list of credit card industry metrics that report leading, coincident and
lagging indicators of the portfolio.
Computes cardholder profitability and enables evaluation of profit dynamics of each card
product.
Detect patterns of card usage that suggest fraudulent use.
Provides "net flow" delinquency data and collector performance trends that can be used for
capacity planning
Integrates with Reveleus' CRM Analytics for better perspective on, and value of customer
relationship
Provides metrics on the Acquirer functions of sales draft processing, disbursements, merchant
charge backs and sales draft retrieval requests
Useful insights on cardholder behavior can be derived from card usage patterns. The trends
thus determined can be used to drive customer relationship management.
2.2.1.4.2 Reveleus Mortgage Analytics
Reveleus Mortgage Analytics delivers analytics for every stage of the Mortgage life cycle. It covers
analysis of Originations; portfolio analytics for Servicing of accounts; analysis for the management
and control of Delinquencies; the monitoring of effectiveness of Collection efforts and the analysis
of Write-Offs and Recoveries.
Reveleus Mortgage Analytics is designed to easily combine information from across different
phases of the mortgage life-cycle into meaningful analysis and insight. This allows traditional to
work off common data, metrics, categories and definitions ensuring reliance on a single version of
the truth. Some of the other features are:
Facilitates proactive management of the Mortgage Portfolios - Acquired and Internal.
Enables multi-dimensional analysis from Originations to Write-Offs / Foreclosures
Enables factual and consistent risk measurement.
Enables Marketing to target the right demographic profiles to build a better portfolio.
Quickly and accurately evaluates credit risk of the portfolio.
2.3 Reveleus ORTOS
ORTOS Operational Risk Tool Suite is a modular end-to-end solution meeting the operational risk
requirements of Basel II. i-flex, in June 2005 acquired this intellectual property from Capco and
added this as the Operational Risk Analytic to the Reveleus product. This makes Reveleus a total
Basel II compliant solution.

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Reveleus ORTOS creates a bespoke process map against which assessments are conducted,
losses are recorded, risk indicators are captured and analyzed and historical data maintained.
Some of the features are:
Supports the structured analysis of operational risk information in relation to process flows,
organizational units and locations
Categorizes Losses by cause, event, effect categories specified as per Basel II
Rapidly develops tailored self-assessments using library of question/answer types, forms, and
templates.
Achieves Transparency in Operational Risk Management
Reveleus ORTOS identifies, gathers and analyses all relevant data (as per Basel II guidelines)
necessary for effective operational risk management across the organization. This information is
plugged into a comprehensive management reporting facility which could be used to monitor and
manage operational losses, drill down across firm wide aggregation of self assessments and risk
indicators analyses and proactively address areas of potential operational risk exposure in terms of
the quality of the control environment and avoidance of real operational loss.
Alerts Management to Potential Risks
The risk indicator system gives early warning of potential risks and performance trends, and
provides managers with an opportunity to pro-actively manage potential issues. In defining
indicators, thresholds and notification/escalation and reporting paths are established. It also
includes a consolidated action tracking platform that enables management to assess and decide on
appropriate action to mitigate, transfer, avoid or accept the operational risk exposure identified.
2.4 Daybreak
Daybreak is the application used for direct and indirect consumer finance lending, including
installment loans, home equity loans, unsecured lines of credit and operating lease. Daybreak fully
automates the lending and financing process of each of these products, from origination into
servicing and through collections. It also supports a wholesale floor planning module for dealer
inventory management.
Daybreak solutions are provided by SuperSolutions Corp acquired by i-flex in early 2004.
Some of the features and advantages of Daybreak are:
Reduce average costs per loan by processing more transactions and data in less time, thus
increasing productivity.
Single points of data entry help reduce error.
Facilitate seamless transfer of data between modules, ensuring complete data integrity.
Flexible and the user-configurable options support business strategies ensuring compliance
with lending policies. This flexibility also allows business to introduce new products, strategies
and policies easily and quickly a key factor in winning new customers and higher retention
rates.
Consistent data across all modules and products ensures superior reporting capabilities,
compliance analysis and risk management.

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Identifies delinquent accounts and forwards these accounts to appropriate work queue.
Tracks all customer related communications, identifies promises-to-pay commitments and
sends user-defined letters.
Supports multiple payments types and automates fee generation.
Tracks and maintains relevant information for all accounts impacted by federal bankruptcy
proceedings.
Can build work queues to improve procedural handling of sensitive accounts.
Tracks all expenses and required information related to asset repossession, foreclosure
procedures and collateral liquidation.
Provides quality, real-time data about customers helping to maintain account, title, insurance
and other transaction documents.
Allows creating and managing unlimited number of fee and expense categories.
Tracks collateral information effectively by updating valuations, process insurance, warranty
claims, titles and other user-defined information.
2.4.1 Daybreak Modules
Daybreak installment loans - supports closed-end, fixed-rate loans for multiple, user-defined
collateral types.
Daybreak lines of credit - manages a portfolio of revolving credit programs such as home
equity lines of credit, in-store revolving credit programs, and overdraft credit lines.
Daybreak leases - supports consumer leases with sophisticated termination and re-marketing
programs.
2.5 Castek
i-flex has entered the insurance domain by taking a majority stake in Castek Software Inc., the
Toronto-based provider of insurance systems for the global Property & Casualty (P&C) insurance
industry. Recognized for the advanced architecture and flexibility of its products, Castek provides
carriers with a suite of core business processing systems for insurance product and process
configuration, policy processing, customer billing and claims management.
2.5.1 Castek - Solutions offered:
Casteks insure
3
(pronounced insure cubed) solution consists of 5 modules:
Insure
3
Policy
Insure
3
Billing
Insure
3
Claims
ClaimsPath.

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2.5.1.1 Insure
3
Policy
Policy administration module allows to process full policy life cycle beginning with prescreening,
quote and application entry through to rating, underwriting and issuance of policies. It also provides
support for midterm and out-of-sequence changes, scenario analysis, and automated renewals.
Following are the modules within Insure
3
Policy:
2.5.1.1.1 Insurance Customer Information
The customer information module provides One stop access to all customer information, both
Organization and individual. The model relates all information about customers and policies to the
customer or account that owns them. It includes information like Demographic info for any party,
businesses, agents, contact information, professional and civic associations, and government
agencies; home, mailing and billing addresses; new address types can be easily added. Various
customer relationships such as associations or affinity group memberships, employees, business
contacts, claimants or any other significant relationship that need to be tracked.
Some of the other information recorded is:
Competitor products, as part of product portfolio.
Prior policy loss history from other carrier loss runs, as part of customer loss information.
Details about customer business operations from commercial customers i.e. their operational
profile.
Customer status on a product line
Assignment of individual customers to a household and tracking of members within that
household.
2.5.1.1.2 Product Configuration
Product configuration module has all product information stored as data, so that any product
changes do not have to be coded. This ensures new product introduction in a much faster time.
2.5.1.1.3 Policy Administration
In addition to iCRM (insurance CRM) capabilities, Insure3 Policy is a powerful system that supports
rapid insurance product definition and introduction, and complete policy life cycle management for
all P&C (Property and Casualty) lines of business. On top of initial application, quote, underwriting,
issuance, billing and renewal, the system also fully supports midterm changes, including automated
out-of-sequence processing, comprehensive transaction history, user-defined security and
authorization as well as task management.
Some of the advantages are:
New business prescreening of potential business and quote functionality. Avoids re-keying of
information form quote to a policy.
Scenario Analysis exploring rate differences for various coverage, limit and deductible
options.
Mid-term changes supports real-time processing of midterm changes, cancellations,
reinstatements, rewrites and premium audits.

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Business User Interfaces Has been designed to dynamically react to product definitions
maintained through the product configuration module. This allows insurers to get new products
to market without the need for IT to modify user interface.
2.5.1.2 Insure
3
Billing
Insure
3
Billing provides flexible and customizable billing and payments systems for Insure
3
Policy. It
is an account-based customer billing and collection system that supports the complete billing life
cycle from flexible payment plan to parameter-driven automated processing. It facilitates integration
with any existing CRM system.
Insure
3
billing is designed to support best practices for the complete billing life cycle from billing
account setup to payment scheduling, invoicing and automated payment reconciliation and
exception processing. It also supports a variety of billing methods (direct bill invoice, credit card,
EFT/ bank account withdrawal), payment methods (cheque, money order, ATM, internet banking,
credit card, EFT etc.) and frequencies (one-time or any number of installments equal or unequal).
Taxation is also supported by the Billing system.
2.5.1.3 Insure
3
Claims
Insure
3
Claims supports the entire claims lifecycle, from first notice of loss through assignment,
adjudication, settlement and recovery. Real-time financial activity tracking provides adjusters with a
clear summary for each claim, claimant and coverage, enabling informed decisions.
2.5.1.4 ClaimsPath
ClaimsPath is a claims communication tool that connects adjusters directly with their preferred
service providers on a real-time basis. This enables the control the costs of claims processing and
enhance customer service levels by providing with real-time information at every step.

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Chapter 3
i-flex Consulting
i-flex Consulting, i-flex's consulting arm, provides comprehensive business and technology consulting
solutions that enable financial services enterprises to:
create new business models
enhance competitive advantage in the digital market place
implement efficient ways of transacting business
The business consultants in i-flex Consulting have extensive experience in Retail, Corporate Banking,
Investment Banking, Treasury, Credit (retail and corporate), Risk Management, Trade Finance, Fund
Management, Central Banking and Capital Market areas. The technology consultants have developed
and implemented solutions for financial services enterprises in back-office operations, Internet solutions,
payment services, business intelligence and CRM.
The Consulting Practices followed by i-flex Consulting are:
3.1 Business and IT Strategy Consulting
Business and IT Strategy Consulting focuses on business needs of customer and propose
strategies aligning to customers business vision; identify and mitigate technology risks and deliver
flexible, scalable, cost-effective systems.
Specific services include:
3.1.1 IT Strategy and Plan
Business compulsion of offering services through multiple delivery channels makes technology
architecture definition and application selection/ development and implementation increasingly
complex. Information Technology has become so infrastructural in the emerging processes of the
Financial Services industry that any effort in formulating business and strategy plan must actively
embed a concurrent IT Strategy plan.
i-flex Consulting offers its professional services towards devising a comprehensive IT strategy. The
consulting team assesses the present state of technology, infrastructure and automation in the
different areas, identify and prioritize the key problem areas and define opportunities for providing
IT solutions. This is done in the background of some facts like protecting the current strengths,
current investments in assets, technology and work practices.
3.1.2 e-Business and Internet Strategy
The Internet has created an environment of immense opportunity along with intense global
competition. As new business models evolve rapidly, organizations need to re-invent themselves in
order to retain and increase their market share. Financial Institutions are rapidly introducing new
customized products and devising innovative delivery channels to reach their customers, anytime,
anywhere and anyhow.
i-flex Consulting help organizations meet the challenges of today's global market place by providing
them with the tools that they need to compete more effectively. Offerings in the business and
technology strategies help in creating business opportunities and implement solutions in this ever-

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changing e-business environment. This includes defining the e-business strategy and assisting in
implementing the plan.
3.1.3 Customer Relationship Management
Customer Relationship Management offers an end-to-end integrated approach in adopting a
customer-centric business approach. From the initial strategy definition, to configuration and
implementation, the solutions offered are industry specific and aligned to business objectives. The
approach is to leverage on existing technology infrastructure strengths, while providing a CRM
solution that integrates customer-facing applications with existing back-office systems.
3.1.4 Business Intelligence
The functioning of banks has become highly information-intensive, requiring timely access to data
originating at various sources, in an integrated manner. In this context, Business Intelligence (BI)
initiatives act towards increasing information efficiency and sharpening business intelligence focus.
i-flex Consulting assists in adopting technologies that provide decision support, while providing
agility and the ability to act or react with the requisite speed and generate valuable analytical
insights from available data. It also helps Financial Institutions in defining BI Strategy, requirement
analysis, development, implementation plan and implementation of the solutions.
3.2 Business and Technology Consulting
Business and Technology Consulting deploy services in focused areas like Requirement and
Functional Specification, Technology Architecture definition, Software Package selection. It helps
the financial enterprises in defining business, technology and process requirements using the
extensive expertise in providing solutions to the financial services industry worldwide.
Service Offerings:
i-flex consulting has extensive experience in executing Requirements Specification assignments for
Financial Services enterprises worldwide. Domain areas of specialization include the following:
3.2.1 Requirements and Functional Specification
i-flex Consulting has extensive experience in executing Requirements Specification assignments
for Financial Services enterprises worldwide. Domain areas of specialization include the following:
Consumer Banking - Teller Applications Loans & Deposits, Card products, Remittance
services (collections and payments)
Corporate Banking - Loans and Deposits, Cash Management Services (collections and
payments), Advisory Services
Investment Banking /Mergers & Acquisitions - Securities Trading, Portfolio Management,
Custodial Services, Derivatives, Trading and Processing
Treasury - Foreign Exchange, Trade Finance, Correspondent Banking, Money Market
Data warehousing & CRM - Financial warehouses, Management Information Systems, CRM
functionality
Capital Market - Depository Services, Registrar and Transfer Agents activities

161
Fund management - Mutual fund operations and management, Portfolio management and
analysis, Back office operations and accounting
Inter-Bank Solutions - Automated Clearing Houses, Central Bank Reporting, Settlement
Systems
Delivery Channels Internet, Call Center, Mobile & Tele-banking, ATMs/ Kiosks, Branch
operations
3.2.2 Business Process Redesign
i-flex Consulting provides Business Process Reengineering services using proven methodologies to
facilitate planning and deployment effective business strategies so as to gain significant (even
radical) improvement in performance, cost and quality. The project is initiated by understanding the
business processes and use of technology to provide the foundation for the business reengineering
exercise. It analyzes Value Chain process flow to identify process improvement opportunities,
identify changes required, eliminate redundancies and incorporate new process definitions. The
impact of this change on organization structure, roles and responsibilities and use of technology is
assessed.
3.2.3 Risk Management
The risk management framework has Enterprise Risk Management at the apex, which branches
mainly into Liquidity Risk, Market Risk, Credit Risk and Operational Risk areas.
Understanding the banking needs, i-flex Consulting effectively guides banks through various levels
of implementing a modern risk management system, right from defining a risk management
strategy to conducting detailed risk reviews at different levels of detailing to design and
implementation of risk management solutions.
The Risk Management Group at i-flex Consulting offer expertise in areas like treasury and dealing
room systems, credit risk management, securitization, and risk modeling, to offer leading-edge risk
management solutions.
3.2.4 Technology Architecture
As banks and financial institutions grapple with issues such as delivering new products, cutting
costs, increasing product relationships per customer, integrating multiple delivery channels,
identifying and mitigating business risks and complying with enhanced regulatory requirements,
their reliance on technology to perform effectively in each of these areas continues to grow. While
at a strategic level the need to invest in IT is generally well understood, the availability of competing
technologies presents an enormous challenge in arriving at an enterprise-wide architecture. In the
absence of a well thought-out and cohesive technology blueprint, IT investments often end up
being islands of information or disparate systems consisting of jumbled mass of different
technologies, resulting in high maintenance costs and frustrating integration requirements.
i-flex consulting ensures the investment protection and flexibility by aligning the architectural
decisions with business processes and requirements. It delivers a cohesive or tight knit "blueprint"
for the enterprise to achieve consistent business value through the application of technology. The
critical components that make up the approach in defining the enterprise architecture are:
Enterprise Architecture Blueprinting
System Integration
Package evaluation & selection

162
Informational and Database Architecture design
Process Integration
Infrastructure design
Performance Engineering and Capacity planning
3.2.5 Software Package Evaluation and Selection
The banks and Financial Institutions today increasingly prefer good quality packaged solutions to
package implementation to custom-built solutions for most business automation requirements. In
comparison with custom-built software applications, products have distinct advantages such as
reduced cost of ownership and accelerated time to market. However, in most areas of business
there are a plethora of enterprise package applications available today and the decision to choose
the appropriate package is often not an easy one. When an organization decides to buy a software
product it not only requires financial justification but also consideration of myriad factors such as
vendor stability, goodness-of-fit, interface with other applications, implementation issues, peripheral
investments and extensibility being just a few of them.
i-flex consulting with its rich blend of experienced functional and technical professionals employs a
structured methodology to ably assist clients in selecting the best-suited software package. This is
achieved through a sequence of well-defined steps spanning three phases, which are briefly
described here:
Initial Package Investigation - Conducted primarily to test the market and establish if a
package-based approach is viable based on the customers high level needs. This phase
involves the development of an initial request for information (RFI) followed by a review of
vendor responses
Package Evaluation - For thorough evaluation of packages identified as an outcome of the first
phase, through detailed RFP's covering multiple criteria such as functional feature-list,
technical architecture, interfaces, flexibility/extensibility etc. Evaluation criteria are agreed upon,
responses to RFP's are evaluated and a final short list made for final selection.
Final Package Selection - For finalizing the selection process and procurement of a package
solution. The focus here is around the development of a business case, considering in detail
the total cost of ownership (e.g., licensing, annual maintenance, customization, implementation,
operations and hardware & environmental software), certain non-commercial considerations
such as SLA and the resultant benefits. The final recommendation to purchase is made in this
Phase
3.2.6 IT Securities Policies and Procedures
e-Banking, multiple electronic delivery channels, online transaction processing, networking, and the
emergence of the Internet have changed the way customers interact with the Financial Institutions.
It has also changed the way information is captured, recorded, processed, stored and used, leading
to increased security risk.
The IT security consultancy service offerings include:
Review of the existing security and privacy policies, standards and management processes,
and suggesting scope for improvement.
Review of business strategy, security and privacy requirements.

163
Design of security architecture for controls and policies relating to the organization, its
personnel and its assets.
Security reviews, specifically relating to:
Cyber Security
Network penetration
LAN Security
Design security architecture for physical and logical controls, network and computer
management, identification and authentication of users' confidentiality, integrity, availability and
non-repudiation.
Selection of security products.
Implementation of IT Security infrastructure
3.2.7 Project Management
The investment by banks and financial institutions in information systems has steadily increased,
and thereby the importance of managing projects effectively and efficiently. There has also been
increased business pressure in an uncertain economy, with the emphasis on deriving optimal value
out of systems. Apart from time, cost and quality, which remain imperatives irrespective of the size
of the project, the challenges and opportunities for managing large-scale projects spanning multiple
technologies, vendors, locations and organizational cultures assume completely different
dimensions. Good projects benefit from careful planning, time-tested processes and active
management.
i-flex has effectively distilled and institutionalized best practices from engagements that have been
successfully completed for Banking and Financial services clients, in a highly optimized, predictable
and repeatable process framework assessed at CMM Level-5. From conceptualizing projects on
the drawing board, beginning-of-stage planning through project phase-out, i-flex Consulting offers
end-to-end consulting services which would include amongst others:
Define and manage project scope to minimize creep
Set and manage expectations
Deploy suitable process components
Prepare detailed project plans outlining policies and procedures for allied functions of
configuration management and quality assurance
Plan for all stages of the projects including - application walkthrough, testing, data conversion,
training, rollout and support
Identify and mitigate risks
Establish milestones and track progress
Manage Vendors and technology
Manage multi-location implementation issues, change management and training
Post-implementation review and audit through metrics analysis leading to phase-out

164
Status tracking and reporting across multiple phases
3.2.8 Basel II Offerings
i-flex consulting, through its Risk Management, Data Warehousing and System Integration
expertise, offers Consulting services during all stages of Basel II Implementation program.
Identify gaps against target compliance level
Prepare Basel II implementation roadmaps -covering policies, processes, data and systems
Develop information and technology architecture including data historisation infrastructure.
Implement a Credit rating engine and Risk analytics either by enhancing your existing
framework, or through implementation of our pre-packaged solution framework or a third-party
package
Assist institutions in implementing third party solutions.
Establish Loss and Risk categorization, measurement and monitoring framework.
Redesign Credit Processes in line with BCBS (Basel Committee on Banking Supervision)
Principles for Management of Credit Risk Implement Technology solutions using our large pool
of data-warehousing and system integration experts.
Implement quantitative methodologies for calculating Probability of Default (PD).
3.3 Process and Quality Consulting
Process and Quality Consulting assist customers in achieving higher software development
process maturity levels. The Process Consulting and Quality Management Consultancy experts
and SEI-CMM Lead Assessors assist IT companies and Financial Services organizations in
achieving higher software development process maturity levels.
The Process and Quality Consulting offers services in the following areas:
Software Process Quality Consulting - assist IT companies and Financial Services
organizations in achieving higher software development process maturity levels.
CBA-IPI Assessments offerings include Gap Analysis, Assessment Readiness reviews,
Formal CBA IPI Assessments, Software Process Quality Consulting
Process and Quality Improvement Planning (PQIP) - a comprehensive solution that aims at
guiding the client organization to a higher level of maturity.
Process and Quality Implementation - provide services in supporting organizations in
implementing Quality Improvement plans. Specific offerings in this area include Developing
Standards and Procedures for software development framework, Identify tools and work-aids
for process implementation, Train and guide quality function members, Identify pilots for SPI
implementation, monitor and analyze the pilot implementation results, Establish Corporate
Metrics Program, Conduct periodic process compliance audits, Set up and monitor SEPG and
SQA functions.

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Chapter 4
PrimeSourcing The Services Offering

i-flexs global IT services business provides customized solutions in corporate, retail, private, investment
banking and insurance domain. PrimeSourcing has dedicated Centers of Excellence in Business
Intelligence, CRM, Payment Solutions and Testing Services. The Division operates development centers
across India, the USA, and Singapore. It has a solutions center in Europe, a specialty center around
Oracle technologies, a virtual university (Prime University) to enable continuous learning.
With over 3,200 employees, PrimeSourcing has serviced customers in over 40 countries.
As the global IT services arm of i-flex, PrimeSourcing contributes about 47% to the companys revenues.
Its technology and domain experiences garnered from servicing 164 financial institutions across 48
countries positions it perfectly to service entire range of IT needs across Retail, Corporate, Private and
Investment Banking as well as trusts, Mutual funds and stock exchanges.
The outsourcing services include application development, enterprise application integration, re-
engineering and migration/ porting, production support and maintenance, testing, web-based solutions,
mainframe systems, business intelligence applications, CRM strategies and implementations, payment
systems, infrastructure services, consulting, BPO services, and setting up of dedicated offshore
development centers.
The Division focuses exclusively on the financial services domain, for compliance, application
development, re-engineering, integration, testing, implementation or maintenance needs.
PrimeSourcing has serviced more than 160 financial institutions across 40+ countries, including tier one
banks. It operates development centers across India, the USA, and Singapore, and has dedicated
Centers of Excellence in business intelligence, CRM, payment solutions and testing services.
PrimeSourcing offers services through following verticals which are based on the segment of the bank.
4.1 PrimeSourcing Retail Banking
It offers services in the areas of:
Branch banking system.
Seamless integration with ATM/ teller applications, IVR phone banking, Internet Banking.
Loan Processing Systems.
Retail, Housing, Credit Card Management
Funds Transfer.
Mortgage solutions.
Foreign exchange and money market solutions.
Customer transaction data warehousing/ mining.

166
4.2 PrimeSourcing Corporate Banking
Within the domain of Corporate Banking, Some of the projects executed are:
Loan approval systems
Credit Rating systems
Collateral Management Systems
Self-assessment/credit audit systems
Data warehousing MIS and regulatory reporting
PrimeSourcing mainly offers services in the following areas:
4.2.1 Treasury Management Solutions
The Treasury Management Solution offers capabilities such as easy monitoring of liquidity, interest
rates & currency exposures across enterprise. The solutions are tuned towards:
Improved forecasting
segmented cost allocation control on costs
improved liquidity management
control on services outsourced
compliance with the changing tax laws and cross-border regulations
The treasury management solutions help make sound treasury decisions and thereby achieve
greater profitability on a diversified portfolio of debt, investment and derivative instruments.
4.2.3 Cash Management Solutions
Cash Management Solutions offers solutions in the areas mentioned below:
Funds transfer cycle
Real-time Gross Settlement - continuous settlement of payments on an individual order basis
without netting debits with credits; happens throughout the day rather than at the end of the
day.
Continuous Linked Settlement a service for very high value Global Forex Settlement finally
and irrevocably. It eliminates settlement risk and improves liquidity management.
SWIFT and SWIFTnet - Society for Worldwide Inter-bank Financial Telecommunication
supplies secure messaging services and interface software to wholesale financial entities.
SWIFTnet is an IP based connectivity platform, which provides advanced messaging improving
Straight Through Processing, standardized messaging, and a single window connection to
multiple market infrastructures.

167
4.2.4 Trade Finance Solutions
Trade Finance Solutions caters to wide range of instruments including export bills under Letter of
Credits and export bills under collection. The Services offered include:
Development, Maintenance, Migration and Integration of Treasury Systems
Warrants Trading
Credit Risk
Credit Appraisal
Trade Finance
Forex Systems
Asset Management
Fund Management
Fixed Income
4.3 PrimeSourcing Private Banking
The Private Banking Solutions offered encompass:
4.3.1 Wealth Management Solutions
Wealth Management Solutions range from specific point solutions, such as financial planning tools
and contact management systems, to robust wealth management platforms which enable:
Improved customer knowledge - provide technologies for account aggregation and data
consolidation
Increased advisor productivity and improved service and communication - with features such
as alerts, contact management tools, continuous market information feeds and automated
reporting capabilities
Greater consistency and control across the organization in managing customer assets
4.3.2 Mutual Funds and Portfolio Management
The expertise offered under Mutual Fund
Analysis and management analyze with what if scenarios on the portfolio
Modeling and re-balancing helps in analysis of mix of various types investments in the
portfolio on risks and returns.
Performance measurement - keeping track of the performance of the portfolio
Design of agency systems that provide adequate distribution networks
Functional specifications for compliance, tax and financial reporting systems
Fund administration services

168
4.4 PrimeSourcing Investment Banking
The Investment Banking vertical of the PrimeSourcing offers solutions that cover Application
development for structured finance management, share and unit tracking and revenue
management systems
Internet-based applications for fund transfers, online investments and corporate banking
accounts
Corporate account information, internet-based investments and treasury management
applications and portal development
Strategy consulting, business process consulting and technology consulting
CRM application development, customization for sales and distribution and customer relations
and business development
PrimeSourcing offers its services typically in the following areas:
4.4.1 Portfolio Management Solutions
The services offered include:
Design and development of portfolio management systems
Multi-currency accounting for funds, securities and cash holdings
Wide spectrum of instruments, including common and preferred stock, fixed/ floating/ zero
coupon bonds, Eurobonds, debentures, CDs/CPs, treasury bills, and rights and warrants
Corporate actions, including cash dividends, stock dividend/bonus, optional dividends, stock
split and reverse, rights and spin-off, partial, full maturity and redemption, conversion, merger,
takeover, and rights and warrants exercises
4.4.2 Capital Markets Solutions
The PrimeSourcing IB also offers services in the area of Capital Markets which include order
management, trading, clearing and settlement, surveillance, risk management, data warehousing,
business intelligence and reporting. It also offers a comprehensive back-office solution for
brokerage firms, providing a highly flexible back-office broking environment.
It also offers the internet trading solution through Brokers plaza creating an IT infrastructure for the
broker community enabling retail trading on the Internet, without expensive upfront investments in
software and hardware systems. It can also link multiple clearing banks, depository participants and
custodians for straight-through-processing and complete e-business enablement
4.4.3 Risk Management Solutions
The IB Services addresses the following areas in Risk Management
Market risk management
Operational risk management
Credit risk management
Basel II compliance

169
4.5 PrimeSourcing Insurance
The Insurance Vertical of the PrimeSourcing division offers expertise in property and casualty, life,
health, annuities and reinsurance. Services offered in the core areas include new business
underwriting, policy, claims and billing administration under the Insure
3
suite.
Some of the Insurance Solutions offered are:
Customer reinsurance solutions
P2P (proposal to policy) accelerator, an integrated browser-based application aimed at
improving productivity by automating and streamlining new business processes from
application submission to contract issuance
Collaborative development methodology, reducing implementation time and improving quality
Data management comprising data warehousing and business intelligence services such as
fraud analysis, auto insurance, reinsurance and life insurance BSPs (business solution packs)
a KPO approach that eliminates capital costs, helps launch new products, builds systems and
trains people
4.6 Center of Excellence Payment Solutions
As mentioned earlier, PrimeSourcing has setup of Center of Excellences and one of them is
Payments Solutions. The Payment solution CoE acts as a horizontal not just across all the
PrimeSourcing verticals mentioned above, but also across Products and Consulting. Some of the
solutions offered by the CoE Payment solutions are:
High Value Fund Transfer Solutions provides real time, secure, multi currency, multi location,
high value funds transfer services.
Bulk Payment Solutions for payroll, pensions, dividends and supplier payments.
EBPP (Electronic Bill Payment and Presentment) solutions integrates with credit card
payment gateways
EIPP (Electronic Invoice Presentment & Payment) solutions interface between multiple
buyers and sellers offering centralized view of invoices & customized workflow.
Remittance solutions enable secure collection and disbursement of FX remittances
SWIFTnet solutions offers services including strategic consulting for the protocol network
services from SWIF.
Payment Decision Solutions central systems on which online credit decisions depend.
PKI (Public Key Infrastructure) Solutions provides certificate-based authentication,
authorization and cryptography services
Card System solutions for various types of card payments (Visa, Master etc.), private label,
co-branded and Smart cards.

170
Chapter 5
Compliance Solutions
5.1 Anti Money Laundering
What is Money Laundering?
Money Laundering is the practice of engaging in financial transactions in order to conceal the
identity, source and / or destination of money. To put this in simple words, all the illegal activities
are funded by cash as funds when routed through official channels (e.g. banks) can be traced.
However, when these illegal activities are carried on across countries on a very large scale (e.g.
terrorism, drug trafficking etc.), it is high impossible for cash to be moved physically. In such cases,
money is moved through financial transactions which prima facie appear to be perfect and normal.
This is typically done by multi-layering wherein the source and the final destination is at times
difficult to be traced even on investigation. Such activities are known as Money Laundering.
Todays financial havens, offshore trusts, creative financial products, and sophisticated
technologies such as smart cards, online banking and electronic cash have increased opportunities
for money laundering. Conservative estimates place the money laundered annually in the region of
USD 500 billion to 1.5 trillion. The deeper this money sinks into the financial system, the more
difficult it is to trace. Apart from being detrimental to public order and security, money laundering
can considerably compromise the economic stability of nations and, therefore the global economy
as a whole.
The nexus between organized crime in areas such as drug trafficking, international fraud, arms
dealing, terrorism, and the highly sophisticated and complex money laundering network has now
acquired alarming proportions. These concerns have led to concerted international action for an
effective solution to combat this growing menace. Governments and several international agencies
such as the IMF, the World Bank, the United Nations, the Basel committee on Banking Supervision
and the Financial Action Task Force (FATF) have evolved recommendations to deter and detect
money laundering at an early stage.
An effective Anti Money Laundering solution should ideally be a combination of sound policies,
procedures, processes and controls supplemented by technology. The power of information
technology can be significantly leveraged to identify suspicious activities using sophisticated
detection techniques and behavioral analysis and also for effective reporting. i-flex leverages these
technological advances and offers a complete spectrum of anti-money laundering services.
i-flex offers end-to-end solutions in this domain, addressing the following:
assist a financial institution in developing practices and procedures
help in implementing appropriate controls and compliance procedures
provide guidance and evaluate businesses' technology requirements to meet compliance laws
undertake bespoke development of AML solutions to meet specific needs of financial
institutions
implement third-party AML solutions and integrate the same with the current technology
environment
provide an enterprise-wide, end-to-end solution to meet compliance requirements

171
i-flex has partnered with Mantas, worlds preferred behavior analysis solution provider, to
implement and integrate its Money Laundering monitor. The solution offers state-of-the-art
Advanced Behavior Analytics with features such as Audit trails, Transaction Monitoring, Risk
Profiling, Watch-List monitoring, Record Keeping and Regulatory Reporting.
5.2 Basel II
5.2.1 Need for Basel Accord
The global recession in the early 1980s due to soaring interest rates and high oil prices resulted in
a high incidence of bank failures. Banking industry has always been regulated as they run their
business with other peoples money. The regulators primary objective, therefore, is to ensure
safety of this other peoples money.
One of the key methods amongst several ones, by which the regulator (usually, the Central Bank of
the country) controls the banking operations is by defining the Capital-to-asset ratio. This is the
ratio which correlates the capital of a bank (including reserves) to the assets of the bank, which
mainly are the loans and the securities held.
The banking industry's weighted capital-to-asset ratio, during this recession, declined from around
6% to 4%. Regulators in the US and the UK announced a minimum primary capital ratio of 5% for
large banks. In 1988, the central banks of the G-10 countries adopted the Basel Capital Accord.
The major drawback in the first Basel Accord was the inadequate risk differentiation of the assets
held by the bank. This, in turn, meant that for calculation of capital-to-asset ratio, no specific
weights were given to them based on the risk profile these assets.
This encouraged take larger exposure to risky assets, as risky assets carry the potential of higher
returns. In addition, capital market innovations such as asset securitization and credit derivatives
allowed banks to transfer the risk off their books, while lowering their capital charge.
5.2.2 The New Basel Capital Accord Basel II
The 1996 Amendment to Basel I introduced market risk (including interest rate risk) within the ambit
of regulatory capital requirements and also encouraged the development and adoption of internal
measurement approaches for risk measurement and for determining capital allocation. The BIS
(Bank for International Settlements, responsible for advising and coordinating with the world's
Central banks on all areas relating to developments in banking and banking regulation) in 2000
released for consultation, a draft version of a New Capital Accord (commonly called Basel II). The
objectives of the new accord were the following:
Eliminate lower than required calculation of risk-based capital.
Make comprehensive the coverage of risks requiring capital allocation.
Introduce a greater degree of risk sensitivity.
Introduce good practices in risk management.
The draft included Operational risk, a new category of risk, for the purpose of capital requirements.
Capital requirements for credit risk were made more risk sensitive, while appropriate adjustments
were conceived for risk mitigation techniques.
In April 2003, the BIS released the third set of consultative documents and the final version of Basel
II has been released on the June 26, 2004 as "International Convergence of Capital Measurement
and Capital Standards: a Revised Framework".

172
The focus is on lowering regulatory capital requirements for the banks with lower risk, which in turn
would encourage and reward superior risk management procedures. The framework offers banks
the flexibility and freedom to use internal risk models for calculating capital requirements for credit
and operational risks. This move has encouraged banks around the world to review their risk
management systems and practices, and to adopt best practices thereby sharpening their
competitive edge.
Broadly, banks are now faced with the following challenges while implementing Basel II:
Achieving the desired levels of maturity in terms of risk management functions, policies and
processes.
Implementing the data management Infrastructure and analytical applications.
Integrating Basel II program into Enterprise Risk Management.
i-flex offers end-to-end solutions to banks in meeting each of these challenges from initial gap
assessment to complete program management. It assists in all areas of enterprise risk
management; market, credit and operational risks. The key offerings in the Risk Management
include:
Formulation of Risk management policies.
Review of the organizational risk management process; design of the organizational structure
for risk management; definition of roles, responsibilities and process.
Benchmarking of current policies, process and IT infrastructure with best practices and
regulatory standards.
Assistance with evaluating, selecting and implementing risk management systems including
systems for Credit Risk, Treasury Mid-Office, ALM, etc.
Assistance in self-assessment of operational risk.
Assistance in portfolio risk analysis, risk pricing, risk budgeting and implementing economic
frameworks.
5.3 Sarbanes Oxley Act
5.3.1 Genesis of Sarbanes Oxley Act, 2002
Sarbanes Oxley Act, 2002 was enacted as a result of the numerous corporate financial accounting
and reporting scandals that have occurred in recent times across the US. These corporate failures
have resulted in loss of investor trust and confidence and also raised fundamental issues regarding
management values, standards of corporate governance, roles and responsibilities of management
regarding accuracy, integrity and reliability of financial information.
These scandals also forced regulatory bodies and corporations to take a closer look at the internal
control framework, which is the foundation stone for the smooth and effective functioning of any
organization. The Sarbanes Oxley Act mandates that organizations benchmark internal control
systems against best practices frameworks such as COSO (Committee of Sponsoring
Organizations) and CoBIT (Control Objectives for Information and Related Technology).

173
5.3.2 Highlights of Sarbanes Oxley Act
The Act has 11 titles, of which Section 302 (Corporate Responsibility) and Section 404
(Management Assessment of Internal Controls) have far-reaching effect and pose implementation
and reporting challenges.
Section 302 requires quarterly assessment of Internal Controls by the management, and Section
404 requires an annual attestation of management assertion by an Independent Auditor. Section
404 casts responsibility on the CEO and CFO for:
Establishing and maintaining Internal Controls and procedures
Evaluation of Internal Controls and procedures
Reporting on accuracy and completeness of financial statements and effectiveness of Internal
Controls.
Section 404 applies to all public companies that have reporting obligations under Section 13 (a) or
15(d) of the Securities Exchange Act of 1934. This includes their divisions and wholly owned
subsidiaries, foreign private issuers, but excludes registered investment companies and issuers of
asset-backed securities.
For organizations with public equity float of greater than US 75 Million, the deadline for
implementation is year-ending on, or after, November 15, 2004. For other organizations the
deadline is July 15, 2005.
Any corporate misconduct, intentional or otherwise, will attract heavy financial penalties and
imprisonment.
i-flex offers solutions that believes that Section 404 compliance can be turned into competitive
advantage by the critical examination of current processes, current technology, various risks and
mitigating controls existing in an organization. Companies can save time, effort and costs by
adopting a unified view for compliance with various regulatory norms. Further, SOX compliance,
which encompasses the entire gamut of organizational activities - people, process and technology,
can be implemented as a part of an Enterprise Risk Management Framework.
Even though SOX is not applicable to all organizations, it is recommended that companies
voluntarily implement Internal Controls Framework as Industry Best Practices.
5.3.3 i-flex offerings for Section 404 compliance
i-flex has an established consulting practice for SOX Section 404 compliance, which offers an end-
to-end partnership; from initial gap analysis to complete program management.
Gap Analysis - Broad level study and analysis of the existing Internal Controls Framework to
identify the gaps and suggest corrective action wherever necessary
Plan - Draw up a "Strategy / Action Plan for Section 404 Compliance" along with activities,
resource requirements, timelines and effort estimates
Document Processes/Procedures - Prepare detailed documentation of business processes
and procedures, taking into account the business model, organization structure, data &
documentation flow, authorization matrix

174
Document Internal Controls Framework - Identify and document the risks and risk mitigation
measures in the Internal Control Framework. Also provide process improvement suggestions in
line with industry best practices and standards.
Testing - Assist organizations in testing of internal controls identified
Training - Provide training to the staff to create awareness about SOX compliance
Implementation - Assist in the implementation of Internal Control Framework improvements
Technology Tools for ongoing compliance - Help in identification and selection of SOX
compliance tool / technology
Program Management - Act as Program Managers for the execution of SOX Section 404
projects. Co-ordinate and build consensus across the organization on the approach,
methodology & execution and track project progress for any corrective action

175
Appendix 1
Asset Liability Management
This is a term typically applicable to a bank or a financial institution. The definition of this term can be said
as A risk management technique designed to earn an adequate return while maintaining a comfortable
surplus of assets beyond liabilities.
Banks and Financial Institutions create assets viz. Loans, Investment in Bonds and securities, Real estate
etc, from their liabilities i.e. Deposits. On one hand where the banks have to honor their obligation of
retiring their liabilities, they are potentially exposed to the risks on assets. They could be on loans going
bad, bonds or other securities suffering a setback in the markets. The exposure to risks could result in
potential mismatch of the asset liabilities. At the same time, the bank should not be keeping its
liabilities (deposits) unutilized which could result in lower returns on the funds deployed. Again this could
affect the banks performance as it has to honor its commitment of the contracted interest to the
depositors.
Appendix 2
Capital-to-Asset Ratio
A bank's capital-to-asset ratio is a gauge for determining how much capital it needs as a cushion against
credit risks. The ratio is calculated by dividing shareholders' equity, including capital, by risk-weighted
assets, such as loan claims and shareholdings. The capital adequacy standards set by the Bank for
International Settlements require banks operating internationally to hold capital equivalent to at least 8%
of their total risk-weighted assets. A new set of BIS rules would be put into effect from 2005 calls on
banks to calculate risk-weighted assets according to the creditworthiness of each borrower. The move is
aimed at making the capital-to-asset ratio of each bank more accurately reflect risk exposure.

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