Study Note - 1
OVER VIEW OF FINANCIAL MANAGEMENT
1.1 Finance Related Discipline
This Section includes :
INTRODUCTION :
Finance is called “The science of money”. It studies the principles and the methods of obtaining
control of money from those who have saved it, and of administering it by those into
whose control it passes. Finance is a branch of Economics till 1890. Economics is defined as
study of the efficient use of scarce resources. The decisions made by business firm in production,
marketing, finance and personnel matters form the subject matters of economics.
Finance is the process of conversion of accumulated funds to productive use. It is so intermingled
with other economic forces that there is difficulty in appreciating the role it plays.
MEANING AND DEFINITION OF FINANCE :
Howard and Uptron in his book introduction to Business Finance defined, “as that administrative
area or set of administrative function in an organization which relate with the arrangement
of cash and credit so that the organization may have the means to carry out its objectives
as satisfactorily as possible”.
Meaning and Definition of Finance
Meaning and Definition of Financial Management
Finance and Related Disciplines
Economics
Accounting
Production
Marketing
Quantitative Methods
Costing
Law
Taxation
Treasury Management
Banking
Insurance
International Finance
Information Technology
2
In simple terms finance is defined as the activity concerned with the planning, raising, controlling
and administering of the funds used in the business. Thus, finance is the activity concerned
with the raising and administering of funds used in business.
MEANING AND DEFINITION OF FINANCIAL MANAGEMENT :
Financial management is managerial activity which is concerned with the planning and controlling
of the firm’s financial resources.
Definitions
Howard and Uptron define financial management “as an application of general managerial
principles to the area of financial decision-making”.
Weston and Brighem define financial management “as an area of financial decision making,
harmonizing individual motives and enterprise goal”.
“Financial management is concerned with the efficient use of an important economic resource,
namely capital funds” - Solomon Ezra & J. John Pringle.
“Financial management is the operational activity of a business that is responsible for obtaining
and effectively utilizing the funds necessary for efficient business operations”- J.L. Massie.
“Financial Management is concerned with managerial decisions that result in the acquisition
and financing of long-term and short-term credits of the firm. As such it deals with the situations
that require selection of specific assets (or combination of assets), the selection of specific
liability (or combination of liabilities) as well as the problem of size and growth of an enterprise.
The analysis of these decisions is based on the expected inflows and outflows of funds
and their effects upon managerial objectives”.- Phillippatus.
Nature of Financial Management
The nature of financial management refers to its relationship with related disciplines like economics
and accounting and other subject matters.
The area of financial management has undergone tremendous changes over time as regards its
scope and functions. The finance function assumes a lot of significance in the modern days in
view of the increased size of business operations and the growing complexities associated
thereto.
FINANCE AND OTHER RELATED DISCIPLINES :
Financial management, is an integral part of the over all management, on other disciplines and
fields of study like economics, accounting, production, marketing, personnel and quantitative
methods. The relationship of financial management with other fields of study is explained as
under:
3
Finance and Other Disciplines
Economics Corporate Finance
Responsibility Cost Accounting
Financial Accounting Business Finance
Transactional Accounting Accounting
Management Accounting Human Resource Accounting
Finance and Economics
Finance is a branch of economics. Economics deals with supply and demand, costs and profits,
production and consumption and so on. The relevance of economics to financial management
can be described in two broad areas of economics i.e., micro economics and macro economics.
Micro economics deals with the economic decisions of individuals and firms. It concerns itself
with the determination of optimal operating strategies of a business firm. These strategies
includes profit maximization strategies, product pricing strategies, strategies for valuation of
firm and assets etc. The basic principle of micro economics that applies in financial management
is marginal analysis. Most of the financial decisions should be made taken into account
the marginal revenue and marginal cost. So, every financial manager must be familiar with
the basic concepts of micro economics.
Macro economics deals with the aggregates of the economy in which the firm operates. Macro
economics is concerned with the institutional structure of the banking system, money and
capital markets, monetary, credit and fiscal policies etc. So, the financial manager must be
aware of the broad economic environment and their impact on the decision making areas of
the business firm.
Finance and Accounting
Accounting and finance are closely related. Accounting is an important input in financial
decision making process. Accounting is concerned with recording of business transactions. It
generates information relating to business transactions and reporting them to the concerned
parties. The end product of accounting is financial statements namely profit and loss account,
balance sheet and the statements of changes in financial position. The information contained
in these statements assists the financial managers in evaluating the past performance and future
direction of the firm (decisions) in meeting certain obligations like payment of taxes and
so on. Thus, accounting and finance are closely related.
FINANCE
4
Finance and Production
Finance and production are also functionally related. Any changes in production process may
necessitate additional funds which the financial managers must evaluate and finance. Thus,
the production processes, capacity of the firm are closely related to finance.
Finance and Marketing
Marketing and finance are functionally related. New product development, sales promotion
plans, new channels of distribution, advertising campaign etc. in the area of marketing will
require additional funds and have an impact on the expected cash flows of the business firm.
Thus, the financial manager must be familiar with the basic concept of ideas of marketing.
Finance and Quantitative Methods
Financial management and Quantitative methods are closely related such as linear programming,
probability, discounting techniques, present value techniques etc. are useful in analyzing
complex financial management problems. Thus, the financial manager should be familiar
with the tools of quantitative methods. In other way, the quantitative methods are indirectly
related to the day-to-day decision making by financial managers.
Finance and Costing
Cost efficiency is a major strategic advantage to a firm, and will greatly contribute towards its
competitiveness, sustainability and profitability. A finance manager has to understand, plan
and manage cost, through appropriate tools and techniques including Budgeting and Activity
Based Costing.
Finance and Law
A sound knowledge of legal environment, corporate laws, business laws, Import Export guidelines,
international laws, trade and patent laws, commercial contracts, etc. are again important
for a finance executive in a globalized business scenario. For example The guidelines of Securities
and Exchange Board of India [SEBI] for raising money from the capital markets. Similarly,
now many Indian corporate are sourcing from international capital markets and get their
shares listed in the international exchanges. This calls for sound knowledge of Securities Exchange
Commission guidelines, dealing in the listing requirements of various international
stock exchanges operating in different countries.
Finance and Taxation
A sound knowledge in taxation, both direct and indirect, is expected of a finance manager, as
all financial decisions are likely to have tax implications. Tax planning is an important function
of a finance manager. Some of the major business decisions are based on the economics of
taxation. A finance manager should be able to assess the tax benefits before committing funds.
Present value of the tax shield is the yardstick always applied by a finance manager in investment
decisions.
Finance and Treasury Management
Treasury has become an important function and discipline, not only in banks, but in every
organization. Every finance manager should be well grounded in treasury operations, which
is considered as a profit center. It deals with optimal management of cash flows, judiciously
investing surplus cash in the most appropriate investment avenues, anticipating and meeting
5
emerging cash requirements and maximizing the overall returns, it helps in judicial asset liability
management. It also includes, wherever necessary, managing the price and exchange
rate risk through derivative instruments. In banks, it includes design of new financial products
from existing products.
Finance and Banking
Banking has completely undergone a change in today’s context. The type of financial assistance
provided to corporate has become very customized and innovative. During the early and
late 80’s, commercial banks mainly used to provide working capital loans based on certain
norms and development financial institutions like ICICI, IDBI, and IFCI used to provide long
term loans for project finance. But, in today’s context, these distinctions no longer exist. Moreover,
the concept of development financial institutions also does not exist any longer. The
same bank provides both long term and short term finance, besides a number of innovative
corporate and retail banking products, which enable corporate to choose between them and
reduce their cost of borrowings. It is imperative for every finance manager to be up-to date on
the changes in services & products offered by banking sector including several foreign players
in the field. Thanks to Government’s liberalized investment norms in this sector.
Finance and Insurance
Evaluating and determining the commercial insurance requirements, choice of products and
insurers, analyzing their applicability to the needs and cost effectiveness, techniques, ensuring
appropriate and optimum coverage, claims handling, etc. fall within the ambit of a finance
manager’s scope of work & responsibilities.
International Finance
Capital markets have become globally integrated. Indian companies raise equity and debt funds
from international markets, in the form of Global Depository Receipts (GDRs), American Depository
Receipts (ADRs) or External Commercial Borrowings (ECBs) and a number of hybrid
instruments like the convertible bonds, participatory notes etc., Access to international markets,
both debt and equity, has enabled Indian companies to lower the cost of capital. For
example, Tata Motors raised debt as less than 1% from the international capital markets recently
by issuing convertible bonds. Finance managers are expected to have a thorough knowledge
on international sources of finance, merger implications with foreign companies, Leveraged
Buy Outs (LBOs), acquisitions abroad and international transfer pricing. The implications
of exchange rate movements on new project viability have to be factored in the project
cost and projected profitability and cash flow estimates. This is an essential aspect of finance
manager’s expertise. Similarly, protecting the value of foreign exchange earned, through instruments
like derivatives, is vital for a finance manager as the volatility in exchange rate
movements can erode in no time, all the profits earned over a period of time.
Finance and Information Technology
Information technology is the order of the day and is now driving all businesses. It is all pervading.
A finance manager needs to know how to integrate finance and costing with operations
through software packages including ERP. The finance manager takes an active part in
assessment of various available options, identifying the right one and in the implementation
of such packages to suit the requirement.
6
1.2 Objective & Scope of Financial Management
This section includes :
INTRODUCTION :
Financial management is that managerial activity which isconcerned with the planning and
controlling of the firm’s financial resources. The funds raised from the capital market needs to
be procured at minimum cost and effectively utilised to maximise returns on investments.
There is a necessity to make the proper balancing of the risk-return trade off.
OBJECTIVE OF FINANCIAL MANAGEMENT :
Financial Management as the name suggests is management of finance. It deals with planning
and mobilization of funds required by the firm. There is only one thing which matters for
everyone right from the owners to the promoterers and that is money. Managing of finance is
nothing is but managing of money. Every activities of an organization is reflected in its financial
statements. Financial Management deals with activities which have financial implications.
The very objective of Financial Management is to maximize the wealth of the shareholders by
maximizing the value of the firm. This prime objective of Financial Management is reflected in
the EPS (Earning per Share) and the market price of its shares.
The earlier objective of profit maximization is now replaced by wealth maximization. Since
profit maximization cannot be the sole objective of a firm it is a limited one. The term profit is
a vague phenomenon and if given undue importance problems may arise whareas wealth
maximization on the other hand overcomes the drawbacks of profit maximization. Thus the
objective of Financial Management is to trade off between risk and return. The objective of
Financial Management is to make efficient use of economic resources mainly capital.
The functions of Financial Management involves acquiring funds for meeting short term and
long term requirements of the firm, deployment of funds, control over the use of funds and to
trade-off between risk and return.
SCOPE OF FINANCIAL MANAGEMENT :
Financial Management today covers the entire gamut of activities and functions given below.
The head of finance is considered to be important ally of the CEO in most organizations and
performs a strategic role. His responsibilities include:
Objective of Financial Management
Scope of Financial Management
Role of Financial Management
Liquidity
Profitability
Management
Functions
Investment decisions
Financing Decisions
Dividend Decisions
7
a. Estimating the total requirements of funds for a given period.
b. Raising funds through various sources, both national and international, keeping in mind
the cost effectiveness;
c. Investing the funds in both long term as well as short term capital needs;
d. Funding day-to-day working capital requirements of business;
e. Collecting on time from debtors and paying to creditors on time;
f. Managing funds and treasury operations;
g. Ensuring a satisfactory return to all the stake holders;
h. Paying interest on borrowings;
i. Repaying lenders on due dates;
j. Maximizing the wealth of the shareholders over the long term.
k. Interfacing with the capital markets;
l. Awareness to all the latest developments in the financial markets;
m. Increasing the firm’s competitive financial strength in the market &
n. Adhering to the requirements of corporate governance.
ROLE OF FINANCIAL MANAGEMENT :
To participate in the process of putting funds to work within the business and to control
their productivity; and
To identify the need for funds and select sources from which they may be obtained.
The functions of financial management may be classified on the basis of liquidity, profitability
and management.
1. Liquidity
Liquidity is ascertained on the basis of three important considerations:
a. Forecasting cash flows, that is, matching the inflows against cash outflows;
b. Raising funds, that is, financial management will have to ascertain the sources from
which funds may be raised and the time when these funds are needed;
c. Managing the flow of internal funds, that is, keeping its accounts, with a number of
banks to ensure a high degree of liquidity with minimum external borrowing.
2. Profitability
While ascertaining profitability, the following factors are taken into account:
a. Cost control: expenditure in the different operational areas of an enterprise can be
analysed with the help of an appropriate cost accounting system to enable the financial
manager to bring costs under control.
b. Pricing: Pricing is of great significance in the company’s marketing effort, image and
sales level. The formulation of pricing policies should lead to profitability, keeping, of
course, the image of the organization intact.
c. Forecasting Future Profits: Expected profits are determined and evaluated. Profit levels
have to be forecast from time to time in order to strengthen the organization.
8
d. Measuring Cost of Capital: Each source of funds has a different cost of capital which
must be measured because cost of capital is linked with profitability of an enterprise.
3. Management
The financial manager will have to keep assets intact, for assets are resources which enable a
firm to conduct its business. Asset management has assumed an important role in financial
management. It is also necessary for the financial manager to ensure that sufficient funds are
available for smooth conduct of the business. In this connection, it may be pointed out that
management of funds has both liquidity and profitability aspects. Financial management is
concerned with the many responsibilities which are thrust on it by a business failures, financial
failures do positively lead to business failures. The responsibility of financial management
is enhanced because of this peculiar situation. Financial management may be divided
into two broad areas of responsibilities, which are not by any means independent of each
other. Each, however, may be regarded as a different kind of responsibility; and each necessitates
very different considerations. These two areas are:
The management of long-term funds, which is associated with plans for development
and expansion and which involves land, buildings, machinery, equipment, transport
facilities, research project, and so on;
The management of short-term funds, which is associated with the overall cycle of
activities of an enterprise. These are the needs which may be described, as working
capital needs.
FUNCTIONS OF FINANCIAL MANAGEMENT :
The modern approach to the financial management is concerned with the solution of major
problems like investment financing and dividend decisions of the financial operations of a
business enterprise. Thus, the functions of financial management can be broadly classified
into three major decisions, namely:
(a) Investment decisions,
(b) Financing decisions,
(c) Dividend decisions.
The functions of financial management are briefly discussed as under:
1. Investment Decision
The investment decision is concerned with the selection of assets in which funds will be
invested by a firm. The assets of a business firm includes long term assets (fixed assets) and
short term assets (current assets). Long term assets will yield a return over a period of time in
future whereas short term assets are those assets which are easily convertible into cash within
an accounting period i.e. a year. The long term investment decision is known as capital budgeting
and the short term investment decision is identified as working capital management.
Capital Budgeting may be defined as long – term planning for making and financing proposed
capital outlay. In other words Capital Budgeting means the long-range planning of allocation
of funds among the various investment proposals. Another important element of capital budgeting
decision is the analysis of risk and uncertainity. Since, the return on the investment
proposals can be derived for a longer time in future, the capital budgeting decision should be
evaluated in relation to the risk associated with it.
9
On the other hand, the financial manager is also responsible for the efficient management of
current assets i.e. working capital management. Working capital constitutes an integral part of
financial management. The financial manager has to determine the degree of liquidity that a
firm should possess. There is a conflict between profitability and liquidity of a firm. Working
capital management refers to a Trade – off between liquidity (Risk) and Profitability.
Insufficiency of funds in current assets results liquidity and possessing of excessive funds in
current assets reduces profits. Hence, the finance manager must achieve a proper trade – off
between liquidity and profitability. In order to achieve this objective, the financial manager
must equip himself with sound techniques of managing the current assets like cash, receivables
and inventories etc.
2. Financing Decision
The second important decision is financing decision. The financing decision is concerned with
capital – mix, (financing – mix) or capital structure of a firm. The term capital structure refers
to the proportion of debt capital and equity share capital. Financing decision of a firm relates
to the financing – mix. This must be decided taking into account the cost of capital, risk and
return to the shareholders. Employment of debt capital implies a higher return to the share
holders and also the financial risk. There is a conflict between return and risk in the financing
decisions of a firm. So, the financial manager has to bring a trade – off between risk and return
by maintaining a proper balance between debt capital and equity share capital. On the other
hand, it is also the responsibility of the financial manager to determine an appropriate capital
structure.
3. Dividend Decision
The third major decision is the dividend policy decision. Dividend policy decisions are concerned
with the distribution of profits of a firm to the shareholders. How much of the profits
should be paid as dividend? i.e. dividend pay-out ratio. The decision will depend upon the
preferences of the shareholder, investment opportunities available within the firm and the
opportunities for future expansion of the firm. The dividend pay out ratio is to be determined
in the light of the objectives of maximizing the market value of the share. The dividend decisions
must be analysed in relation to the financing decisions of the firm to determine the portion
of retained earnings as a means of direct financing for the future expansions of the firm.
FINANCIAL
MANAGEMENT
1. INVESTMENT
DECISIONS
2. FINANCING
DECISIONS
3. DIVIDEND
DECISIONS
A. CapitalBudgeting
B. Working Capital
Management
A. Cost of Capital
B. Capital Structure
Decisions
C. Leverages
A. Dividend Policy
B. Retained - Earnings
10 Fianancial Management & international finance
COOSTv-eVrO VLUieMEw- PoRfO FFiInTa nAcNiaAlL YMSIaSnagement
1.3 Planning Environment
This section includes :
INTRODUCTION :
Financial planning involves analyzing the financial flows of a company, forecasting the consequences
of various investment, financing and dividend decisions and weighing the effects of
various alternatives. The idea is to determine where the firm has been, where it is now and
where it is heading – not only the most likely course of events, but deviation from the most
likely outcome. The advantage of financial planning is that it forces management to take account
of possible deviation from the company’s anticipated path.
The aim in financial planning should be to match the needs of the company with those of the
investors with a sensible gearing of short-term and long-term fixed interest securities. Financial
planning aims at the eliminations of waste resulting from complexity of operation. For e.g.
– technological advantage, higher taxes fluctuations of interest rates. Financial planning helps
to avoid waste by providing policies and procedures, which make possible a closer co-ordination
between various functions of the business enterprise. A firm, which performs no financial
planning, depends upon past experience for the establishment of its objectives, policies and
procedures.
It may be summarized that financial planning should:-
• Determine the financial resources required in meeting the company’s operating program.
• Forecast the extent to which these requirements will be met by internal generation of
funds and to what extent they will be met from external sources.
• Develop the best plans to obtain the required external funds.
• Establish and maintain a system of financial control governing the allocation and use
of funds.
• Formulate programs to provide the most effective cost - volume - profit relationship.
• Analyze the financial results of operation.
• Report the facts to the top management and make recommendations on future operations
of the firm.
• Steps in Financial Planning
• Establishing Objectives
• Policy formulation
• Forecasting
• Formulation of procedures
• Characteristics of Financial Planning
• Computerized Financial Forecasting and Planning Models
• Limitations of Financial Planning
11
STEPS IN FINANCIAL PLANNING :
Establishing Objectives
Policy Formulation
Forecasting
Formulation of Procedures
Establishing objectives
The financial objective of any business enterprise is to employ capital in whatever proportion
necessary and to increase the productivity the remaining factors of production over the long
run. Although the extent to which the capital is employed varies from firm to firm, but the
overall objective is identical in all firms. Business enterprise operates in a dynamic society,
and in order to take advantage of changing economic conditions, financial planners should
establish both short term and long term objectives. The long-term goal of any firm is to use
capital in correct proportion.
The objectives of the company are sometimes revealed in the vision statement of th4e company.
The chieftains of the companies know it very well that in today’s world, innovation and
adaptation is crucial to be successful in the dynamic market. The impact of innovation on key
value drivers also has to be examined to remain in the forefront in the industry. While establishing
the objectives, the innovation and the value-driver should be clearly stated.
Constant innovation and adaptation of key business processes is assuming increasing importance
in establishing the objective of the company. As companies seek to innovate, they can be
slotted into one of the three strategic positions:
(i) Product Innovator
Manufacturing companies that focus primarily on products and services fall into this category.
They seek to gain the competitive advantage by improving their product and service attributes.
A company that is a new entrant into the market normally comes up with an “innovative” idea
in product development. Some of these ideas pay off in terms of high profit margins, while
others may have to be reworked to become money-spinners. For attaining a sustainable advantage,
continuous improvement should be targeted at the following value drivers:
Product development—Innovation is considered a major component in the product
development life cycle. Innovative ideas generated during informal brainstorming sessions
in startup companies, or at formal meetings in mature companies are crucial to
create a commercially viable product. These ideas also help to improve business processes,
technologies and investments.
The name— If a company introduces an “innovative” product in the market, but the
brand name of the new offering fails to differentiate it from earlier versions or the
offerings of competitors, the benefits of innovation are not realized. Innovation must
be integrated into the brand name so that it is indicative of being a unique or superior
product.
Distribution channels— Companies can offer their products/services through a network
of channels. The choice of the right distribution channel would determine the
product’s acceptance and success. It is important for companies to select new and
12
innovative distribution channels in today’s ‘borderless’ world, rather than persist with
traditional channels. Such channels would strengthen the company’s offering to the
final customer.
Unilever, a multinational manufacturer of foods, home and personal care products exemplifies
innovation in the product innovator position. Through constant innovation, the company
has brought out several well-known products like Lipton tea, Hellman’s manyonnaise and
Calvin Klein perfumes in the span of two years only. The company uses a formal innovation
process to generate new ideas from all employees across the board.
Hindusthan Lever in India is a company in the category of “product innovator”. After dominating
the detergent market for a period of more than 35 years, in the post liberalization period
they faced fierce competition from Nirma, Ariel of Proctor and Gamble, Henko of Henkel.
They invested heavily in research in the detergent market. The brand ‘Surf’ changed its identity
from time to time (“power packed surf”, “Surf international”, “Surf with wash “booster”,
“Surf Excel”, etc.,)
(ii) Value Network Architect
Companies in this category seek to enhance shareholder value by utilizing resources of the
entire business network to their advantage. Some companies strategically position themselves
to create value. Therefore, adaptation and positioning are important, and innovative ways of
doing so would indicate their chances of success. To make a mark in this niche, managers
must seek innovative ways of identifying profit zones and positioning the company. Similarly,
there must be continuous effort across the board to come up with innovative ways to
forge ahead in relevant business processes. Such efforts include identifying best practices and
core activities of competitors; and adapting and capitalizing on them.
The Airlines companies thrive on value networking. The India companies in the private sector
(Sahara India, Jet Airways) have identified their profitable sectors and maximizing value by
giving discounts on ticket-price. At the same time they offer better quality service.
(ii) Relationship owner
Companies that focus on increasing shareholder value by establishing and improving relationships
with various network players fit into this position.
Innovation is key to such businesses and market leadership can be gained by anticipating
customer requirements, before customers realize it or competitors provide it. Innovative techniques
can be used to gain an insight into customers businesses, and their purchasing power
and patterns; thereafter production and distribution strategies can be formulated.
For instance, Amazon. Com encourages innovative thinking to establish good relations with
its customers. Though the company has worldwide operations, it personalizes its products
and services and ensures prompt delivery. Besides, maintaining good relations with its customers,
Amazon.com monitors all activities of the supply chain to gain cost efficiency. The
relationship owner should be wary if competitors offer a wide range of products, for it gives
the competitor a wider platform to establish a bond with customers.
Policy Formulation
Financial policies are guides to all actions, which deal with procuring, administering and disbursing
the funds of business firms. The policies may be classified into several broad categories:
13
Policies governing the amount of capital required for firms to achieve their financial
objective.
Policies which determine the control by the parties who furnish the capital.
Policies which act as a guide in the use of debt or equity capital.
Policies which guide management in the selection of sources of funds.
Policies which govern credit and collection activities of the enterprise.
Forecasting
A fundamental requisite of financial planning is the collection of facts, however where financial
plans concern the future, “facts” are not available. Therefore financial management is
required to forecast the future in order to predict the variability of factors influencing the type
of policies the policies formulate.
Formulation of Procedures
Financial policies are broad guides which to be executed properly, must be translated into
detailed procedures. This helps the financial manager to put planned activities into practice.
The objective setting and forecasting may be done by considering some facts and figures. But
formulation of procedure is the backbone of procurement, operation, distribution, logistics
and collection from debtors. It is a complex flowchart involving all possible options.
CHARACTERISTICS OF FINANCIAL PLANNING :
Simplicity of purpose
The planning schedule should be organized and should be as simple as possible so that the
understanding of it becomes easier.
Intensive Use
A wasteful use of capital is almost as bad as inadequate capital. A financial plan should be
such that it will provide for an intensive use of funds. Funds should not remain idle, nor
should there be any paucity of funds. Moreover, they should be made available for the optimal
utilization of projects.
Financial contingency
In fact, planning, as it is commonly practiced today, tends to build in rigidities, which work
against a quick and effective response to the unexpected event. Contingency planning or a
strategy for financial mobility should be brought into the open for a careful review. Every
business has objectives that guide policy in their most basic form and include survival, profitability
and growth. Growth objectives that are central to our philosophy of successful management
may be expressed in a variety of ways – sales, profits, market share, geographical
coverage and product line; but they are all contingent on a continuous flow of funds which
make it possible for the management to implement decisions. Financial contingency planning
is a strategy, which a firm adopts in situations of adversity.
Objectivity
The figures and reports to be used for a financial plan should be free from partiality, prejudice
and personal bias. A lapse from objectivity is undesirable as it may mislead and make it difficult
if not impossible for a firm to prepare a fact-finding plan.
14
Comparisons
Figures and reports should be expressed in terms of standards of performance. Financial executives
often take initiative decisions based upon their personal judgments. These decisions
are subjective. If standards of performance, including those of past performance, are expressed,
the subjective element, which is likely to creep into a financial plan, can be eliminated.
Flexibility
The financial plan should be such that it can be made flexible, so that it can be modified or
changed, if it is necessary to do so. Making provisions for valuable or convertible securities
can do this. It would be better to avoid restrictive or binding provisions in debentures and
preferred stock. Flexible sinking fund position may be introduced in debenture financing.
The environment of a firm may change from time to time. It is therefore advisable to have a
more versatile plan than a routine one.
Profitability
A financial plan should maintain the required proportion between fixed charge obligations
and the liabilities in such a manner that the profitability of the organization is not adversely
affected. The most crucial factor in financial planning is the forecasting of sales, for sales
almost invariably represent the primary source of income and cash receipts. Besides, the operation
of the business is geared to the anticipated volume of sales. The management should
recognize the likely margins of error inherent in forecasts, and this recognition would enable
the management to avoid the hazards involved in attaching a false accuracy to forecast data
based on tenuous assumptions.
Maneuverability
Maneuverability is the direct result of a management’s adherence to the financial structure
which is acceptable to the business community; that is creditors, shareholders, bankers, etc. It
is necessary to choose a financial plan, which may control the crisis, the crisis that may develop
from time to time. It is well known that any financial plan should aim at a proper balance
between debt and equity. This is essential to ensure that the stake of the entrepreneur in an
industry or a concern is substantial, so that his handling of the affairs, financial and others may
be in its best interest.
Risks
There are different types of risks but the financial manager is more concerned about the financial
risk which is created by a high debt-equity ratio than about any other risk. If earnings are
high, the financial risk may not have much of an impact. In other words if the economic risks
of the business activities are reduced to minimum, a firm may not be exposed to financial risks.
Its refinancing should be planned in such a manner that the impact of risk is not seriously felt.
Planning is essential for any business operations so that the capital requirement may be assessed
as accurately as possible. A plan should be such that it should serve a practical purpose.
It should be realistic and capable of being put to intensive use. But a proper balance between
fixed and working capital should be maintained.
COMPUTERIZED FINANCIAL FORECASTING AND PLANNING MODELS :
Recently many companies have spent considerable amounts of time and money developing
models to represent various aspects of their financial planning process. These representations
are computerized and are generally called financial planning models.
15
Financial planning models are often classified according to whether they are deterministic or
probabilistic and whether they attempt to optimize the value of some objective function net
income and stock price.
Deterministic model
This model gives a single number forecast of a financial variable or variables without stating
anything about the probability of occurrence. For example a budget simulator company that
employ budget simulators, enter estimated further revenues and expenses into the computer
and receive as output an estimate of various financial variables, such as net income and earning
per share. The model tells nothing about the chances of achieving these estimates, nor
does it indicate whether the company will be able to manage its resource in such a way to
attain higher levels of these variables.
Probabilistic model
This model is becoming increasingly popular because they often provide financial decision
makers with more useful information than other models. Though deterministic model yield
single-point estimate, probabilistic model yield more general probability distribution.
Optimization model
This model determines the values of financial decision variables that optimize (maximize or
minimize), some objective function such as profit or cost. For example consider an oil refinery
whose capacity and production costs are known. By combining these known figures with
estimates of the sales price for gasoline and heating fuel, it is possible, with the use of an
optimization model to specify what output product mix will achieve an optimal level of operating
income. Optimization models are not used widely in finance, even though various applications
have been proposed in the financial literature.
LIMITATION OF FINANCIAL PLANNING :
Plans are decisions and decisions require facts. Facts about the future are non-existent; consequently,
assumptions concerning the future must be substituted. Since future conditions cannot
be forecasted accurately, the adaptability of plan is seriously limited. This is true for plans,
which cover several years in advance, since reliability of forecasting decreases with time. On
the other hand, plans, which cover a relatively short period, are interest rates, and general
business conditions can be predicted with a good degree of accuracy. One way to offset the
limitations imposed by management’s inability to forecast future condition is to improve their
forecasting techniques. Another way to overcome this limitation is to revise plans periodically.
The development of variable plans, which take into account changing conditions, will
go a long way in eliminating this limitation. Variable budgets are examples variable plans.
Another serious difficulty in planning is the reluctance or inability of the management to change
a plan once it has been made. There are several reasons for this. First, plans relating to capital
expenditure often involve colossal expenditure and commitments for funds are made months
in advance and cannot be readily changed. Second, in addition to advance arrangements regarding
capital, management often makes commitments for raw material and equipment prior
to the time when the plan is to be initiated. Third, management personnel are psychologically
against change, which creates rigidity. Financial planning is limited when there is lack of
coordination among the personnel. Financial planning affects each function in the organization,
and to be effective, each function should be coordinated in order to ensure consistency in
action.
16
1.4 Key Decisions of Financial Management
This section includes :
INTRODUCTION :
One of the most important functions of the financial manager is to ensure availability of adequate
financing. Financial needs have to be assessed for different purposes. Money may be
required for initial promotional expenses, fixed capital and working capital needs. Promotional
expenditure includes expenditure incurred in the process of company formation. Fixed
assets needs depend upon the nature of the business enterprise – whether it is a manufacturing,
non-manufacturing or merchandising enterprise. Current asset needs depend upon the
size of the working capital required by an enterprise.
Determining Financial Needs
Determining Sources of Funds
Financial Analysis
Optimal Capital Structure
Cost Volume Profit Analysis
Profit Planning and Control
FUNCTIONAL AREAS OF Fixed Assets Management
FINANCIAL MANAGEMENT Project Planning and Evaluation
Capital Budgeting
Working Capital Management
Dividend Policies
Acquisitions and Mergers
Corporate Taxation
Fig: Functional areas of financial management
FUNCTIONAL AREAS OF FINANCIAL MANAGEMENT
Determining the source of Funds
Financial Analysis
Optimum Capital Structure
C V P Analysis
Profit Planning and Control
Fixed Assets Management
Project Planning and evaluation
Capital Budgeting
Working Capital
Dividend Policies
Acquisitions and Mergers
Corporate taxation
17
(i) Determining Sources of Funds
The financial manager has to choose sources of funds. He may issue different types of securities
and debentures. He may borrow from a number of financial institutions and the public.
When a firm is new and small and little known in financial circles, the financial manager faces
a great challenge in raising funds. Even when he has a choice in selecting sources of funds, that
choice should be exercised with great care and caution. A firm is committed to the lenders of
finance and has to meet terms and conditions on which they offer credit. To be precise, the
financial manager must definitely know what he is doing.
(ii) Financial Analysis
It is the evaluation and interpretation of a firm’s financial position and operations, and involves
a comparison and interpretation of accounting data. The financial manager has to interpret
different statements. He has to use a large number of ratios to analyse the financial status
and activities of his firm. He is required to measure its liquidity, determine its profitability,
and assess overall performance in financial terms. This is often a challenging task, because he
must understand importance of each one of these aspects to the firm; and he should be crystal
clear in his mind about the purposes for which liquidity, profitability and performance are to
be measured.
(iii) Optimal Capital Structure
The financial manager has to establish an optimum capital structure and ensure the maximum
rate of return on investment. The ratio between equity and other liabilities carrying fixed charges
has to be defined. In the process, he has to consider the operating and financial leverages of his
firm. The operating leverage exists because of operating expenses, while financial leverage
exists because of the amount of debt involved in a firm’s capital structure. The financial manager
should have adequate knowledge of different empirical studies on the optimum capital
structure and find out whether, and to what extent, he can apply their findings to the advantage
of the firm.
(iv) Cost-Volume-Profit Analysis
This is popularly known as the ‘CVP relationship’. For this purpose, fixed costs, variable costs
and semi-variable costs have to be analysed. Fixed costs are more or less constant for varying
sales volumes. Variable costs vary according to sales volume. Semi-variable costs are either
fixed or variable in the short run. The financial manager has to ensure that the income for the
firm will cover its variable costs, for there is no point in being in business, if this is not accomplished.
Moreover, a firm will have to generate an adequate income to cover its fixed costs as
well. The financial manager has to find out the break-even-point-that is, the point at which
total costs are matched by total sales or total revenue. He has to try to shift the activity of the
firm as far as possible from the break-even point to ensure company’s survival against seasonal
fluctuations.
(v) Profit Planning and Control
Profit planning and control have assumed great importance in the financial activities of modern
business. Economists have long considered the importance of profit maximization in influencing
business decisions. Profit planning ensures attainment of stability and growth. In view
of the fact that earnings are the most important measure of corporate performance, the profit
test is constantly used to gauge success of a firm’s activities. Profit planning is an important
responsibility of the financial manager. Profit is the surplus which accrues to a firm after its
total expenses are deducted from its total revenue. It is necessary to determine profits properly,
for they measure the economic viability of a business. The first element in profit is revenue
or income. This revenue may be from sales or it may be operating revenue, investment
income or income from other sources. The second element in profit calculation is expenditure.
This expenditure may include manufacturing costs, trading costs, selling costs, general administrative
costs and finance costs. Profit planning and control is a dual function which enables
management to determine costs it has incurred, and revenues it has earned, during a particular
period, and provides shareholders and potential investors with information about the earning
strength of the corporation. It should be remembered that though the measurement of profit is
not the only step in the process of evaluating the success or failure of a company, it is nevertheless
important and needs careful assessment and recognition of its relationship to the company’s
progress. Profit planning and control are important be, in actual practice, they are directly
related to taxation. Moreover, they lay foundation of policies which determine dividend, and
retention of profit and surplus of the company. Profit planning and control are an inescapable
responsibility of the management. The break-even analysis and the CVP relationship are important
tools of profit planning and control.
(vi) Fixed Assets Management
A firm’s fixed assets are land, building, machinery and equipment, furniture and such intangibles
as patents, copyrights, goodwill, and so on. The acquisition of fixed assets involves
capital expenditure decisions and long-term commitments of funds. These fixed assets are
justified to the extent of their utility and / or their productive capacity. Because of this longterm
commitment of funds, decisions governing their purchase, replacement, etc., should be
taken with great care and caution. Often, these fixed assets are financed by issuing stock, debentures,
long-term borrowings and deposits from public. When it is not worthwhile to purchase
fixed assets, the financial manager may lease them and use assets on a rental basis. To
facilitate replacement to fixed assets, appropriate depreciation on fixed assets has to be formulated.
It is because of these facts that management decision on the acquisition of fixed assets
are vital; if they are ill-designed they may lead to over-capitalisation. Moreover, in view of the
fact that fixed assets are maintained over a long period of time, the assets exposed to changes
in their value, and these changes may adversely affect the position of a firm.
(vii) Project Planning and Evaluation
A substantial portion of the initial capital is sunk in long-term assets of a firm. The error of
judgement in project planning and evaluation should be minimized. Decisions are taken on
the basis of feasibility and project reports, containing analysis of economic, commercial, tech
19
nical, financial and organizational viabilities. Essentiality of a project is ensured by technical
analysis. The economic and commercial analysis study demand position for the product. The
economy of size, choice of technology and availability of factors favouring a particular industrial
site are all considerations which merit attention in technical analysis. Financial analysis is
perhaps the most important and includes forecast of cash in-flows and total outlay which will
keep down cost of capital and maximize rate of return on investment. The organizational and
man-power analysis ensures that a firm will have the requisite manpower to run the project. In
this connection, it should be remembered that a project is exposed to different types of uncertainties
and risks. It is, therefore, necessary for a firm to gauge the sensitivity of the project to
the world of uncertainties and risks and its capacity to withstand them. It would be unjustifiable
to accept even the most profitable project if it is likely to be the riskiest.
(viii) Capital Budgeting
Capital budgeting decisions are most crucial; for they have long-term implications. They relate
to judicious allocation of capital. Current funds have to be invested in long-term activities in
anticipation of an expected flow of future benefits spread over a long period of time. Capital
budgeting forecasts returns on proposed long-term investments and compares profitability of
different investments and their cost of capital. It results in capital expenditure investment. The
various proposal assets ranked on the basis of such criteria as urgency, liquidity, profitability
and risk sensitivity. The financial analyser should be thoroughly familiar with such financial
techniques as pay back, internal rate of return, discounted cash flow and net present value
among others because risk increases when investment is stretched over a long period of time.
The financial analyst should be able to blend risk with returns so as to get current evaluation of
potential investments.
(ix) Working Capital Management
Working capital is rightly an adjunct of fixed capital investment. It is a financial lubricant
which keeps business operations going. It is the life-blood of a firm. Cash, accounts receivable
and inventory are the important components of working capital, which is rotating in its nature.
Cash is the central reservoir of a firm and ensures liquidity. Accounts receivables and
inventory form the principal utility of production and sales; they also represent liquid funds in
the ultimate analysis. The financial manager should weigh the advantage of customer trade
credit, such as increase in volume of sales, against limitations of costs and risks involved therein.
He should match inventory trends with level of sales. The uncertainties of inventory planning
should be dealt with in a rational manner. There are several costs and risks which are related to
inventory management. The risks are there when inventory is inadequate or in excess of requirements.
The former may hold up production, while the latter would result in an unjustified
locking up of funds and increase the cost of capital. Inventory management entails decisions
about the timing and size of purchases purely on a cost basis. The financial manager
should determine the economic order quantities after considering the relationships of different
cost elements involved in purchases. Firms cannot avoid making investments in inventory
because production and deliveries involve time lags and discontinuities. Moreover, the de20
mand for sales may vary substantially. In the circumstances, safety levels of stocks should be
maintained. Inventory management thus includes purchases management and material management
as well as financial management. Its close association with financial management
primarily arises out of the fact that it is a simple cash asset.
(x) Dividend Policies
Dividend policies constitute a crucial area of financial management. While owners are interested
in getting the highest dividend from a corporation, the Board of Directors may be interested
in maintaining its financial health by retaining the surplus to be used when contingencies
arise. A firm may try to improve its internal financing so that it may avail itself of benefits
of future expansion. However, the interests of a firm and its stockholders are complementary,
for the financial management is interested in maximizing the value of the firm, and the real
interest of stockholders always lies in the maximization of this value of the firm; and this is the
ultimate goal of financial management. The dividend policy of a firm depends on a number of
financial considerations, the most critical among them being profitability. Thus, there are different
dividend policy patterns which a firm may choose to adopt, depending upon their suitability
for the firm and its stockholders.
(xi) Acquisitions and Mergers
Firms may expand externally through co-operative arrangements, by acquiring other concerns
or by entering into mergers. Acquisitions consist of either the purchase or lease of a smaller
firm by a bigger organization. Mergers may be accomplished with a minimum cash outlay,
though these involve major problems of valuation and control. The process of valuing a firm
and its securities is difficult, complex and prone to errors. The financial manager should,
therefore, go through a valuation process very carefully. The most difficult interest to value in
a corporation is that of the equity stockholder because he is the residual owner.
(xii) Corporate Taxation
Corporate taxation is an important function of the financial management, for the former has a
serious impact on the financial planning of a firm. Since the corporation is a separate legal
entity, it is subject to an income-tax structure which is distinct from that which is applied to
personal income.
21
1.5 Emerging Role of Finance Manager
This section includes :
Role of the Finance Manager
INTRODUCTION :
There are two essential aspects of finance function – one, procurement of funds and two, an
effective utilization of these funds in the business. In respect of these two aspects, the role
finance manager is described below:
ROLE OF THE FINANCE MANAGER :
The traditional role of the finance manager is to confine to the raising of funds in order to meet
operating requirements of the business. This traditional approach has been criticized by modern
scholars on the following grounds. It was prevalent till the mid-1950s.
1. The traditional approach of raising funds alone is too narrow and thus it is outsiderlooking-
in approach.
2. It viewed finance as a staff specialty.
3. It has little concern how the funds are utilized.
4. It over-emphasized episodic events and non-recurring problems like the securities and
its markets, incorporation, merger, consolidation, reorganization, recapitalization and
liquidation etc.
5. It ignored the importance of working capital management.
6. It concentrated on corporate finance only and ignored the financial problems of sole
trader and partnership firms.
7. Traditional approach concentrated on the problems of long-term financing and ignored
the problems of short-term financing.
There was a change from traditional approach to the modern concept of finance function since
the mid-1950s. the industrialization, technological innovations and inventions and a change
in economic and environment factors since the mid-1950s necessitated the efficient and effective
utilization of financial resources. Since then, finance has been viewed as an integral part
of the management. The finance manager is, therefore, concerned with all financial activities
of planning, raising, allocating and controlling the funds in an efficient manner. In addition,
profit planning is another important function of the finance manager. This can be done by
decision making in respect of the following areas:
1. Investment Decisions for obtaining maximum profitability after taking the time value
of the money into account.
2. Financing decisions through a balanced capital structure of Debt-Equity ratio, sources
of finance, EBIT/EPS computations and interest coverage ratio etc.
3. Dividend decisions, issue of Bonus Shares and retention of profits with objective of
maximization of market value of the equity share.
4. Best utilization of fixed assets.
5. Efficient working capital management (inventory, debtors, cash marketable securities
and current liabilities).
6. Taking the cost of capital, risk, return and control aspects into account.
7. Tax administration and tax planning.
8. Pricing, volume of output, product-mix and cost-volume-profit analysis (CVP Analysis).
9. Cost control.
10. Stock Market— Analyse the trends in the stock market and their impact on the price of
Company’s share and share buy-back.
1.6 Earnings Distribution Policy
This Section includes:
INTRODUCTION:
The earnings which are distributed to shareholders is referred as Dividend. It is the reward of
the shareholders for investments made by them in the shares of the company. The investors
are interested in earning the maximum return on their investments and to maximize their
wealth. A company, on the other hand, needs to provide funds to finance its long-term growth.
MEANING OF EARNING DISTRIBUTION :
If a company pays out as dividend most of what it earns, then for business requirements and
further expansion it will have to depend upon outside resources such as issue of debt or new
shares. Dividend policy of a firm, thus affects both the long-term financing and the wealth of
shareholders. As a result, the firm’s decision to pay dividends must be reached in such a
manner so as to equitably apportion the distributed profits and retained earnings becomes
possible. Since dividend is a right of shareholders to participate in the profits and surplus of
the company for their investment in the share capital of the company, they should receive fair
amount of the profits. The company should, therefore, distribute a reasonable amount as dividends
(which should include a normal rate of interest plus a return for the risks assumed) to its
members and retain the rest for its growth and survival.
CONSIDERATIONS WHILE DISTRIBUTING THE EARNINGS :
A firm takes into account the following consideration to determine the appropriate dividend
policy:
Investment opportunities
Firms, which have substantial investment opportunities generally, tend to maintain
low pay out ratio, to conserve resources for growth. On the other hand, firms, which
have limited avenues, often usually permit more generous payout ratio.
Liquidity
Payment of dividend is largely dictated by the amount of cash available certainly this is
what Modigliani & Miller suggest should be the case. On the other hand, if failure to
pay the dividend is interrupted adversely by the capital market, the best interest of the
shareholder’s wealth might be advanced by making sure that cash is available for payment
of dividend, by borrowing or by passing up otherwise beneficial investment opportunities.
Meaning of Earning Distribution
Considerations while distributing the earnings
23
Control
External financing unless through rights issue, lead to dilution of control. Thus, if
major holders are averse to dilution of control, the company tends to rely more on
retained earnings and maintain low payout ratio.
Clientele effect
The clientele effect shows that a company’s dividend policy may depend on the “preferred
habits” of the majority shareholders. If the dividend policy of a company is not
consistent with the preferences of majority shareholders many investors would want
to dispose off their holdings in the company, causing the market price of shares to fall.
Information content of dividends
Some believe that, the level of dividends and particularly the changes in the level of
dividends conveys new information to the world. An increased level of dividend might
be a signal that the management views the future with confidence. A shareholder
might interpret large dividend also as the failure of management to find new investment
opportunities for future expansion. This is definitely contrary to what the management
wishes the interpretation to be.
1.7 Complaince of Regulatory Requirements
In Formulation of Financial Strategies
This Section Includes :
INTRODUCTION :
The legal form of a firm’s organization and the regulatory framework governing it is significantly
influence the financial decisions of the firms. This point can be illustrated with the
following examples:-
A private limited company cannot raise equity capital by issuing shares to the public.
A company which comes under the purview of the Foreign Exchange Management Act
(FEMA) cannot undertake certain kinds of investment.
This chapter seeks to build an awareness and appreciation of the forms of organization and
the regulatory framework as applicable to business firms in India.
LEGAL FORMS OF ORGANIZATIONS :
Companies may be classified into various kinds on the following basis:
I. Classification on the basis of incorporation
II. Classification on the basis of liability
III. Classification on the basis of number of members
IV. Classification on the basis of control
V. Classification on the basis of ownership
I) Classification on the basis of incorporation
1) Chartered companies – These are the companies which are incorporated under a
special charter granted by the king or Queen in (in England) e.g., the East India
Company, the Bank of England. A chartered company is governed by its charter
that defines the nature of the company and at the same time incorporates it. These
companies find no place in India after the country attained independence in 1947.
Legal forms of Organizations
SEBI Act, 1992
Measures and Reforms
Secondary Market and Intermediaries
Mutual Funds
Investor Protection Measures
Regulatory requirements in formulation of financial Strategies
25
2) Statutory companies – These are the companies which are created by a special Act
of the Legislature, e.g., the RBI, the LIC, the IFC, the UTI. These are mostly concerned
with public utilities, e. g., railways, gas and electricity company and enterprises
of national importance. The provision of the Companies Act, 1956 apply to
them, if they are not consistent with the provisions of the special Acts under which
they are formed.
3) Registered companies – These are the companies which are formed and registered
under the Companies Act, 1956, or were registered under any of the earlier Companies
Act. These are by most, commonly found companies.
II Classification on the basis of Liability
1) Companies limited by shares – Where the liability of the members of a company is
limited to the unpaid amount on the shares, the companies is known as a company
limited by shares. A company limited by shares may be a public company or a
private company.
2) Company limited by guarantee – Where the liability of the members of a company
is limited to a fixed amount which the members undertake to contributes to the
assets of the company in case of its winding up, the company is called a company
limited by guarantee.
3) Unlimited companies – A company without limited liability is known as unlimited
company. In case of such a company every member is liable for the debts of
the company in proportion to his interest in the company.
III Classification on the basis of number of mumbers
1) Private company – A private company means a company which by its articles:
a) Restricts the right to transfer its shares
b) Limits the number of its members to 50
c) Prohibits any invitation to the public to subscribe for any shares in or debentures
of the company.
2) Public company – A public company means a company which by its articles:
a) Does not restrict the right to transfer its shares, if any
b) Does not limit the number of its members
c) Does not prohibit any invitation to the public to subscribe for any share or debentures
of the company.
IV Classification on the basis of control
1) Holding company – A company is known as the holding company of another if
it has control over the other company.
2) Subsidiary company – A company is known as a subsidiary of another company
when control is exercised by the latters (called the holding company) over
the former, called a subsidiary company.
A company is deemed to be a Holding Company of acompany in the following three cases:
a) Company controlling composition of Board of Directors.
b) Holding the majority if shares.
c) Subsidiary of another subsidiary.
V Classification on the basis of ownership
1) Government company – Any company in which at least 51% of the paid-up
share capital is held by the Centre Government or by any state Government or
Governments, or partly by the Central Government & partly by state Governments,
e.g., State Trading Corporation of India.
2) Non-government company – Any company in which the Central Government
or any State Government or Governments holds less than 50% of the paid-up share
capital.
Foreign company. Any company which is incorporated outside India & has a place of business
in India, i.e., where representatives of a foreign company frequently come and stay in a hotel
in India for purchasing machinery, raw material , etc., is called foreign company has a place of
business in India.
Associations not for profit. The Central Government may grant a license for registration,
to an association not for profit with limited liability without using the word “Limited”
or the words “Private Limited” to their names. Such license may be granted if it
is proved to the satisfaction of the Central Government that it
a) Is about to be formed as a limited company for promoting commerce, science, religion,
charity or any other useful object.
b) It tends to apply its profits, if any, other income in promoting its objects and to prohibit
the payment of any dividend to it’s members.
One-man company. This is a company (usually private) in which one man holds practically
the whole of the share capital of the company, and in order to meet the statutory
requirement of minimum numbers of members, some dummy members who are usually
the nominees of the principal shareholder, who is the virtual owner of the business
and who carries it on with limited liability.
Public financial institutions. The following financial institutions shall be regarded as
public financial institutions:
a) The Industrial Credit and Investment Corporation of India (ICICI)
b) The Industrial Finance Corporation of India (IFCI)
c) The Industrial Development Bank of India (IDBI)
d) The Life Insurance Corporation of India (LIC)
e) The Unit Trust of India (UTI)
27
The Central Government is authorized to specify any institution to be a public financial institution.
But no institution shall be so specified unlessa)
It has been established as per the constitution on by or under any other Central Act
b) Not less than 51% of the paid-up share capital of such an institution is held or controlled
by the Central Government.
In every country corporate investment and financing decision are guided, shaped and circumscribed
by a fairly comprehensive regulatory framework which seeks to
Define avenues of corporate investment available to business firms in different categories,
ownership-wise and size-wise.
Induce investments along certain lines by providing incentives, concessions and reliefs.
Impose restrictions on the ways and means by which business firms can raise and
deploy funds.
The principal elements of this regulatory framework are:-
Companies Act.
Securities and Exchange Board of India Guidelines.
Provision of the Companies Act, 1956
The Companies Act, 1956, as amended up to date covers both the financial and nonfinancial
aspects of the working of the corporate sector. It aims at developing integrated relationship
between promoters, investors and company management.
This act seeks to:-
Ensure a minimum standard of business integrity and conduct in the promotion and
management of companies.
Elicit full and fair disclosure of all reasonable information relating to the affairs of the
company.
Promote effective participation and control by shareholders and protect their legitimate
interests.
Ensure proper performance of duties by the company management.
Empower the government to intervene and investigate into the affairs of companies
which are managed in a manner prejudicial to the interest of the shareholders or the
public.
It contains specific provisions to regulate:-
The issue of capital and matters incidental thereto, viz., content and format of prospectus
Capital structure of companies
Dividend distribution
Inter-corporate investment
Matters regarding shareholders’ meetings and the format of annual accounts
Procedure for the allotment of shares and the issue of certificates
Issue of shares at premium or discount
Voting rights of shareholders
Some of the important company law provisions pertaining to financial management are:
A company can issue only two kinds of shares: equity shareholders and preference
shares.
Additional shares has to be offered to existing equity shareholders in proportion to
the shares held by them unless the company decides otherwise by passing a special
resolution, or by passing an ordinary resolution and securing the permission of the
central government, in case of further issue.
Share capital cannot be issued unless a prospectus, giving prescribed information
about the company, is furnished.
Debenture carrying voting rights cannot be issued.
The board of directors of a company of a subsidiary thereof, shall not, except with the
consent of the company in a general meeting, borrow money which, together with
those already borrowed by the company (apart from temporary loans obtained from
the company’s bankers in the ordinary courses of business), exceeds the aggregate of
the paid-up capital of the company and its free reserves.
A company can, buy up to 10 percent of the subscribed capital of another corporate
body, provided that the aggregate of investment made in all other corporate bodies
does not exceed 30 percent of the subscribed capital of the investing company.
Dividends are payable only out of profits, after setting aside a certain percentage
towards reserves.
A company is required to prepare its financial statements (profit and loss account
and balance sheet) in a certain manner and format and get the same audited by a
chartered accountant.
A public company is required to get its audited financial statements approved by its
shareholders. (The financial statements along with the Directors’ Report, Auditors’
Report, and annexures to the financial statements as prescribed by the Company’s
Act constitute the Annual Report of the company).
All equity shareholders have a voting power, but now companies have been allowed to issue
non-voting shares. Earlier the law did not permit companies to repurchase their own shares,
but now they have been allowed to do so upto a limited extent. The Compains Act is administered
by the Department of Company Affairs and the Company Law Board of the ministry
of Law and Justice and Company Affairs of the Union Government.
29
Historically speaking: Capital Issues (Control) Act, 1947
Prior to the established of the Securities & Exchange Board of India (SEBI), Capital issues in
India were regulated by the Capital Issues (Control) Act, 1947.
The primary objectives of this act were:-
1) To protect the investing public;
2) To ensure that investment by the corporate were in accordance with the plannes and that
they are not wasteful and in non-essential channels;
3) To ensure that the capital structure of companies was sound in the public interest;
4) To ensure that there is no undue congestion of public issues in any part of the year; and
5) To regulate the volume, terms and conditions for foreign investment.
The Act required companies to obtain prior approval for issues of capital to the public, and for
pricing of public and right issues. It empowered the GOI to regulate the timing of new issues
by private sector companies, the companies, the composition of securities to be issued, interest
(dividend) rates which can be offered on debentures, floatation costs, and the premium to be
charged on securities.
SECURITIES AND EXCHANGE BOARD OF INDIA ACT, 1992 :
In the year 1991, major steps were being taken towards liberalization and reforms in the Indian
financial sector. As a result, thereafter, the volume of business in the primary and secondary
securities markets increased significantly. This globalisation process made the financial system
vulnerable to external shocks, which was further worsened with the various malpractices
that crept into the system. All these developments established that, the then existing regulatory
framework was fragmented, ill coordinated and inadequate and that there was a need for
an autonomous, statutory and integrated organization to ensure the smooth function of the
system. The SEBI came into being as a response to these requirements.
The SEBI was established in 1988 through an administrative order, but it became a statutory
and really powerful organization since 1992 with the formation of Securities and Exchange
Board Act, 1992 when the (Capital Issues Control Act) CICA was replaced and the office of the
Controller of Capital Issues (CCI) was abolished.
The SEBI is a body of six members comprising the Chairman, two members from the Government
of India, Ministries of Law and Finance, one member from the RBI and two other members.
The office of the SEBI is in Mumbai.
Objectives, Functions and powers of SEBI :
The overall objective of the SEBI, as enshrined in the preamble of the SEBI Act, 1992 is “to
protect the interests of investors in securities and to promote the development of, and to regulate
the securities market and for matters connected therewith or incidental thereto”
To carry out its objectives, the SEBI performs the following functions:-
Regulate the business in stock exchanges and other securities markets;
Registering and regulating the working of stock brokers, sub-brokers, share transfer
agents, bankers to an issue, merchant bankers, underwriters, portfolio managers, investment
advisor and such other intermediaries, who are associated with the securities
market in any manner;
Registering and regulating the working of depositories, custodians of securities, FIIs,
credit rating schemes, including mutual funds;
Promoting and regulating Self-Regulatory Organisations (SROs);
Prohibiting fraudulent and unfair trade practices relating to the securities market;
Providing investors’ education and training of intermediaries in securities market;
Prohibiting & Regulating substantial acquisition of shares and takeovers of companies;
Calling for information from, undertaking inspection, conducing inquiries and audits
of the stock exchanges and intermediaries and intermediaries and self-regulatory organizations
in the securities market;
Performing such functions and exercising such powers under the Securities Contract
(Regulation) Act, (SCRA) 1956 as may be delegated to it by the Central Government;
Levying fees & other charges for carrying out its work;
Conducing research for the above purposes;
Performing such other functions that may be prescribed
Under the SEBI Act, some of the powers exercised by the Central Government under
SCARPowers to prohibit contracts in certain cases.
They relate to the –
Powers to call for periodical return, direct enquries to be made from any recognized
stock exchange;
Grant approval to any recognized stock exchange & to make bye-laws for the regulation
and control of contracts;
Powers to make & amend bye-laws of recognized stock exchanges;
Licensing of dealers in securities, in certain areas;
Powers to compel listing of securities by public companies;
Granting approval to amendment to the rules of a recognized stock exchange;
Powers to ask every recognized stock exchange, to furnish to the SEBI, a copy of the
annual report containing particulars that may be prescribed;
Powers to supercede the governing body of a recognized stock exchange;
Powers to suspend business of any recognized stock exchange;
31
List of Recognised Stock Exchanges
The Bombay Stock Exchange Ltd. The Ahmedabad Stock Exchange Ltd.
Bangalore Stock Exchange Ltd. Bhubaneshwar Stock Exchange Ltd.
The Calcutta Stock Exchange Assn. Ltd. Cochin Stock Exchange Ltd.
The Delhi Stock Exchange Ltd. The Gauhati Stock Exchange Ltd.
The Hyderabad Stock Exchange Ltd. Jaipur Stock Exchange Ltd.
Kanara Stock Exchange (Mangalore) Ludhiana Stock Exchange Ltd.
Madras Stock Exchange Ltd. Pune Stock Exchange Ltd.
Madhya Pradesh Stock Exchange (Ignore) The Vadodara Stock Exchange Ltd.
The Magadh Stock Exchange Ltd. The Combatore Stock Exchange Ltd.
Saurashtra Kutch Stock Exchange Ltd. OTC Exchange of India
The Ulttar Pradesh Stock Exchange Assn. Ltd. National Stock Exchange of India Ltd.
MEASURES AND REFORMS :
To introduce improved and greater transparency in the stock market and capital market, in the
interest of healthy capital market development, a number of steps have been taken by SEBI
during recent years. The important steps are:-
The issue of capital by companies no longer requires any consent from any authority
either for making the issue or for pricing it.
Efforts have been made to raise the standards of disclosure in public issues and enchance
their transparency.
The offer document is now made public even at the draft stages.
Companies making their first public issue are eligible to do so only if they have three
years of dividend-paying track record preceding an issue. Those not meeting this requirement
can still make an issue if their projects are appraised by banks or FIs with
minimum 10 percent participation in the equity capital of the issuer, or if their securities
are listed on the OTCEI (Over-the Counter Exchange of India)
For issues above Rs. 100 Crore, Book Building requirement has been introduced.
The pricing of preferential allotment has to be market related levels, and there is a fiveyear
lock-in period for such allotment.
In case of proportionate allotment scheme, a minimum of 50 percent of the net offer to
the public is to be reserved for individual investors applying for securities not exceeding
1000 securities, and the remaing part can be allotted to applications for more than
1000 securities.
Initially, the underwriting of issues to public was mandatory, but now this stipulation
has been removed.
Bankers to an issue and portfolio managers have to be registered with the SEBI.
SECONDARY MARKET AND INTERMEDIARIES :
The governing boards and various committees of stock exchanges (SEs) have been recognized,
restructured and board-based.
Inspection of all 22 SEs has been carried out to determine the extent of compliance with
the directives of the SEBI.
Computerised or screen – based trading has been achieved on almost all exchanges
except some of the smaller ones.
Corporate membership of SEs is now allowed, encouraged and preferred. The Articles
of Association of SEs have been amended so as to increase their membership.
All these have been directed to establish either a clearing house or a clearing corporation.
The Bombay Stock Exchange (BSE) has been asked to reduce trading period or settlement
cycle from 14 to 7days for B group shares.
A Process through which investor grievances against brokers may find redressal through
a complaint to the SEBI has been put in place.
All the recommendations of the Dave Committee for improved working of the OTCEI
have been accepted. The SEBI has strengthened its own investigation and enforcement
machinery.
In accordance with the recommendations of G.S. Patel Committee, BSE has been allowed
to introduce a revised Carry Forward System (CFS) of trading. Other SEs can
introduce forward trading only with the prior permission of the SEBI. Transactions are
not allowed to be carried forward for more than 90 days now. The share received by
financial funding carry forward transactions have to be deposited than kept in the custody
of the clearing house of the SE or its authorized agent. Every member is required
to keep books and records of the sources of finance with the sub-accounts being maintained
in the clearing house. The scrip-wise carry forward position has to be disclosed
to the market. The SEs are required to introduce the ‘twin track’ system which will
segregate transactions into carry forward and cash transactions, and each one of the
former will be identified with a transaction identification number till its final settlement.
The brokers are required to ensure segregation of client account and own account.
The capital adequacy norms of 3% for individual brokers and 6% for corporate brokers
introduced.
Both the brokers and sub-brokers have been brought within the regulatory fold for the
first time now; and the concept of the dual registration of stock fold for the first time
33
SEBI and the SEs has been introduced. The total number of registered brokers and subbrokers
was 8,746 at the end of March 1996, of which 1917 were corporate members.
Penal action can now be taken directly by the SEBI against any member of a SE for
violation of any provision of the SEBI Act.
It has been made mandatory for the stock brokers to disclose the transaction price and
brokerage separately in the contract notes issued by them to their clients.
The daily margin and additional margin for volatile scrips are now levied on a weekly
and market-to-market basis.
The SEs have amended their Listing Agreement such that the issuers have now to provide
shareholders with cash flows statements in a prescribed format, along with the
complete balance sheet and the profit and loss statement.
The trading hours in almost all the SEs been increased from 2½ hours to 3 hours day.
Compulsory audit of the brokers’ book and filling of the audit reports with the SEBI
has now been mandatory.
A system of market making in less liquid scrips on selected transaction has been introduced.
Insider trading has been prohibited and such trading has been made a criminal offence
punishable in accordance with the provisions of the SEBI Act.
Registrars to Issues (RI) and Share Transfer Agents (STA) have now been classified into
two categories: Category I with a minimum net worth requirement of Rs. 6 lakhs who
carry on the activities both as RI and STA, and Category II with a minimum net worth
requirement of Rs. 3 lakhs who can carry on any one of these activities.
Till end-August 1997, Merchant Bankers (MBs) were classified into four categories,
each with different responsibilities and commensurate with capital requirements, with
effect from September 1997, such a classification has been abolished and there will be
only one entity now, namely, MBs. A system of penalty points for MBs for defaults
committed by them have been introduced. It is provided that they can be suspended or
deauthorised after a maximum of 8 penalty points. The MBs have to fulfill capital adequacy
requirements also.
MUTUAL FUNDS :
It bars mutual funds from options trading, short selling and carrying forward transactions
in securities. It has been permitted to invest only in transferable securities in the
money and capital markets or any privately placed debentures or securities debt.
Restrictions have also placed on them to ensure that investments under an individual
scheme, do not exceed 5% and investment in all schemes put together does not exceed
10% of the corpus. Investments under all schemes cannot exceed 15% of the funds in
the shares and debentures of a single company.
It grants registration to only those mutual funds that can prove an efficient and orderly
conduct of business. The track record of sponsors, a minimum experiences of five years
in the relevant filed of financial services, integrity in business transactions and financial
soundness are taken into account.
Prescribes the advertisement code for the marketing schemes of mutual funds, the contents
of the trust deed, the investment management agreement and the scheme-wise
balance sheet.
They are required to be formed as trusts and management by separately formed Asset
Management Companies (AMC). The minimum net worth of such AMCs are stipulated
at Rs. 5 crores of which, the minimum contribution of the sponsor should be 40%.
Furthemore, the mutual fund should have a custodian who is not associated in any
way with the AMC and registered with the SEBI.
The minimum amount raised in closed-ended scheme should be Rs.20 crores and for
the open-ended scheme, Rs. 50 croces. In case, the amount collected falls short of the
minimum prescribed, the entire amount should be refunded not latter than six weeks
from the date of closure of the scheme. If this is not done, the funds is required to pay
an interest at the rate of 15% per annum from the date of expiry of six weeks.
The mutual funds obligation to publish scheme-wise annual reports, furnish six monthly
unaudited accounts, quarterly statements of the movements of the net asset value and
quarterly portfolio statements to the SEBI.
There is also a stipulation that the mutual funds should ensure adequate disclosures to
the investors.
SEBI prohibits the participation of mutual funds in the promoter’s quota shares.
SEBI has agreed to let the mutual funds buy-back the units of their schemes, however,
the funds cannot advertise this facility in their prospectus.
SEBI is also empowered to investigate into transactions of deliberate manipulation,
price rigging or deterioration of the financial position of mutual funds, & can suspend
the registration of mutual funds if found guilty.
Miscellaneous
FIIs are also required to be registered with the SEBI.
It is required that the companies to be registered as depositories must have a net worth
of Rs. 100 crore. Similarly custodians are required to have a net worth of Rs. 50 crore,
and they are to get their systems and procedures evaluated externally.
Venture Capital Funds (VCFs) allowed to invest in unlisted companies, to financial
Committee, the minimum turnaround companies and to provide loans.
As per the approved modified takeover code recommended by the Bhagwati Committee,
the minimum public offer of 20% purchase, when the threshold limit to 2% equity
is crossed, is made mandatory. Those in control are permitted to 2% of shares per
35
annum upto a maximum of 51%. The acquirers have escrow deposits have to be higher
for conditional public offers unless the acquirer agrees to buy a minimum of 20%.
INVESTOR PROTECTION MEASURES :
The SEBI has introduced an automated complaints handling system to deal with investor complaints.
To create an awareness among the issuers and intermediaries of the need to redress
investor grievances quickly, the names of the companies against whom maximum number of
complaints have been received. To help investors in respect of delay in receiving funds orders
in case of oversubscribed issues, a facility in the form of stockinvest has been introduced. To
ensure that no malpractice takes place in the allotment of shares, a representative of the SEBI
supervises the allotment process. It has also accorded recognition to several genuine, active
investor associations. It issues advertisements from time to time to guide and enlighten investors
on various issues related to the securities market and their rights and remedies.
The complaints received by the SEBI are categorized in five types:
Type I : Non-receipt of refund orders/allotment letters/stockinvests.
Type II : Non- receipt of dividend
Type III : Non- receipt of share certificates/bonus shares.
Type IV : Non- receipt of debenture certificates/interest on debentures/redemption
amount of debentures/interest on delayed payment of interest.
Type V : Non-receipt of annual reports, rights issue forms/interest on delayed receipt
of refund orders/dividends.
REGULATORY REQUIREMENTS IN FORMULATION OF FINANCIAL STRATEGIES :
The two major regulatory authorities are the Reserve Bank of India (RBI) and the Securities
Exchange Board of India (SEBI). The regulations in the Companies Act, Income Tax Act etc.
are more for governance and compliance than for strategy. RBI mainly regulates the commercial
banks which in turn may influence the policies of a company. Some of the situations a
finance manager has to face, which requires regulatory compliance are:
1. Raising finance through IPO or SPO
IPO refers to Initial Public Offering, the first time a company comes to public to raise money.
SPO refers to Seasonal Public Offering, the second and subsequent time a company raises
money from the public directly. There are regulatory guidelines prescribed by SEBI regarding
the entire process of going public which includes disclosure to public regarding the potential
use of the cash, financial projections and percentage of shares offered to various stakeholders
etc. Similarly, every time a company wants to access the capital market, either for raising
finance through debt or equity, these regulatory compliances have to be met where finance
manager will play a key role in providing the necessary information both at the time of raising
resources and also at regular intervals subsequently thereafter.
2. Capital Structure changes
Today, companies are permitted to buy their own shares. The finance manager, some times,
for strategic reasons, decides to reduce the equity capital. This is technically known as capital
reduction, which again requires regulatory compliances prescribed by SEBI and Companies
Act.
3. Credit rating
Whenever a company wants to raise money through debt, or through a new instrument, the
instrument has to be rated by a credit rating agency like CRISIL, ICRA etc. as per the SEBI
guidelines. Similarly, a company also has to be rated. The whole exercise of initiating the
rating process providing the relevant information and answering the queries of the rating
agencies will be the responsibility of the CFO.
4. Foreign exchange transactions
A company needs foreign exchange for a variety of reasons like importing equipment, setting
up of foreign offices, travel of salesmen and other company employees etc. Similarly, a company
may receive remittances of foreign exchange for exports made. In either of these situations,
the rules and regulations relating to foreign exchange transactions needs to be complied
with by the Finance Manager, on behalf of the organization. It involves some filing of returns
in the prescribed format.
5. Derivative transactions
Whenever a company uses derivatives for hedging, there are accounting and disclosure requirements
to be complied with as per Companies Act & GAAP Accounting, accounting standards
of ICAI and the international accounting standards. For example, hedge accounting has
to be maintained and profits/losses due to hedging should be reported.
6. Project financing
If a company goes for major project financing option, involving multiple agencies like suppliers,
contractors etc, there are a number of requirements for the various stakeholders and financiers
like consortium of banks, private equity players etc. Finance Manager plays an important
role in complying with the requirements of various agencies involved in the exercise.
Fianancial Management & international finance 37
1.8 Sources of Finance - Long Term, Short Term and International
This section includes:
INTRODUCTION :
Companies raise long term funds from the capital markets. Funds availbale for a period of less
than one year are short term funds. With the increase in cross-border transactions,international
sources of funds are also available. An effective trade-off between the domestic funds and
international funds shall contribute towards increasing profitability and wealth maximisation.
LONG TERM SOURCE :
To enable the investments, creation of assets and infrastructure, an organisation require long
term sources of funds. They are:
• Long Term Source
• Short Term Source
• International Sources
1. Equity Share Capital
Equity share capital is a basic source of finance for any Company. It represents the ownership
interest in the company. The characteristics of equity share capital are a direct consequence of
its position in the company’s control, income and assets. Equity share capital does not have
any maturity nor there is any compulsion to pay dividend on it. The equity share capital
provides funds, more or less, on a permanent basis. It also works as a base for creating the debt
and loan capacity of the firm. The advantages and limitations of equity share capital may be
summarized as follows:
Advantages of Equity Share Financing
a. Since equity shares do not mature, it is a permanent source of fund. However, a company,
if it so desires, can retire shares through buy-back as per the guidelines issued by
the SEBI.
b. The new equity share capital increases the corporate flexibility from the point of view
of capital structure planning. One such strategy may be to retire debt financing out of
the funds received from the issue of equity capital.
c. Equity share capital does not involve any mandatory payments to shareholders.
d. It may be possible to make further issue of share capital by using a right offering. In
general, selling right shares involves no change in the relationship between ownership
and control. Existing shareholders can maintain their proportionate holding by exercising
their pre-emptive right.
Limitations of Equity Share Financing
a. The equity share capital has the highest specific cost of capital among all the sources.
This necessitates that the investment proposals should also have equally high rate of
return.
b. Equity dividends are paid to the shareholders out of after-tax profits. These dividends
are not tax deductible, rather imply a burden of Corporate Dividend tax on the company.
c. At times, the new issue of equity capital may reduce the EPS and thus may have an
adverse effect on the market price of the equity share.
d. Excessive issue of equity share can dilute the ownership of the Company.
2. Preference Share Capital
The preference share capital is also owners capital but has a maturity period. In India, the
preference shares must be redeemed within a maximum period of 20 years from the date of
issue. The rate of dividend payable on preference shares is also fixed. As against the equity
share capital, the preference shares have two references: (i) Preference with respect to payment
of dividend, and (ii) Preference with reference to repayment of capital in case of liquidation of
company.
However, the preference share capital represents an ownership interest and not a liability of
the company. The preference shareholders have the right to receive dividends in priority over
the equity shareholders. Indeed, it is this preference which distinguishes preference shares
from equity shares. A dividend need not necessarily be paid on either type of shares. However,
if the directors want to pay equity dividend, then the full dividend due on the preference
39
shares must be paid first. Failure to meet commitment of preference dividend is not a ground
for liquidation. The advantages and disadvantages of the preference share capital are as follows:
Advantages of Preference Share Financing
a. The preference shares carry limited voting right though they are a part of the capital.
Thus, these do not present a major control or ownership problem as long as the dividends
are paid to them.
b. As an instrument of financing, the cost of capital of preference shares is less than that of
equity shares.
c. The preference share financing may also provide a hedge against inflation because the
fixed financial commitment which is unaffected by the inflation.
d. As there is no legal compulsion to pay preference dividend, a company does not face
liquidation or other legal proceedings if it fails to pay the preference dividends.
Limitations of Preference Share Financing
a. The cost of capital of preference shares is higher than cost of debt.
b. Though there is no compulsion to pay preference dividend, yet the non-payment may
adversely affect the market price of the equity shares and hence affect the value of the
firm.
c. The compulsory redemption of preference shares after 20 years will entail a substantial
cash outflow from the company.
d. If the company is not able to earn a return at least equal to the cost of preference share
capital, then it may result in decrease in EPS for the equity shareholders.
3. Debentures
A bond or a debenture is the basic debt instrument which may be issued by a borrowing company
for a price which may be less than, equal to or more than the face value. A debenture also
carries a promise by the company to make interest payments to the debenture-holders of specified
amount, at specified time and also to repay the principal amount at the end of a specified
period. Since the debt instruments are issued keeping in view the need and cash flow profile of
the company as well as the investor, there have been a variety of debt instruments being issued
by companies in practice. In all these instruments, the basic features of being in the nature of a
loan is not dispensed with and, therefore, these instruments have some or the other common
features as follows:
(i) Credit Instrument—A debenture-holder is a creditor of the company and is entitled
to receive payments of interest and the principal and enjoys some other rights.
(ii) Interest Rate— In most of the cases, the debt securities promise a rate of interest
payable periodically to the debt holders. The rate of interest is also denoted as coupon
rate.
(iii) Collateral— Debt issue may or may not be secured and, therefore, debentures or
other such securities may be called secured debentures or unsecured debentures.
(iv) Maturity Date— All debt instruments have a fixed maturity date, when these will
be repaid or redeemed in the manner specified.
(v) Voting Rights— As the debt holders are creditors of the company, they do not
have any voting right in normal situations.
(vi) Face Value— Every debt instrument has a face value as well as a maturity value.
(vii) Priority in Liquidation— In case of liquidation of the company, the claim of the
debt holders is settled in priority over all shareholders and, generally, other unsecured
creditors also.
In practice, different types of debentures have been issued. These are:
(a) Convertible Debentures— In this case, the debentures are converted, fully or
partially, into equity shares some time after the date of issue.
(b) Non-convertible Debentures— These debentures remain a debt security till
maturity. Interest is paid on these debentures as per terms and conditions.
(c) Innovative Debentures— Companies have come forward to issue a debt security
with different attractive and innovative features. Some of these are - Secured
Premium Notes, Optionally Convertible Debentures, Triple Option Convertible
Debentures, etc. Financial Institutions such as IDBI have issued Deep
Discount Bonds (DDBs) from time to time to procure funds for a longer period.
4. Lease and Hire Purchase
Instead of procuring funds, and purchasing the equipment, a firm can acquire the asset itself
on lease. In this case, the asset is financed by the lessor but the lessee gets the asset for use. In
case of hire purchase, the assets are acquired on credit and payments are made as per terms
and conditions.
5. Term Loans
This is also an important source of long-term financing. There are different financial institutions
(National level as well as State level) which provide financial assistance for taking up
projects. Term loan, as a source of long-term finance, is discussed in detail, at a later stage in
this chapter.
SHORT TERM SOURCES OF FINANCE/ WORKING CAPITAL MARGIN:
A project requires working capital margin to take up day-to-day operations. The working capital
amount is divided into two parts- (a) Permanent working capital, and (b) Temporary working
capital. The Permanent working capital should be financed from long-term sources and
temporary working capital should be financed from short term sources. Some of the shortterm
sources are:
1. Trade Credit
The credit extended in connection with the goods purchased for resale by a retailer, or for raw
materials used by manufacturer in producing its products is called the trade credit. The trade
credit may be defined as the credit available in connection with goods and services purchased
for resale. It is the ‘resale’ which distinguishes trade credit from other sources. For example,
fixed assets may be purchased on credit, but since these are to be used in the production process
rather than for resale, such credit purchase of fixed assets is not called the trade credit.
When a firm buys goods from another, it may not be required to pay for these goods immediately.
During this period, before the payment becomes due, the purchaser has a debt outstanding to
the supplier. This debt is recorded in the buyer’s balance sheet as creditors; and the
corresponding account for the supplier is that of debtors. Normal business transactions,
41
therefore, provide the firm with a source of short-term financing (trade credit) because of the
time gap between the receipts of goods and services and payment thereof. The amount of such
financing depends on the volume of purchases and the payment timing. Small and new firms
are usually more dependent on the trade credit, as they find it difficult to obtain funds from
other sources. Trade credit may take form of open account or bills payable.
2. Accrued Expenses
Another source of short-term financing is the accrued expenses or the outstanding expenses
liabilities. The accrued expenses refer to the services availed by the firm, but the payment for
which has not yet been made. It is a built-in and an automatic source of finance as most of the
services, are paid only at the end of a period. The accrued expenses represent an interest free
source of finance. There is no explicit or implicit cost associated with the accrued expenses and
the firm can save liquidity by accruing these expenses.
3. Commercial Papers
Commercial Paper (CP) is an unsecured promissory note issued by a firm to raise funds for a
short period, generally, varying from a few days to a few months. For example, in India, the
maturity period of CP varies between 15 days to 1 year while in some other countries, the
maturity period may go up to 270 days. It is a money market instrument and generally purchased
by commercial banks, money market mutual funds and other financial institutions
desirous to invest their funds for a short period. As the CP is unsecured, the firms having good
credit rating can only issue the CP.
The firm or the dealers in CP sell these to the short-term lenders who use it as interest earning
investment of temporary surplus of operating funds. The nature of these surpluses and motives
for buying the CP suggest that all the holders of the Cp expect to be paid in full at maturity.
The maturity term of CP is not generally extended. This expectation on the part of shortterm
tenders requires that the borrowing firm must be (i) an established and profitable firm,
and (2) consistently maintaining a credit goodwill in the market and having good credit rating.
The interest cost of the CP depends upon the amount involved, maturity period and the prime
lending rates of commercial banks. The main advantage of CP is that the cost involved is lower
than the prime lending rates. In addition to this cost, the borrowing firm has to bear another
cost in the form of placement fees payable to the dealer of CP who arranges the sale.
Issue of Commercial Papers in India
CP was introduced as a money market instruments in India in January, 1990 with a view to
enable the companies to borrow for short term. Since the CP represents an unsecured borrowing
in the money market, the regulation of CP comes under the purview of the Reserve Bank of
India which has issued Guidelines in 2000 superseding all earlier Guidelines. These Guidelines
are aimed at:
(i) Enabling the highly rated corporate borrowers to diversify their sources of shortterm
borrowings, and
(ii) To provide an additional instrument to the short-term investors.
These Guidelines have stipulated certain conditions meant primarily to ensure that only financially
strong companies come forward to issue the CP. The main features of the guidelines
relating to issue of CP in India may be summarized as follows:
42 Fianancial Management & international finance
COOSTv-eVrO VLUieMwE -oPfR OFiFnITa nAcNiAalL YMSIaSnagement
(a) CP should be in the form of usance promissory note negotiable by endorsement and
delivery. It can be issued at such discount to the face value as may be decided by the
issuing company. CP is subject to payment of stamp duty.
(b) In terms of the guidelines, the issuer company is not permitted to take recourse to the
underwriters for underwriting the issue of CP.
(c) CP is issued in the denomination of Rs. 5,00,000 and the minimum lot or investment is
Rs. 5,00,000 per investor. The secondary market transactions can be Rs.5,00,000 or multiples
thereof. The total amount proposed to be issued should be raised within two
weeks from the date on which the proposal is taken on record by the bank.
(d) CP should be issued for a minimum period of 15 days and a maximum of 12 months.
No grace period is allowed for repayment and if the maturity date falls on a holiday,
then it should be paid on the previous working day. Each issue of CP is treated as a
fresh issue.
(e) Commercial papers can be issued by a company whose (i)tangible net worth is not less
than Rs. 4 crores, (ii) funds based working capital limit is not less than 4 crores, (iii)shares
are listed on a stock exchange, (iv) specified credit rating of P2 is obtained from CRISIL
or A2 from ICRA, and (v) the barrowed account of the company is standard asset for
the bank.
(f) The issue expenses consisting of dealer’s fees, credit rating agency fees and other relevant
expenses should be borne by the issuing company.
(g) CP may be issued to any person, banks, companies, NRI, FII. The issue of CP to NRIs
can only be on a non-re-patriation basis and is not transferable.
(h) An issue can issue CP upto a limit approved by the Board of Directors.
(i) Deposits by the issuer of CP have been exempted from the provisions of Section 58A of
the Companies Act, 1956.
In case, the CPs are issued to NRI or OCB, the amount shall be received by inward remittance
from outside India or form an account held as per RBI Regulations.
Any company proposing to issue CP has to submit an application to the bank which provides
working capital limit to it, along with the credit rating of the firm. The issue has to be privately
placed within two weeks by the company or through a merchant banker. The initial investor
pays the discounted value of the CP to the firm. Thus, CP is issued only through the bank who
has sanctioned the working capital limit and it does not increase the working capital resources
of the firm.
The annual financing cost of CP depends upon the discount on issue and the maturity
period. The annualized pre-tax cost of CP may be ascertained as follows:
SP MP
FV SP
Annual Financing Cost
360 = − ×
Where FV = Face value of CP
SP = Issue price of CP
MP = Maturity period of CP.
Fianancial Management & international finance 43
For example, a CP of the face value of Rs. 5,00,000 is issued at Rs. 4,80,000 for a maturity
period of 120 days. The annual financing cost of the CP is:
12.5%
120
360
4,80,000
50,00,000 48,00,000 Annual Financing Cost = − × =
CP as a Source of Financing
From the point of the issuing company, CP provides the following benefits:
(a) CP is sold on an unsecured basis and does not contain any restrictive conditions.
(b) Maturing CP can be repaid by selling new CP and thus can provide a continuous
source of funds.
(c) Maturity of CP can be tailored to suit the requirement of the issuing firm.
(d) CP can be issued as a source of fund even when money market is tight.
(e) Generally, the cost of CP to the issuing firm is lower than the cost of commercial bank
loans.
However, CP as a source of financing has its own limitations
(i) Only highly credit rated firms can use it. New and moderately rated firms generally are
not in a position to issue CP.
(ii) CP can neither be redeemed before maturity nor can be extended beyond maturity.
So, CP is advantageous both to the issuer as well as to the investor. The issuer can raise shortterm
funds at lower costs and the investor as a short term outlet of funds. CP provides liquidity
as they can be transferred. However, the issuer must adhere to the RBI guidelines.
4. Inter-corporate Deposits (ICDs)
Sometimes, the companies borrow funds for a short-term period, say up to six months, from
other companies which have surplus liquidity for the time being. The ICDs are generally unsecured
and are arranged by a financier. The ICDs are very common and popular in practice as
these are not marred by the legal hassles. The convenience is the basic virtue of this method of
financing. There is no regulation at present in India to regulate these ICDs. Moreover, these are
not covered by the Section 58A of the Companies Act, 1956, as the ICDs are not for long term.
The transactions in the ICD are generally not disclosed as the borrowing under the ICDs imply
a liquidity shortage of the borrower. The rate of interest on ICDs varies depending upon the
amount involved and the time period. The entire working of ICDs market is based upon the
personal connections of the lenders, borrowers and the financiers.
5. Short-term Unsecured Debentures
Companies have raised short-term funds by the issue of unsecured debentures for periods up
to 17 months and 29 days. The rate of interest on these debentures may be higher than the rate
on secured long-term debentures. It may be noted that no credit rating is required for the issue
of these debentures because as per the SEBI guidelines, the credit ratings required for debentures
having maturity period of 18 months or more. The use of unsecured debentures as a
source of short-term financing, however, depends upon the state of capital market in the
economy. During sluggish period, the companies may not be in a position to issue these debentures.
Moreover, only established firms can issue these debentures as new company will
not find favour from the investors. Another drawback of this source is that the company procures
funds from retail investors instead of getting a lump-sum from one source only. Further,
that the issue of securities in capital market is a time consuming process and the issue must be
planned in a proper way.
6. Bank Credit
Credit facility provided by commercial banks to meet the short-term and working capital requirements
has been important short term sources of finance in India. The bank credit, in
general, is a short, term financing, say, for a year or so. This short-term financing to business
firm is regarded as self-liquidating in the sense that the uses to which the borrowing firm is
expected to put the funds are ordinarily expected to generate cash flows adequate to repay the
loan within a year. Further, these loans are called self-liquidating because the bank’s motive to
provide finance is to meet the seasonal demand, e.g., to cover the seasonal increase in inventories
or receivables. In principle, the bank credit is intended to carry the firm through seasonal
peaks in financing need. The amount of credit extended by a bank may be referred to as a
credit limit which denotes the maximum limit of loan which the firm can avail from the bank.
Sometimes, the bank may approve separate limits for peak season and non-peak season.
Types of Bank Credit
In India, banks may give financial assistance in different shapes and forms. The usual form of
bank credit is as follows:
A. Overdraft— It is the simplest of different forms of bank credit. In this case, the borrowing
firm which already has a current account with the bank is allowed to withdraw more (up to a
specified limit) over and above the balance in the current account. The firm is not required to
seek approval of the bank authority every time it is overdrawing.
B. Cash Credit— The credit facility under the cash credit is similar to the over draft. Under the
cash credit, a loan limit is sanctioned by the bank and the borrowing fund can withdraw any
amount at any time, within that limit. The interest is charged at the specified rate on the amount
withdrawn and for the relevant period. The bank may or may not charge any minimum commitment
fee.
C. Bills Purchased and Bills Discounting— Commercial banks also provide short-term credit
by discounting the bill of exchange emerging out of commercial transactions of sale and purchase.
In the normal course of credit sales, the seller of the goods may draw a bill on the buyer
of the goods who accepts the bill and there by promises to pay the bill as per terms and conditions
mentioned in the bill. However, if the seller wants the money before the maturity date of
the bill, he can get the bill discounted by a bank which will pay the amount of the bill to the
seller after charging some discount. The discount depends upon the amount of the bill, the
maturity period and the prime lending rate prevailing at that time.
The bill discounting is common only among small-size business firms. One of the short-coming
of the bill discounting system is that the bank, which discounts that bill, must establish and
verify the creditworthiness of the buyer, which, at times, may be difficult, complicated and
time consuming process.
D. Letter of Credit— A letter of credit is a guarantee provided by the buyer’s banker to the
seller that in case of default or failure of the buyer, the bank shall make the payment to the
seller. The responsibility of the buyer is assumed by the bank in case the latter fails to honour
45
his obligations. The letter of credit issued by the bank may be given by the buyer to the seller
along with the bill of exchange. So, in fact, the letter of credit becomes a security of the bill and
any bank (or the bank or the seller) will have no problem in discounting the bill.
E. Working Capital Term Loan— Generally, the banks while granting working capital facility
to a customer stipulate that a margin of 25% would be required to be provided by the customer
and hence the bank borrowing remains only limited to 75% of the security offered. In other
words, against a security of Rs. 100, the bank gives a loan of up to Rs. 75. The short-fall is
generally treated as Working Capital Term Loan (WCTL). This WCTL is to be repaid in a
phased manner varying between a period of two to five years.
F. Funded Interest Term Loan— Sometimes, a company because of its operations may not be
able to pay the interest charge on its working capital cash credit facility obtained from a commercial
bank. Such accumulation of unserviced interest makes the cash credit account irregular
and in excess of the sanctioned limit. It also prevents the firm to make further operations in
the account. Such unserviced accumulated interest may be transferred by the bank from cash
credit account to Funded Interest Term Loan (FITL). This will enable the firm to operate its
cash credit account. The FITL is considered separately for repayment.
INTERNATIONAL SOURCES :
A. Depository Receipts (DR)
A DR means any instrument in the form of a depository receipt or certificate created by the
Overseas Depository Bank outside India and issued to the non-resident investors against the
issue of ordinary shares. A Depository Receipt is a negotiable instrument evidencing a fixed
number of equity shares of the issuing company generally denominated in US dollars. DRs are
commonly used by those companies which sell their securities in international market and
expand their shareholdings abroad. These securities are listed and traded in International Stock
Exchanges. These can be either American Depository Receipt (ADR) or Global Depository Receipt
(GDR). ADRs are issued in case the funds are raised though retail market in United States.
In case of GDR issue, the invitation to participate in the issue cannot be extended to retail US
investors. As the DRs are issued in overseas capital markets, the funds to the issuer are available
in foreign currency, generally in US $.
B. Foreign Currency Convertible Bonds (FCCBs)
The FCCB means bonds issued in accordance with the relevant scheme and subscribed by a
non-resident 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. The FCCBs are unsecured, carry a fixed rate of interest and an option for
conversion into a fixed number of equity shares of the issuer company. Interest and redemption
price (if conversion option is not exercised) is payable in dollars. Interest rates are very
low by Indian domestic standards. FCCBs are denominated in any freely convertible foreign
currency.
FCCBs have been popular with issuers. Local debt markets can be restrictive in nature with
comparatively short maturities and high interest rates. On the other hand, straight equityissue
may cause a dilution in earnings, and certainly a dilution in control, which many shareholders,
especially major family shareholders, would find unacceptable. Thus, the low coupon
security which defers shareholders dilution for several years can be alternative to an issuer.
Foreign investors also prefer FCCBs because of the Dollar denominated servicing, the conver46
sion option and the arbitrage opportunities presented by conversion of the FCCBs into equity
at a discount on prevailing Indian market price.
C. External Commercial Borrowings (ECB)
Indian promoters can also borrow directly from foreign institutions, foreign development bank,
World Bank, etc. It is also known as Foreign Currency Term loans. Foreign institutions provide
foreign currency loans and financial assistance towards import of plants and equipments. The
interest on these loans is payable in foreign currency. On the payment date, interest amount is
converted into domestic currency at the prevailing foreign exchange rate. The borrowings,
repayment and interest payments can be tailor-made in view of the cash flow position of the
project.
Other Sources
In addition to the sources discussed above, there are some sources which may be availed by a
promoter on casual basis. Some of these are:
(a) Deffered Credit— Supplier of plant and equipment may provide a credit facility and
the payment may be made over number of years. Interest on delayed payment is payable
at agreed terms and conditions.
(b) Bills Discounting— In this scheme, a bill is raised by the seller of equipment, which is
accepted by the buyer promoter of the project. The seller realizes the sales proceeds by
getting the bill discounted by a commercial bank which, in turn gets the bill rediscounted
by IDBI.
(c) Seed Capital Assistance— At the time of availing loan from financial institutions, the
promoters have to contribute seed capital in the project. In case, the promoters do not
have seed capital, they can procure the seed capital from ‘Seed Capital Assistance
Schemes’. Two such schemes are:
(i) Risk Capital Foundation Scheme— The scheme was promoted by IFCI to provide
seed capital upto Rs. 40 lakhs to the promoters.
(ii) Seed Capital Assistance Scheme— Under this scheme, seed capital for smaller
projects is provided upto Rs. 15 lakhs by IDBI directly or through other financial institutions.
47
1.9 Exchange Rate – Risk Agencies Involved And Procedure Followed
In International Financial Operations
This Section Includes :
INTRODUCTION :
In view of the substantial and significant stake in foreign countries, foreign exchange risk has
become an integral part of the management activities of any multinational enterprise. Therefore,
the management must be aware of the various techniques of dealing with ERR. Covering
the foreign exchange risk is also known as hedging the risk. If a company in its wisdom does
not want to hedge, it tantamount to have the view that the future movements of exchange rates
will be in its favour. On the contrary, the conservative enterprises may adopt the policy of
hedging everything.
EXCHANGE RATE RISK ASSESSMENT :
Exchange rate risk (ERR) is inherent in the businesses of all multinational enterprises as they
are to make or receive payments in foreign currencies. This risk means eventual losses incurred
by these enterprises due to adverse movements of exchange rates between the dates of
contract and payment. However, ERR does not imply that it will result into losses only. Gains
may also accrue if the movement of rates is favorable.
Hedging obviously means a certain cost to an enterprise. Suppose the company hedges the
exposure and the forward rates move in favour of the company due to a shift in economic
factors between the dates of invoice and conversion of currency, the company would suffer or
lose on this account.
There are two types of techniques to cover exchange rate risk: internal techniques, adopted by
the enterprise to limit the exchange risk, and external techniques that require a recourse to
forward market, money market and external organizations.
EXPOSURES :
Multinational enterprises are subject to the following three types of risks/exposures:
Transaction Exposure
Consolidation Exposure
Economic Exposure
Assessment of Exchange Rate Risk
Exposures
Hedging Tools
Accounting for the Effect of Changes in Foreign Exchange Rates
Transaction Exposure
Whenever there is a commitment to pay foreign currency or possibility to receive foreign currency
at a future date, any movement in the exchange rate will affect the domestic value of the
transaction. The following situations give rise to transaction exposure:
Trade transactions with foreign countries when billing is done in foreign currencies
like export or imports;
Banking and financial transactions done in foreign currencies like lending and borrowing
or equity participation, etc.
Consolidation (or Translation) Exposure
This results from direct (joint ventures) or indirect investments (portfolio participation) in foreign
countries. When balance sheets are consolidated, the value af assets expressed in the national
currency varies as a function of the variation of the currency of the country where investment
was made. If, at the time of consolidation, the exchange rate is different from what it
was at the time of the investment, there would be a difference of consolidation. The accounting
practices in this regard vary from country to country and even within a country from company
to company.
There is great responsibility on the part of corporate finance manager, who is expected to
manage the assets and liabilities with fluctuating foreign exchange rates in such a way that the
profits and cash-flow levels stick to budgeted levels as far as possible.
Economic Exposure
In an open economy, the strength of currencies of competitors due to relative costs and prices
in each country which, in turn, have a bearing on exchange rate and the structure of business
itself gives rise to economic exposure which may put companies at a competitive disadvantage.
Though this is not a direct foreign exchange risk exposure, the underlying economic
factors may become a risk factor.
HEDGING TOOLS :
Internal Techniques Of Hedging
There are several techniques which can be used in this category to reduce the exchange rate
risk:
Choosing a particular currency for invoice
Leads and Lags
Indexation clauses in contracts
Netting
Shifting the manufacturing base
Centre of reinvoicing
Swaps
Choice of the Currency of Invoicing
In order to avoid the exchange rate risk, many companies try to invoice their exports in the
national currency and try to pay their suppliers in the national currency as well. This way an
49
exporter knows exactly how much he is going to receive and how much he is to pay, as an
importer.
This method is a noble one. However, an enterprise suffers under this method if the national
currency appreciates; this is likely to result into a loss of market for the products of the company
if there are other competitors.
Companies may also have recourse to invoicing in a currency whose fluctuations are less erratic
than those of the national currency. For example, in the countries of the European Union,
the use of European Currency Unit (ECU) is gaining popularity.
Leads and Lags
This technique consists of accelerating or delaying receipt or payment in foreign exchange as
warranted by the position/expected position of the exchange rate. The principle involved is
rather simple.
If depreciation of national currency is apprehended, importing enterprises like to clear their
dues expeditiously in foreign currencies; exporting enterprises prefer to delay the receipt from
their debtors abroad. These actions, however, if generalized all over the country, may weaken
the national currency. Therefore, certain countries like France regulate the credits accorded to
foreign buyers to avoid market disequilibrium.
The converse will hold true if an appreciation of national currency is anticipated; importing
enterprises delay their payments to foreigners while the exporting ones will attempt to get
paid at the earliest. These actions may have a snowballing effect on national currency appreciating
further.
Indexation Clauses in Contracts
For protecting against the exchange rate risk, sometimes, several clauses of indexation are
included by exporters or importers.
A contract may contain a clause whereby prices are adjusted in such a manner that fluctuations
of exchange rate are absorbed without any visible impact. If the currency of the exporting
country appreciates, the price of exports is increased to the same extent or vice-versa. Therefore,
the exporter receives almost the same amount in local currency. Thus, exchange rate risk
is borne by the foreign buyer.
There is another possibility where the contracting parties may decide to share the risk. They
may stipulate that part of exchange rate variation, intervening between the date of contract
and payment, will be share by the two in accordance with a certain formula, for example, halfhalf
or one-third, two-third, etc.
Netting (Internal Compensation)
An enterprise may reduce its exchange risk by making and receiving payments in the same
currency. Exposure position in that case is simply on the net balance. Hence an enterprise
should try to limit the number of invoicing currencies. The choice of currency alone is not
sufficient. Equally important is that the dates of settlement should match.
50 Fianancial Management & international finance
COOSTv-eVrO VLUieMwE -oPfR OFiFnITa nAcNiAalL YMSIaSnagement
Bilateral
Netting may be bilateral or multilateral. It is bilateral when two companies have trade relations
and do buying and selling reciprocally. For example, a parent company sells semi-finished
products to its foreign subsidiary and then repurchases the finished product from the
latter.
Multilateral
Netting can equally be multilateral. This is taken recourse to when internal transactions are
numerous. Volume of transactions will be reduced because each company of the group will
pay or be paid only net amount of its debit or credit.
Switching the Base of the Manufacture
In the case of manufacturing companies, switching the base of manufacture may be useful so
that costs and revenues are in the same currency, e.g. Japanese car manufacturers have opened
factories in Europe.
Reinvoicing Centre
A reinvoicing centre of a multinational group does billing in respective national currencies of
subsidiary companies and receives the invoices made in foreign currency from each one of
them. It would be preferable, if possible, to locate the reinvoicing centre in a country where
exchange regulations are least constraining.
The centre itself is a subsidiary of the parent company. The principle is simple: the invoices if
foreign currencies are made in the name of the reinvoicing centre by the subsidiaries. And, the
centre, in turn, will send our equivalent sums in national currency. Likewise, payments in
foreign currencies to suppliers are made by the centre and it receives equivalent sums in the
national currencies from the subsidiaries concerned. Figure indicates how the flow of currencies
takes place.
Receipts and Payments through Reinvoicing Centre
The management of exchange risk is thus centralized at a single place. This helps in reducing
the volumes of foreign currency transfers and hedging costs. However, one often encounters
Client Reinvoicing Supplier
Pays in
Foreign Foreign
Pays Pays in Local
Currency
Pays in Local
Currency
Subsidiary A,
Payes in Payes in
Foreign Foreign
51
the problem where dates of maturity do not match. Besides, the exchange regulations in some
countries may not permit reinvoicing.
Swaps in Foreign Currencies
Swap is an agreement reached between two parties which exchange a predetermined sum of
foreign currencies with a condition to surrender that sum on a pre-decided date. It always
involves two simultaneous operations: one spot and the other on a future date.
There are various types of swaps such as cross-credit swaps, back-to-back credit swaps, and
export swaps, etc.
External Hedging Tools
Risks under transaction exposure can be minimized using various tools available in the foreign
exchange and financial markets. Of these, four are important.
Forward exchange contracts
Money market hedge
Currency Futures
Options
Forward Exchange rate Contracts
You would like to recap the basic features of forward contracts that we learnt in Part 1.
The contract is for the purchase or sale of a specified quantity of a specified currency
price is agreed today.
Performance is at a future date. This future time can be either a specified date, or any
time between two specified dates.
Both parties are obliged to perform.
Other relevant points are
1. Though spot rates can be obtained for most of the currencies, it may not be possible to
enter into forward exchange contracts for all those currencies for which there is a spot
market. The reason is insufficiency of demand, or a high volatility in exchange rates.
2. The length of time (depth) up to which one can stretch forward depends upon demand
levels. In India, forward rates are available for 6 month periods and can be rolled over.
Exotic (minor) currencies such as Argentinean Peso may not have a forward exchange
market beyond three months. The longer is the period into future time – span, the
wider is the bid-ask spread. The size of spread for a given currency increases with
maturity.
3. There are three standard periods of time in a forward market, namely, “ one – month”,
“three – months” and “six-months”. Rates for such periods can be had instantly alongside
spot rates.
4. Forward rates for odd-periods, falling outside the ambit of standard periods, e.g. 72
days or 95 days can also be secured, but are specifically tailor-made to suit the needs of
customers.
5. Generally, a forward exchange contract is entered for delivery of underlying foreign
currency asset on a given specified future date. But this is not always the case. There
can be variations, and banks do provide built-in flexibility to traders, to accommodate
them in situations where the delivery date is uncertain. These are known as option
forward exchange contracts.
Forward Contracts
A forward contract as we know is a contract to either buy or sell soreign currency, on a future
date. We also know that both the parties under the contract are obligated to perform. Suppose,
you have entered into a forward contract. You could either be
a) A buyer of foreign currency (Importer)
b) A seller of foreign currency (Exporter)
You could close out this contract either:
a) On the due date of settlement of the forward contract. Or,
b) On any date prior to the due date of settlement of the forward contract.
Closing out can be done either by:
a) Honoring the contract
b) Rolling over the contract (i.e., extending the contract.)
c) Cancelling the contract.
Money Market Hedge
Money market is a market for short-term instruments. In this market you can borrow or lend
for a short period of time. Salient features are:
1. Short period of time – ranges from an “overnight” time period (a day comprising 24
hours from the close of business hours on day – 1 till close of business hours on day-2)
to generally six to twelve months.
2. Each time period will have its own interest rates – lowest for overnight periods, and
increasing gradually with the tenor of the borrowing/lending.
3. Money market rates are always given in nominal annual rates. If a rate of 8% is quoted,
it means 8% per annum and will have to be adjusted for the relevant time period. A
three-month tenor would thus carry interest at 2% (8 x 3/12)
4. Interest or deposit rates differ from country to country, and hence currency to currency.
Money market hedge involves:
Borrowing in foreign currency (say $) in the case of exports
Investing in foreign currency (say ¥) in the case of imports
53
Steps to be adopted
1. Identify Whether Foreign Currency (FC) is asset or liability
Importer will have foreign currency liability,
Exporter will have foreign currency asset.
2. Create the opposite position to be need either by borrowing or depositing the amount
equal to present value of FC liability or FC asset and rates are adjusted for the period of
loan or deposit
Importer will create FC asset,
Exporter will create FC liability.
3. Convert the borrowed funds into required currency
Importers have to convert domestic currency into foreign currency at spot rate,
Exporters have to convert FC funds borrowed into domestic currency at spot rate.
4. Invest the borrowed funds
Importer will deposit the FC overseas,
Exporter will deposit in domestic.
5. Settle the payments by withdrawing deposited amounts along with interest
Importer will receive maturity proceeds of FC asset and settle FC liability,
Exporter will get the asset value from overseas customer, and settle FC liability
there itself.
Currency Futures
You are already familiar with the relevance and significance of both futures and options in the
context of stock market operations. (Refer to the Chapter on Derivatives). In the context of
international finance, such derivative instruments come in handy as one of the tools to hedge
the risks in exchange rate movements. These are known as currency futures or currency options.
A brief summary of salient features are touched upon in the following paragraphs.
Financial futures contracts include – besides stock market indices – futures contracts for interest
rates, and currencies. We are concerned with currency futures and currency options in this
chapter.
What are Currency Futures?
Financial futures contracts were first introduced by the International Monetary Markets Division
of Chicago Mercantile Exchange, in order to meet the needs for managing currency risks,
and prompted by a galloping growth in international business. London International Financial
Futures and Options Exchange (LIFFE), set up in 1982 had been dealing in currency futures,
but have restricted their activity to interest – rate futures.
A currency futures contract is a derivative financial instrument that acts as a conduct to transfer
risks attributable to volatility in prices of currencies. It is a ontractual agreement between a
buyer and a seller for the purchase and sale of a particular currency at a specific future date, at
a predetermined price. A futures contract involves an obligation on both the parties to fulfill
the terms of the contract.
The fundamental advantage is hedging risks.
In a currency futures contract, one of the ‘paid’ of the currencies is invariably the US $. That is,
you can buy or sell a futures contract only with reference to the USD. There are six steps involved
in the technique of hedging through futures. These are:
i) Estimating target outcome (with reference to spot rate available on a given date)
ii) Deciding on whether Futures Contracts should be bought or sold
iii) Determining number of contracts (this is necessary, since contract size is standardized)
iv) Identifying profit or loss on target outcome
v) Closing out futures position and
vi) Evaluating profit or loss on futures
We shall walk through this process, with the help of an example, taking GBP and USD as the
paid of currencies.
Option Contracts
Mechanics of Hedging through Options
Hedging through options is a simple four-step process.
1. Deciding on Call or Put options (i.e., whether to buy or sell a currency)
2. Determining number of contracts
3. Selecting an acceptable exercise price, pay premium and conclude the contract.
4. On maturity, i) If market rate is less favourable, exercise your option under the contract,
and ii) if market rate is more favourable, ignore the contract and buy or sell in the
market.
ACCOUNTING FOR THE EFFECT OF CHANGES IN FOREIGN EXCHANGE RATES
(AS-11) :
This standard deals with accounting for transactions in foreign currencies in the financial statements
of an enterprise and with translation of the financial statements of foreign branches into
rupees for the purpose of including them in the financial statements of the enterprise.
Exchange rate is the ratio for exchange of two currencies as applicable to the realization of a
specific liability or the recording of a specific transactions or a group of inter-related transactions.
As – 11 (revised) suggests the following accounting policy relating to changes in exchange
rates:
55
(i) If any foreign currency loan is linked to purchase of fixed assets from a country
outside India and the loan liability changes as on the balance sheet date because of
exchange rate fluctuations, the resultant loss/gain is adjusted with the carrying
amount of fixed assets.
(ii) Any other monetary items (assets) and liabilities denominated in a foreign currency
is translated into India currency using the closing exchange rate. If the closing
rate is not realistic, an appropriate realistic rate should be used which reflects
the likely realization or disbursements.
(iii) Non-monetary items (assets) other than fixed assets which are carried in terms of
historical cost denominated in terms of foreign currency, should be reported using
the exchange rate at the date of the transactions.
(iv) Non-monetary items other than fixed assets, which are carried in terms of fair value
or other similar valuation, e.g. net realizable value, denominated in a foreign currency
should be reported using the exchange rates that existed when the values
were determined (e.g. if the fair value is determined as on the balance sheet date,
the exchange rate on the balance sheet date may be used); and
(v) Exchange differences arising on foreign currency transactions should be recognized
as income or expense.
(vi) If enterprise enters into a forward exchange contract, the difference between the
forward rate and actual exchange rate as on date of contract should be recognized
as income or loss if the contract measures within the same accounting period. In
case the measuring date falls in the next accounting period, income/loss should be
recognized proportionately.
AS-11 also deals with transaction of manual statements of foreign branches. The financial
statement of foreign branches should be translated by using the procedures given below:
1. Revenue items, except opening and closing inventories and depreciation, should be
translated into reporting currency of the reporting enterprise at average rate. In appropriate
circumstances, weighted average rate may be applied, e.g., where the income or
expenses are not earned or incurred evenly during the accounting period (such as in
the case of seasonal businesses) or where there are exceptionally wide fluctuations in
exchange rate during the accounting period. Opening and closing inventories should
be translated at the rates prevalent at the commencement and close respectively of the
accounting period. Depreciation should be translated at the rates used for the translation
of the values of the assets on which depreciation is calculated.
2. Monetary items should be translated using the closing rate. However, in circumstances
where the closing rate does not reflect with reasonable accuracy the amount in reporting
currency that is likely to be realized form, or required to disburse, the foreign currency
item at the balance sheet date, a rate that reflects approximately the likely realization
or disbursement as aforesaid should be used.
3. Non-monetary items other than inventories and fixed assets should be translated using
the exchange rate at the date of the transaction.
4. Fixed assets should be translated using the exchange rate at the date of the transaction.
Where there has been an increase or decrease in the liability of the enterprise, as expressed
in Indian rupees by applying the closing rate, for making payment towards the
whole or a part of the cost of a fixed asset or for repayment of the whole or a part of
monies borrowed by the enterprise from any person, directly or indirectly, in foreign
currency specifically for the purpose of acquiring a fixed asset, the amount by which
the liability is so increased or reduced during the year, should be added to, or reduced
from, the historical cost of the fixed cost concerned.
5. Balance in ‘head office account’, whether debit or credit, should be reported at the
amount of the balance in the ‘branch account’ in the books of the head office after
adjusting for un responded transactions.
6. The net exchange difference resulting from the translation of items in the financial
statements of a foreign branch should be recognized as income or as expense for the
period, except to the extent adjusted in the carrying amount of the related fixed assets
in accordance with paragraph 4.
7. Contingent liabilities should be translated into the reporting currency of the enterprise
at the closing rate. The translation of contingent liabilities does not result in any exchange
difference as defined in this statement.
8. An enterprise should disclose:
(i) The amount of exchange differences included in the net profit or loss for the
period.
(ii) The amount of exchange differences adjusted in the carrying amount of fixed
assets during the accounting period; and
(iii) The amount of exchange differences in respect of forward exchange contracts to
be recognized in the profit or loss for one or more subsequent accounting periods,
as required by Forward Exchange Contracts.
Comments (0)
Post a Comment