L0 BFS Material

Foundation Course in Banking & Capital MarketsVERSION: 1.1 DATE: 26-MAY-2009

Cognizant Technology Solutions 500 Glenpointe Centre West Teaneck, NJ 07666 Ph: 201-801-0233 www.cognizant.com

2Cognizant Confidential

Foundation Course in Banking and Capital Markets

CONTENTS1.0 1.1 1.2 1.3 1.4 2.0 2.1 3.0 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 4.0 4.1 4.2 4.3 4.4 4.5 5.0 5.1 5.2 5.3 5.4 6.0 6.1 6.2 6.3 6.4 6.5 6.6 6.6 7.0 7.1 7.2 7.3 8.0 BFS CONCEPTS .............................................................................................................................4 CONCEPT OF MONEY ........................................................................................................................... 4 FINANCIAL INSTRUMENTS ........................................................................................................... 10 FINANCIAL MARKETS ................................................................................................................... 19 FINANCIAL STATEMENTS .................................................................................................................... 26 BANKING ...................................................................................................................................39 INTRODUCTION TO BANKING ...................................................................................................... 40 RETAIL BANKING........................................................................................................................47 INTRODUCTION ................................................................................................................................ 47 DEPOSIT PRODUCTS....................................................................................................................... 49 RETAIL CHANNELS ............................................................................................................................ 51 INSTRUMENTS ............................................................................................................................. 56 RETAIL PAYMENTS ............................................................................................................................ 57 ELECTRONIC BANKING................................................................................................................. 58 SALES AND MARKETING ..................................................................................................................... 60 A SCHEMATIC OF A RETAIL BANK ......................................................................................................... 61 MORTGAGES AND CONSUMER LENDING ...................................................................................63 MORTGAGE..................................................................................................................................... 63 OTHER RETAIL LOANS ........................................................................................................................ 70 COMMUNITY BANKS, CREDIT UNIONS & BUILDING SOCIETIES ................................................................... 78 FARM CREDIT................................................................................................................................... 80 RETAIL LENDING CYCLE ...................................................................................................................... 81 CARDS AND PAYMENTS .............................................................................................................85 INTRODUCTION ................................................................................................................................ 85 CREDIT CARD MARKET OVERVIEW ....................................................................................................... 90 MAJOR PLAYERS .............................................................................................................................. 97 RECENT DEVELOPMENTS .................................................................................................................... 97 WHOLESALE BANKING AND COMMERCIAL LENDING ............................................................... 102 INTRODUCTION ......................................................................................................................... 102 CORPORATE LENDING PROCESS ................................................................................................ 102 CREDIT DERIVATIVES ................................................................................................................. 109 TREASURY SERVICES .................................................................................................................. 111 CASH MANAGEMENT ................................................................................................................ 120 TRADE FINANCE ......................................................................................................................... 128 PAYMENTS NETWORK ...................................................................................................................... 139 INVESTMENT MANAGEMENT .................................................................................................. 143 INTRODUCTION .............................................................................................................................. 143 INVESTMENT MANAGEMENT PROCESSES.............................................................................................. 144 DIFFERENT CLASSES OF INVESTMENT MANAGEMENT FIRMS .................................................................... 157 INVESTMENT BANKING AND BROKERAGE............................................................................... 176


Foundation Course in Banking and Capital Markets DEFINITION OF INVESTMENT BANKS ......................................................................................... 176 FUNCTION OF INVESTMENT BANKS:.......................................................................................... 176 MAJOR INVESTMENT BANKS: .................................................................................................... 177 DIVISIONS WITHIN AN INVESTMENT BANK................................................................................ 177 INVESTMENT BANKING POST ECONOMIC CRISIS:...................................................................... 179 BROKERAGE ............................................................................................................................... 179 UNDERWRITING ........................................................................................................................ 181 THE FLOOR OF THE EXCHANGE .................................................................................................. 184 ORDER TYPES ................................................................................................................................. 186 THE OVER-THE-COUNTER (OTC) MARKET.................................................................................. 187 HOW DOES A BROKERAGE FIRM LOOK LIKE? ............................................................................. 188 MARKET INDICES ....................................................................................................................... 192

8.1 8.2 8.3 8.4 8.5 8.6 8.7 8.9 8.10 8.11 8.12 8.13 9.0 9.1 9.2 9.3 9.4 10.0 10.1 10.2 10.3 11.0 11.1 11.2 11.3 12.0

CUSTODY AND CLEARING......................................................................................................... 194 INTRODUCTION ......................................................................................................................... 194 SECURITIES MARKETPLACE ............................................................................................................... 195 TRADING AND SETTLEMENT ...................................................................................................... 198 ASSET SERVICING....................................................................................................................... 210 CLEARING AND SETTLEMENT ................................................................................................... 214 TRADING ...................................................................................................................................... 214 CLEARING ..................................................................................................................................... 216 SETTLEMENT.................................................................................................................................. 218 RISK MANAGEMENT ................................................................................................................ 224CONCEPT OF RISK ........................................................................................................................... 224

TYPES OF RISK................................................................................................................................ 224 RISK MANAGEMENT ....................................................................................................................... 228 CORPORATE SERVICES ............................................................................................................. 240

12.1 BENEFITS ADMINISTRATION ........................................................................................................... 240 13.0 13.1 13.2 13.3 14.0 15.0 15.1 15.2 RECENT DEVELOPMENTS ......................................................................................................... 246 USA PATRIOT ACT ...................................................................................................................... 246 SARBANES OXLEY ACT................................................................................................................ 250 SUB-PRIME MORTGAGE CRISIS ......................................................................................................... 251 GLOSSARY................................................................................................................................ 256 REFERENCES............................................................................................................................. 262 WEBSITES................................................................................................................................... 262 BOOKS ....................................................................................................................................... 262



1.0

BFS CONCEPTS

1.1

CONCEPT OF MONEY

1.1.1 DEFINING MONEYMoney is a standardized unit of exchange. The practical form of money is currency. It varies across countries whereas money remains the same. For example, in India, the currency is the Indian Rupee (INR) and in the US, it is the US Dollar (USD). Due to various economic factors, the value of each countrys currency is not equal. For example, if the exchange rate between US Dollars (USD) and Indian Rupees (INR) is USD 1 = INR 46.70, it implies that one U.S dollar is equivalent to 46.70 Indian Rupees. The USD is normally taken as a benchmark against which to compare the value of each currency.

1.1.2 THE CONCEPT OF INTEREST: SIMPLE INTEREST AND COMPOUND INTERESTInterest is the amount earned on money; there is such an earning because present consumption of the lender is being sacrificed for the future; it is letting somebody else use the money for present consumption. Using an analogy, interest is the rent charged for delaying present consumption of money. Interest rates are not constant and will vary depending on different economic factors A. Simple interest Simple interest is calculated only on the beginning principal. Simple Interest = P*r*t/100 where: P is the Principal or the initial amount borrowed or deposited, to earn or charge interest on, r is the interest rate and t is the time period. Example If someone were to receive 5% interest on a beginning value of $100, the first year they would get: 0.05*$100 = $5 If they continued to receive 5% interest on the original $100 amount, over five years the growth in their investment would look like this: Year 1: (5% of $100 = $5) + $100 = $105



Year 2: (5% of $100 = $5) + $105 = $110 Year 3: (5% of $100 = $5) + $110 = $115 Year 4: (5% of $100 = $5) + $115 = $120 Year 5: (5% of $100 = $5) + $120 = $125 B. Compound interest With compound interest, interest is calculated not only on the beginning interest, but on any interest accumulated with the initial principal in the meantime. Compound interest = [P*(1+r/100)^t P], where: P is the Principal or the initial amount initially borrowed or deposited, to earn or charge interest on, r is the interest rate and t is the time period. Example If someone were to receive 5% compound interest on a beginning value of $100, the first year they would get the same thing as if they were receiving simple interest on the $100, or $5. The second year, though, their interest would be calculated on the beginning amount in year 2, which would be $105. So their interest would be: .05 x $105 = $5.25 If this were to continue for 5 years, the growth in the investment would look like this: Year 1: (5% of $100.00 = $5.00) + $100.00 = $105.00 Year 2: (5% of $105.00 = $5.25) + $105.00 = $110.25 Year 3: (5% of $110.25 = $5.51) + $110.25 = $115.76 Year 4: (5% of $115.76 = $5.79) + $115.76 = $121.55 Year 5: (5% of $121.55 = $6.08) + $121.55 = $127.63 Note that in comparing growth graphs of simple and compound interest, investments with simple interest grow in a linear fashion and compound interest results in geometric growth. So with compound interest, the further in time and investment is held the more dramatic the growth becomes.

1.1.3 INFLATIONInflation captures the rise in the cost of goods and services over a period of time. For example, if Rs.100 today can buy 5 kg of groceries, the same amount of money can only buy 5/ (1+I) kgs of groceries next year, where `I refers to the rate of inflation beyond today. Thus, if the inflation rate is 5%, then everything else being equal (that is, same demand & supply and other market conditions hold), next year, one can only buy 5/ (1.05) worth of groceries.



A quantitative estimate of inflation in a particular economy can be calculated by measuring the ratio of Consumer Price Indices or CPI of two consecutive years. Thats right, the CPI that one hear of, is the weighted average price, of a predefined basket of basic goods. The % increase of the CPI this year vs. the CPI of last year, gives the inflation, or rise in price of consumer goods, over last year. Inflation results in a decrease in the value of money over time. The link between the interest rates, nominal and real, and inflation enables one to identify this impact.

1.1.4 NOMINAL INTERESTNominal rate of interest (N) refers to the stated interest rate in the economy. For example, if counter-party demands 110 rupees after a year in return for 100 rupees lent today, the nominal rate of interest is 10%. This, as one see, includes the inflation rate. Example A person lent out 100 rupees, at 10%, for one year. On maturity, he gets a profit, so he thinks, of 10 rupees. But this sum of 110 rupees buys less than 110 rupees did a year ago, due to inflation! Thus, the value of 110 rupees today is actually, or really, less than the value of 110 rupees a year ago, and it is less by the inflation rate. Thus the real interest he earned is less than 10%.

1.1.4

REAL RATE OF INTEREST

Real rate of interest (R) refers to the inflation-adjusted rate of interest. It is less than the nominal rate of interest for economies having positive rate of inflation. The relationship between the R (real rate of interest), N (nominal rate of interest) and I (rate of inflation) is as: R= N-I (This is a widely used approximation; the exact formula takes into account time value of inflation etc.) Why is it important to know the real rate of return? Take an example where a business is earning a net profit of 7% per annum. But, inflation is also standing at 7%. So, real profit is actually at zero. Example Nominal rate (N) = 10%, Inflation (I) = 5% Therefore, real interest is: R = N I = 5%

Therefore, the real rate of return is not 10% but 5%.



1.1.5 TIME VALUE CONCEPT OF MONEYTime value of money, which serves as the foundation for many concepts in finance, arises from the concept of interest. Because of interest, money on hand now is worth more than the same money available at a later point of time. To understand time value of money and related concepts like Present value and future value, we need to understand the basic concepts of simple and compound interest described above. Future Value Future Value is the value that a sum of money invested at compound interest will have after a specified period. The formula for Future Value is: FV = PV*(1 + i) n Where: FV PV i n : Future Value at the end of n time periods : Beginning value OR Present Value : Interest rate per unit time period : Number of time periods If one were to receive 5% per annum compounded interest on $100 for five

Example years,

FV = $100*(1.05)5 = $127.63 Intra-Year Compounding If a cash flow is compounded more frequently than annually, then intra-year compounding is being used. To adjust for intra-year compounding, an interest rate per compounding period must be found as well as the total number of compounding periods. The interest rate per compounding period is found by taking the annual rate and dividing it by the number of times per year the cash flows are compounded. The total number of compounding periods is found by multiplying the number of years by the number of times per year cash flows are compounded. Example Suppose someone were to invest $10,000 at 8% interest, compounded semiannually, and hold it for five years, Interest rate for compounding period = 8%/2 = 4% Number of compounding periods = 5*2 = 10 Thus, the future value FV = 10,000*(1+0.04) ^10 = $14,802.44 Present value



Present Value is the current value of a future cash flow or of a series of future cash flows. It is computed by the process of discounting the future cash flows at a predetermined rate of interest. If $10,000 were to be received in a year, the present value of the amount would not be $10,000 because we do not have it in our hand now, in the present. To find the present value of the future $10,000, we need to find out how much we would have to invest today in order to receive that $10,000 in the future. To calculate present value, or the amount that we would have to invest today, we must subtract the (hypothetical) accumulated interest from the $10,000. To achieve this, we can discount the future amount ($10,000) by the interest rate for the period. The future value equation given above can be rearranged to give the Present Value equation: PV = FV / (1+I) ^n In the above example, if interest rate is 5%, the present value of the $10,000 which we will receive after one year, would be: PV = 10,000/(1+0.05) = $ 9,523.81 Net Present Value (NPV) Net Present Value (NPV) is a concept often used to evaluate projects/investments using the Discounted Cash Flow (DCF) method. The DCF method simply uses the time value concept and discounts future cash flows by the applicable interest rate factor to arrive at the present value of the cash flows. NPV for a project is calculated by estimating net future cash flows from the project, discounting these cash flows at an appropriate discount rate to arrive at the present value of future cash flows, and then subtracting the initial outlay on the project. NPV of a project/investment = Discounted value of net cash inflows Initial cost/investment. The project/investment is viable if NPV is positive while it is not viable if NPV is negative. Example An investor has an opportunity to purchase a piece of property for $50,000 at the beginning of the year. The after-tax net cash flows at the end of each year are forecast as follows: Year 1 2 3 4 5 6 7 Cash Flow $9,000 8,500 8,000 8,000 8,000 8,000 8,000



8 9 10

7,000 4,500 51,000 (property sold at the end of the 10th year)

Assume that the required rate of return for similar investments is 15.00%. NPV = - 50000 + 9000/ (1+0.15) ^1 + 8500/ (1+0.15) ^2 + .. +51000/ (1+0.15) ^10 = $612.96 However, if we assume that the required rate of return is 16.00%, NPV = - 50000 + 9000/ (1+0.16) ^1 + 8500/ (1+0.16) ^2 + .. +51000/ (1+0.16) ^10 = ($1360.77) Thus, it can be seen that the NPV is highly sensitive to required rate of return. NPV of a project: Increases with increase in future cash inflows for a given initial outlay Decreases with increase in initial outlay for a given set of future cash inflows Decreases with increase in required rate of return

Internal Rate of Return (IRR) Internal Rate of Return (IRR), also referred to as Yield is often used in capital budgeting. It is the implied interest rate that makes net present value of all cash flows equal zero. In the previous example, the IRR is that value of required rate of return that makes the NPV equals zero. IRR = r, where NPV = - 50000 + 9000/(1+r)^1 + 8500/(1+r)^2 + .. +51000/ (1+r) ^10 = $0.00 IRR can be calculated using trial and error methods by using various values for r or using the IRR formula directly in MS Excel. Here, IRR = 15.30%. In other terms, IRR is the rate of return at which the project/investment becomes viable.

1.1.6 COST OF CAPITALWe have seen how different entities such as individuals, corporations and governments raise money. We have also realized that there is a cost for raising money, known as cost of capital. Costs will vary depending on the type of the financing such as equity or debt, who the borrower is (their past record and repayment capacity), and finally the market timing of the borrowings. In case of debt, additionally, the amount of collateral provided and how long the capital is required is also considered. The cost of capital includes interest payable in case of debt and expected returns including dividends in case of equity, apart from the cost of raising such as investment banks fees, regulatory fees and advertising. The tax factor is also considered while computing cost of capital for debt capital since interest paid is a tax deductive expense. Computing cost for different



means of finance such as equity shares, preference shares, debentures or term loan is beyond the purview of this learning program. Since there is a limit to the amount of resources that corporations can raise from any source, they use more than a single source for financing their needs. Also, funds will be raised at different points in time depending on need, availability, and market timing etc. In such cases after computing cost of each source, the firm arrives at a weighted average cost of capital, commonly referred to as cost of capital. Let us take an example: The Good works Company Inc. has Rs. 300 million through different means. The firm has raised Rs. 107 mn through equity, Rs. 13 mn through preference capital, Rs. 80 mn by issuing debentures and Rs. 100 mn by taking a loan a financial institution. Source of finance Equity capital Preference capital Debenture capital Term loan Average cost of capital Cost (per cent) 16.64 15.73 11.08 10.25 Weight 107/300 13/300 80/300 100/300 Product of cost and weight 5.93 0.68 2.95 3.42 12.99 per cent

Looked at it with a different perspective, the cost of capital is the rate of return the firm must earn on its investments in order to satisfy the expectations of investors who provide long-term funds to it. It is an important concept for financing decisions.

1.2

FINANCIAL INSTRUMENTS

1.2.1 RAISING CAPITALCorporations need capital to finance business operations. They raise money by issuing Securities in the form of Equity and Debt. Equity represents ownership of the company and takes the form of stock. Debt is funded by issuing Bonds, Debentures and various certificates. The use of debt is also referred to as Leverage Financing. The ratio of debt/equity shows a potential investor the extent of a companys leverage. Investors choose between debt and equity securities based on their investment objectives. Income is the main objective for a debt investor. This income is paid in the form of Interest, usually as semi-annual payments. Capital Appreciation (the increase in the value of a security over time) is only a secondary consideration for debt investors. Conversely, equity investors are primarily seeking Growth, or capital appreciation. Income is usually of lesser importance, and is received in the form of Dividends.



Debt is considered senior to equity (i.e.) the interest on debt is paid before dividends on stock. It also means that if the company ceases to do business and liquidate its assets, that the debt holders have a senior claim to those assets.

1.2.2 SECURITYSecurity is a financial instrument that signifies ownership in a company (a stock), a creditor relationship with a corporation or government agency (a bond), or rights to ownership (an option). Financial instruments can be classified into: Debt Equity Hybrids Derivatives

DEBT Debt is money owed by one person or firm to another. Bonds, loans, and commercial paper are all examples of debt. BOND An investor loans money to an entity (company or government) that needs funds for a specified period of time at a specified interest rate. In exchange for the money, the entity will issue a certificate, or bond, that states the interest rate (coupon rate) to be paid and repayment date (maturity date). Interest on bonds is usually paid every six months (semiannually). Bonds are issued in three basic physical forms: Bearer Bonds, Registered As to Principal Only and Fully Registered Bonds. Bearer bonds are like cash since the bearer of the bond is presumed to be the owner. These bonds are Unregistered because the owners name does not appear on the bond, and there is no record of who is entitled to receive the interest payments. Attached to the bond are Coupons. The bearer clips the coupons every six months and presents these coupons to the paying agent to receive their interest. Then, at the bonds Maturity, the bearer presents the bond with the last coupon attached to the paying agent, and receives their principal and last interest payment. Bonds that are registered as to principal only have the owners name on the bond certificate, but since the interest is not registered these bonds still have coupons attached. Bonds that are issued today are most likely to be issued fully registered as to both interest and principal. The transfer agent now sends interest payments to owners of record on the interest Payable Date. Book Entry bonds are still fully registered, but there is no physical certificate and the transfer agent keeps track of ownership. U.S. Government Negotiable securities (i.e.,



Treasury Bills, Notes and Bonds) are issued book entry, with no certificate. The customers Confirmation serves as proof of ownership. Principal and Interest Bondholders are primarily seeking income in the form of a semi-annual coupon payment. The annual rate of return (also called Coupon, Fixed, Stated or Nominal Yield) is noted on the bond certificate and is fixed. The factors that influence the bond's initial coupon rate are prevailing economic conditions (e.g., market interest rates) and the issuer's credit rating (the higher the credit rating, the lower the coupon). Bonds that are In Default are not paying interest. Example IBM can issue 10 year bonds with a coupon of 5.5%. Priceline or issue similar of year bonds at 8% The principal or parcan Face amount 10 the bond is what the investor has loaned to the issuer. The difference in coupon depends on the issuers credit The relative "safety" of the principalis due to their credit rating! rating and the type of bond that was issued. CORPORATE BOND A bond issued by a corporation. Corporations generally issue three types of bonds: Secured Bonds, Unsecured Bonds (Debentures), and Subordinated Debentures. All corporate bonds are backed by the full faith and credit of the issuer, but a secured bond is further backed by specific assets that act as collateral for the bond. In contrast, unsecured bonds are backed by the general assets of the corporation only. There are three basic types of Secured Bonds: Mortgage Bonds are secured by real estate owned by the issuer Equipment Trust Certificates are secured by equipment owned and used in the issuers business Collateral Trust Bonds are secured by a portfolio of non-issuer securities. (Usually U.S. Government securities) Secured Bonds are considered to be Senior Debt Securities, and have a senior creditor status; they are the first to be paid principal or interest and are thus the safest of an issuers securities. Unsecured Bonds include debentures and subordinated debentures. Debentures have a general creditor status and will be paid only after all secured creditors have been satisfied. Subordinated debentures have a subordinate creditor status and will be paid after all senior and general creditors have first been satisfied. Case Study Enron set up power plant at Dabhol, India The cost of the project (Phase 1) was USD 920 Million Funding o Equity USD 285 mio o Bank of America/ABN Amro USD 150 mio o IDBI & Indian Banks USD 95 mio o US Govt OPIC USD 100 mio o US Exim Bank USD 290 mio Enron US declared bankruptcy in 2002 Enron Indias assets are mortgaged to various banks as above. Due to interest payments and depreciation, assets are worth considerably less



2.1.3 MUNICIPAL BOND (MUNIS) A bond issued by a municipality. These are generally tax free, but the interest rate is usually lower than a taxable bond. TREASURY SECURITIES Treasury bills, notes, and bonds are marketable securities the U.S. government sells in order to pay off maturing debt and raise the cash needed to run the federal government. When an investor buys one of these securities, he/she is lending money to the U.S. government. Treasury bills are short-term obligations issued for one year or less. They are sold at a discount from face value and don't pay interest before maturity. The interest is the difference between the purchase price of the bill and the amount that is paid to the investor at maturity (face value) or at the time of sale prior to maturity. Treasury notes and bonds bear a stated interest rate, and the owner receives semi-annual interest payments. Treasury notes have a term of more than one year, but not more than 10 years. Treasury bonds are issued by the U.S. Government. These are considered safe investments because they are backed by the taxing authority of the U.S. government, and the interest on Treasury bonds is not subject to state income tax. T-bonds have maturities greater than ten years, while notes and bills have lower maturities. Individually, they sometimes are called "Tbills," "T-notes," and "T-bonds." They can be bought and sold in the secondary market at prevailing market prices. Savings Bonds are bonds issued by the Department of the Treasury, but they aren't are not marketable and the owner of a Savings Bond cannot transfer his security to someone else.

ZERO COUPON BONDS Zeros generate no periodic interest payments but they are issued at a discount from face value. The return is realized at maturity. Zeros sell at deep discounts from face value. The difference between the purchase price of the zero and its face value when redeemed is the investor's return. Zeros can be purchased from private brokers and dealers, but not from the Federal Reserve or any government agency. The higher rate of return the bond offers, the more risky the investment. There have been instances of companies failing to pay back the bond (default), so, to entice investors, most corporate bonds will offer a higher return than a government bond. It is important for investors to research a bond just as they would a stock or mutual fund. The bond rating will help in deciphering the default risk.



COMMERCIAL PAPER An unsecured, short-term loan issued by a corporation, typically for financing accounts receivable and inventories. It is usually issued at a discount to face value, reflecting prevailing market interest rates. It is issued in the form of promissory notes, and sold by financial organizations as an alternative to borrowing from banks or other institutions. The paper is usually sold to other companies which invest in short-term money market instruments. Since commercial paper maturities don't exceed nine months and proceeds typically are used only for current transactions, the notes are exempt from registration as securities with the United States Securities and Exchange Commission. Financial companies account for nearly 75 percent of the commercial paper outstanding in the market. There are two methods of marketing commercial paper. The issuer can sell the paper directly to the buyer or sell the paper to a dealer firm, which re-sells the paper in the market. The dealer market for commercial paper involves large securities firms and subsidiaries of bank holding companies. Direct issuers of commercial paper usually are financial companies which have frequent and sizable borrowing needs, and find it more economical to place paper without the use of an intermediary. On average, direct issuers save a dealer fee of 1/8 of a percentage point. This savings compensates for the cost of maintaining a permanent sales staff to market the paper. Interest rates on commercial paper often are lower than bank lending rates, and the differential, when large enough, provides an advantage which makes issuing commercial paper an attractive alternative to bank credit. Commercial paper maturities range from 1 day to 270 days, but most commonly is issued for less than 30 days. Paper usually is issued in denominations of $100,000 or more, although some companies issue smaller denominations. Credit rating agencies like Standard & Poor rate the CPs. Ratings are reviewed frequently and are determined by the issuer's financial condition, bank lines of credit and timeliness of repayment. Unrated or lower rated paper also is sold in the market. Investors in the commercial paper market include private pension funds, money market mutual funds, governmental units, bank trust departments, foreign banks and investment companies. There is limited secondary market activity in commercial paper, since issuers can closely match the maturity of the paper to the investors' needs. If the investor needs ready cash, the dealer or issuer usually will buy back the paper prior to maturity. EQUITY Equity (Stock) is a security, representing an ownership interest. Equity refers to the value of the funds contributed by the owners (the stockholders) plus the retained earnings (or losses). COMMON STOCK Common stock represents an ownership interest in a company. Owners of stock also have Limited Liability (i.e.) the maximum a shareholder can lose is their original investment. Most of the stock traded in the markets today is common. An individual with a majority shareholding or



controlling interest controls a company's decisions and can appoint anyone he/she wishes to the board of directors or to the management team. Corporations seeking capital sell it to investors through a Primary Offering or an Initial Public Offering (IPO). Before shares can be offered, or sold to the general public, they must first be registered with the Securities and Exchange Commission (SEC). Once the shares have been sold to investors, the shareholders are usually free to sell or trade their stock shares in the Secondary Markets (such as the New York Stock Exchange NYSE). From time to time, the Issuer may choose to repurchase the stock they previously issued. Such repurchased stock shares are referred to as Treasury Stock, and the shares that remain trading in the secondary market are referred to as Shares Outstanding. Treasury Stock does not have voting rights and is not entitled to any declared dividends. Corporations may use Treasury Stock to pay a stock dividend, to offer to employees. STOCK TERMINOLOGY Public Offering Price (POP) The price at which shares are offered to the public in a Primary Offering. This price is fixed and must be maintained when Underwriters sell to customers. Current Market Price The price determined by Supply and Demand in the Secondary Markets. Book Value The theoretical liquidation value of a stock based on the company's Balance Sheet. Par Value An arbitrary price used to account for the shares in the firms balance sheet. This value is meaningless for common shareholders, but is important to owners of Preferred Stock. Example When Cognizant Technology Solutions came out with its Initial Public Offering on NASDAQ in June 1998, the Public Offering Price (POP) was set at $10 per share. The stock was split twice, 2-for-1 in March-2000 and 3-for-1 again in April 2003. As of Dec 6, 2003, the Current Market Price stood at $46.26. However, if the stock-splits are taken into consideration the actual market price would stand at 6 times the Current Market Price at whopping $253.56!! PREFERRED STOCK Preference shares carry a stated dividend and they do not usually have voting rights. Preferred shareholders have priority over common stockholders on earnings and assets in the event of liquidation. Preferred stock is issued with a fixed rate of return that is either a percent of par (always assumed to be $100) or a dollar amount. Although preferred stock is equity and represents ownership, preferred stock investors are primarily seeking income. The market price of income seeking securities (such as preferred stock and debt securities) fluctuates as market interest rates change. Price and yield are inversely related. There are several different types of preferred stock including Straight, Cumulative, Convertible, Callable, Participating and Variable. With straight preferred, the preference is for the current years dividend only. Cumulative preferred is senior to straight preferred and has a first preference for any dividends missed in previous periods.



Convertible preferred stock can be converted into shares of common stock either at a fixed price or a fixed number of shares. It is essentially a mix of debt and equity, and most often used as a means for a risky company to obtain capital when neither debt nor equity works. It offers considerable opportunity for capital appreciation. Non-convertible preferred stock remains outstanding in perpetuity and trades like stocks. Utilities represent the best example of nonconvertible preferred stock issuers. AMERICAN DEPOSITORY RECEIPTS (ADR) The purpose of an ADR is to facilitate the domestic trading of a foreign stock. An ADR is a receipt for a specified number of foreign shares owned by an American bank. ADRs trade like shares, either on a U.S. Exchange or Over the Counter. The owner of an ADR has voting rights and also has the right to receive any declared dividends. An example would be Infosys ADRs that are traded in NASDAQ. HYBRIDS Hybrids are securities, which combine the characteristics of equity and debt. CONVERTIBLE BONDS Convertible Bonds are instruments that can be converted into a specified number of shares of stock after a specified number of days. However, till the time of conversion the bonds continue to pay coupons. Case Study Tata Motors Ltd. (previously known as TELCO) recently issued convertible bond aggregating to $100 million in the Luxemburg Stock Exchange. The effective interest rate paid on the issue was just 4% which was much lower than what it would have to pay if it raised the money in India, where it is based out of. The company would use this money to pay-back existing loans borrowed at much higher interest rates. Why doesnt every company raise money abroad if it has to pay lower interest rates? Will there is Will there be any effect on existing Tata Motors share-holders due to the convertible issue? If Yes, when will this be?

WARRANTS Warrants are call options variants of equity. They are usually offered as bonus or sweetener, attached to another security and sold as a Unit. For example, a company is planning to issue bonds, but the market dictates a 9% interest payment. The issuer does not want to pay 9%, so they sweeten the bonds by adding warrants that give the holder the right to buy the issuers stock at a given price over a given period of time. Warrants can be traded, exercised, or expire worthless.



DERIVATIVES A derivative is a product whose value is derived from the value of an underlying asset, index or reference rate. The underlying asset can be equity, foreign exchange, commodity or any other item. For example, if the settlement price of a derivative is based on the stock price, which changes on a daily basis, then the derivative risks are also changing on a daily basis. Hence derivative risks and positions must be monitored constantly. FORWARD CONTRACT A forward contract is an agreement to buy or sell an asset (of a specified quantity) at a certain future time for a certain price. No cash is exchanged when the contract is entered into. FUTURES CONTRACT A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Index futures are all futures contracts where the underlying is the stock index and helps a trader to take a view on the market as a whole. HEDGING Hedging involves protecting an existing asset position from future adverse price movements. In order to hedge a position, a market player needs to take an equal and opposite position in the futures market to the one held in the cash market. ARBITRAGE Arbitrage: An arbitrageur is basically risk averse. He enters into those contracts were he can earn risk less profits. When markets are imperfect, buying in one market and simultaneously selling in other market gives risk less profit. Arbitrageurs are always in the lookout for such imperfections. OPTIONS An option is a contract, which gives the buyer the right, but not the obligation to buy or sell shares of the underlying security at a specific price on or before a specific date. There are two kinds of options: Call Options and Put Options. Call Options are options to buy a stock at a specific price on or before a certain date. Call options usually increase in value as the value of the underlying instrument rises. The price paid, called the option premium, secures the investor the right to buy that certain stock at a specified price. (Strike price) If he/she decides not to use the option to buy the stock, the only cost is the option premium. For call options, the option is said to be in-the-money if the share price is above the strike price. Example The Infosys stock price as of Dec 6th, 2003 stood at Rs.5062. The cost of the Dec 24th, 2003 expiring Call option with Strike Price of Rs.5200 on the Infosys Stock was Rs.90. This would mean that to break-even the person buying the Call Option on the Infosys stock, the stock price would have to cross Rs.5290 as of Dec 24th, 2003!!



Put Options are options to sell a stock at a specific price on or before a certain date. With a Put Option, the investor can "insure" a stock by fixing a selling price. If stock prices fall, the investor can exercise the option and sell it at its "insured" price level. If stock prices go up, there is no need to use the insurance, and the only cost is the premium. A put option is in-the-money when the share price is below the strike price. The amount by which an option is in-the-money is referred to as intrinsic value. The primary function of listed options is to allow investors ways to manage risk. Their price is determined by factors like the underlying stock price, strike price, time remaining until expiration (time value), and volatility. Because of all these factors, determining the premium of an option is complicated. Types of Options There are two main types of options: American options can be exercised at any time between the date of purchase and the expiration date. Most exchange-traded options are of this type. European options can only be exercised at the end of their life.

Long-Term Options are options with holding period of one or more years, and they are called LEAPS (Long-Term Equity Anticipation Securities). By providing opportunities to control and manage risk or even speculate, they are virtually identical to regular options. LEAPS, however, provide these opportunities for much longer periods of time. LEAPS are available on most widely-held issues. Exotic Options: The simple calls and puts are referred to as "plain vanilla" options. Non-standard options are called exotic options, which either are variations on the payoff profiles of the plain vanilla options or are wholly different products with "optionality" embedded in them. Open Interest is the number of options contracts that are open; these are contracts that have not expired nor been exercised. SWAPS Swaps are the exchange of cash flows or one security for another to change the maturity (bonds) or quality of issues (stocks or bonds), or because investment objectives have changed. For example, one firm may have a lower fixed interest rate, while another has access to a lower floating interest rate. These firms could swap to take advantage of the lower rates. Currency Swap involves the exchange of principal and interest in one currency for the same in another currency. Forward Swap agreements are created through the synthesis of two different swaps, differing in duration, for the purpose of fulfilling the specific timeframe needs of an investor. Sometimes



swaps don't perfectly match the needs of investors wishing to hedge certain risks. For example, if an investor wants to hedge for a five-year duration beginning one year from today, they can enter into both a one-year and six-year swap, creating the forward swap that meets the requirements for their portfolio. Swaptions - An option to enter into an interest rate swap. The contract gives the buyer the option to execute an interest rate swap on a future date, thereby locking in financing costs at a specified fixed rate of interest. The seller of the swaption, usually a commercial or investment bank, assumes the risk of interest rate changes, in exchange for payment of a swap premium. Case Study The World Bank borrows funds internationally and loans those funds to developing countries. It charges its borrowers a cost plus rate and hence needs to borrow at the lowest cost. In 1981 the US interest rate was at 17 percent, an extremely high rate due to the anti-inflation tight monetary policy of the Fed. In West Germany the corresponding rate was 12 percent and Switzerland 8 percent. IBM enjoyed a very good reputation in Switzerland, perceived as one of the best managed US companies. In contrast, the World Bank suffered from bad image since it had used several times the Swiss market to finance risky third world countries. Hence, World Bank had to pay an extra 20 basis points (0.2%) compared to IBM In addition, the problem for the World Bank was that the Swiss government imposed a limit on the amount World Bank could borrow in Switzerland. The World Bank had borrowed its allowed limit in Switzerland and West Germany At the same time, the World Bank, with an AAA rating, was a well established name in the US and could get a lower financing rate (compared to IBM) in the US Dollar bond market because of the backing of the US, German, Japanese and other governments. It would have to pay the Treasury rate + 40 basis points. IBM had large amounts of Swiss franc and German deutsche mark debt and thus had debt payments to pay in Swiss francs and deutsche marks. World Bank borrowed dollars in the U.S. market and swapped the dollar repayment obligation with IBM in exchange for taking over IBM's SFR and DEM loans. It became very advantageous for IBM and the World Bank to borrow in the market in which their comparative advantage was the greatest and swap their respective fixed-rate funding.

1.3

FINANCIAL MARKETS

1.3.1 WHAT ARE FINANCIAL MARKETS?



A financial transaction is one where a financial asset or instrument, such as cash, check, stock, bond, etc are bought and sold. Financial Market is a place where the buyers and sellers for the financial instruments come together and financial transactions take place.

1.3.2

TYPES OF FINANCIAL MARKETS

PRIMARY MARKETS Primary market is one where new financial instruments are issued for the first time. They provide a standard institutionalized process to raise money. The public offerings are done through a prospectus. A prospectus is a document that gives detailed information about the company, their prospective plans, potential risks associated with the business plans and the financial instrument. SECONDARY MARKETS Secondary Market is a place where primary market instruments, once issued, are bought and sold. An investor may wish to sell the financial asset and encash the investment after some time or the investor may wish to invest more, buy more of the same asset instead, the decision influenced by a variety of possible reasons. They provide the investor with an easy way to buy or sell.

1.3.3 THE DIFFERENT FINANCIAL MARKETSA financial market is known by the type of financial asset or instrument traded in it. So there are as many types of financial markets as there are of instruments. Typical examples of financial markets are: Stock market Bond (or fixed income) market Money market

Foreign exchange (Forex or FX for short) market (also called the currency market). Stock and bond markets constitute the capital markets. Another big financial market is the derivatives market. CAPITAL MARKETS Why businesses need capital? All businesses need capital, to invest money upfront to produce and deliver the goods and services. Office space, plant and machinery, network, servers and PCs, people, marketing, licenses etc. are just some of the common items in which a company needs to invest before the business can take off. Even after the business takes off, the cash or money generated from sales may not be sufficient to finance expansion of capacity, infrastructure, and products / services range or to diversify or expand geographically. Some financial services companies need to raise additional capital periodically in order to satisfy capital adequacy norms.



What is the role of Capital Markets? For businesses to thrive and grow, presence of vibrant and efficient capital markets is extremely important. Capital markets have following functions: 1. Channeling funds from savings pool to investment pool channeling funds from those who have money to those who need funds for business purpose. 2. Providing liquidity to investors i.e. making it easy for investors, to buy and sell financial assets or instruments. Capital markets achieve this in a number of ways and it is particularly important for institutional investors who trade in large quantities. Illiquid markets do not allow them to trade large quantities because the orders may simply not get executed completely or may cause drastic fluctuations in price. 3. Providing multitude of investment options to investors this is important because the risk profile, investment criteria and preferences may differ for each investor. Unless there are many investment options, the capital markets may fail to attract them, thus affecting the supply of capital. 4. Providing efficient price discovery mechanism efficient because the price is determined by the market forces, i.e. it is a result of transparent negotiations among all buyers and sellers in the market at any point. So the market price can be considered as a fair price for that instrument. STOCK MARKETS Stock markets are the best known among all financial markets because of large participation of the retail investors. The important stock exchanges are as follows: New York Stock Exchange (NYSE) National Association of Securities Dealers Automated Quotations (NASDAQ) London Stock Exchange (LSE) Bombay Stock Exchange (BSE),

National Stock Exchange of India (NSE) Stock Exchanges provide a system that accepts orders from both buyers and sellers in all shares that are traded on that particular exchange. Exchanges then follow a mechanism to automatically match these trades based on the quoted price, time, quantity, and the order type, thus resulting in trades. The market information is transparent and available real-time to all, making the trading efficient and reliable. Earlier, before the proliferation of computers and networks, the trading usually took place in an area called a Trading Ring or a Pit where all brokers would shout their quotes and find the counter-party. The trading ring is now replaced in most exchanges by advanced computerized and networked systems that allow online trading, so the members can log in from anywhere to carry out trading. For example, BOLT of BSE and Super DOT of NYSE. What determines the share price and how does it change? The share price is determined by the market forces, i.e. the demand and supply of shares at each price. The demand and supply vary primarily as the perceived value of the stock for



different investors varies. Investor will consider buying the stock if the market price is less than the perceived value of the stock according to that investor and will consider selling if it is higher. A large number of factors have a bearing on the perceived value. Some of them are: Performance of the company Performance of the industry to which it belongs State of the countrys economy where it operates as well as the global economy

Market sentiment or mood relating to the stock and on the market as a whole Apart from these, many other factors, including performance of other financial markets, affect the demand and supply. BOND MARKETS As the name suggests, bonds are issued and traded in these markets. Government bonds constitute the bulk of the bonds issued and traded in these markets. Bond markets are also sometimes called Fixed Income markets. While some of the bonds are traded in exchanges, most of the bond trading is conducted over-the-counter (OTC), i.e. by direct negotiations between dealers. Lately there have been efforts to create computer-based market place for certain type of bonds. Participants in the Bond Market Since Government is the biggest issue of bonds, the central bank of the country such as Federal Reserve in US and Reserve Bank of India in India, is the biggest player in the bond market. Like stock markets, one needs to be an authorized dealer of Govt. securities, to subscribe to the bond issues. Typically, the Govt. bond issues are made by way of auctions, where the dealers bid for the bonds and the price is fixed based on the bids received. The dealers then sell these bonds in the secondary market or directly to third parties, typically institutions and companies. If the interest rate is fixed for each bond, why do the bond prices fluctuate? Bond prices fluctuate because the interest rates as well as the perceptions of investors on the direction of interest rates change. Remember, bond pays interest at a fixed coupon rate determined at the time of issue, irrespective of the prevailing market interest rate. Market interest rates are benchmark interest rates, such as Treasury bill rates, which are subject to change because of various factors such as inflation, monetary policy change, etc. So when the prevailing market interest rates change, price of the bond (and not the coupon) adjusts, so that the effective yield for a buyer at the time (if the bond is held to maturity) matches the market interest rate on other bonds of equal tenure and credit rating (risk). So when the market interest rates go up, prices of bonds fall and vice-versa. Therefore, price of bonds changes when market interest rate changes, all bonds have an interest rate risk. If the market interest rates shoot up, then the bond price is affected negatively and an investor who bought the bond at a high price (when interest rates were low) stands to lose money or at least makes lesser returns than expected, unless the bond is held to maturity. Example Bond Price calculation can be summed by an easy formula:



where B represents the price of the bond and CFk represents the kth cash flow which is made up of coupon payments. The Cash Flow (CF) for the last year includes both the coupon payment and the Principal. What would be the bond price for a 3-Year, Rs.100 principal, bond when the interest rate (i) is 10% and the Coupon payments are Rs.5 annually? Would the bond price increase/decrease if the coupon is reduced? What would be happen to bond price if the interest rates came down?

FOREIGN EXCHANGE MARKET Foreign exchange markets are where the foreign currencies are bought and sold. For example, importers need foreign currency to pay for their imports. Government needs foreign currency to pay for its imports such as defense equipment and to repay loans taken in foreign currency. Foreign exchange rates express the value of one currency in terms of another. They involve a fixed currency, which is the currency being priced and a variable currency, the currency used to express the price of the fixed currency. For example, the price of a US Dollar can be expressed in different currencies as: USD (US Dollar) 1 = Indian Rupee (INR) 46, USD 1 = Great Britain Pound (GBP) 0.6125, USD 1 = Euro 0.8780 etc. In this example, USD is the fixed currency and INR, GBP, Euro are the variable currencies. US Dollar, British Sterling (Pound), Euro and Japanese Yen are the most traded currencies worldwide, since maximum business transactions are carried out in these currencies. The exchange rate at any time depends upon the demand supply equation for the different currencies, which in turn depends upon the relative strength of the economies with respect to the other major economies and trading partners. Participants Only authorized foreign exchange dealers can participate in the foreign exchange market. Any individual or company, who needs to sell or buy foreign currency, does so through an authorized dealer. Currency trading is conducted in the over-the-counter (OTC) market. The role of the Central Bank in the foreign exchange market The central bank regulates the markets to ensure its smooth functioning. The degree of regulation depends on the economic policies of the country. The central bank may also buy or sell their currency to meet unusual demand supply mismatches in the markets. The foreign exchange rate and transactions are closely monitored because the fluctuations in Forex markets affects the profitability of imports and exports of domestic companies as well as profitability of investments made by foreign companies in that country. Regulators try to ensure that the fluctuations are not caused by any factor other than the market forces. Example The Bank of Japan plays the role of central bank in Japan. It strictly monitors the exchange rates to ensure that the importers/exporters are not hurt due to any exchange rate fluctuations. Still, the USD/JPY, which is the second most traded currency pair in the world, maintains a long-standing reputation of sharp increases in short-term volatilities.



MONEY MARKET Money market is for short term financial instruments, usually a day to less than a year. The most common instrument is a repo, short for repurchase agreement. A repo is a contract in which the seller of securities, such as Treasury Bills, agrees to buy them back at a specified time and price. Treasury bills of very short tenure, commercial paper, certificates of deposits etc. are also considered as money market instruments. Since the tenure of the money market instruments is very short, they are generally considered safe. In fact they are also called cash instruments. Repos especially, since they are backed by a Govt. security, are considered virtually the safest instrument. Therefore the interest rates on repos are the lowest among all financial instruments. Money market instruments are typically used by banks, institutions and companies to park extra cash for a short period or to meet the regulatory reserve requirements. For short-term cash requirements, money market instruments are the best way to borrow. Participants Whereas in stock market the typical minimum investment is equivalent of the price of 1 share, the minimum investment in bond and money markets runs into hundreds of thousands of Rupees or Dollars. Hence the money market participants are mostly banks, institutions, companies and the central bank. There are no formal exchanges for money market instruments and most of the trading takes place using proprietary systems or shared trading platforms connecting the participants.

1.3.4 REGULATION OF CAPITAL MARKETSThere are many reasons why the financial markets are regulated by governments: Since the capital markets are central to a thriving economy, Governments need to ensure their smooth functioning. Governments also need to protect small or retail investors interests to ensure there is participation by a large number of investors, leading to more efficient capital markets.

Governments need to ensure that the companies or issuers declare all necessary information that may affect the security prices and that the information is readily and easily available to all participants at the same time. Typically the government designates one or more agencies as regulator(s) and supervisor(s) for the financial markets. Thus India has Securities and Exchange Board of India (SEBI) and the US has Securities and Exchange Commission (SEC). These regulatory bodies formulate rules and norms for each activity and each category of participant. For example,



Eligibility norms for a company to be allowed to issue stock or bonds, Rules regarding the amount of information that must be made available to prospective investors, Rules regarding the issue process,

Rules regarding periodic declaration of financial statements, etc. Regulators also monitor the capital market activity continuously to ensure that any breach of laws or rules does not go unnoticed. To help this function, all members and issuers have to submit certain periodic reports to the regulator disclosing all relevant details on the transactions undertaken.

1.3.5 FINANCIAL MARKET SYSTEMSThe demands of the capital market transactions, the need for tracking and managing risks, the pressure to reduce total transaction costs and the obligation to meet compliance requirements make it imperative that the functions be automated using advanced computer systems. Some of the major types of systems in capital market firms are briefly described below. TRADING SYSTEMS The volume of transactions in capital markets demands advanced systems to ensure speed and reliability. Due to proliferation of Internet technology, the trading systems are also now accessible online allowing even more participants from any part of the world to transact, helping to increase efficiency and liquidity. The trading systems can be divided into front-end order entry and back-end order processing systems. Order entry systems also offer functions such as order tracking, calculation of profit and loss based on real-time price movements and various tools to calculate and display risk to the value of investments due to price movement and other factors. Back-office systems validate orders, route them to the exchange(s), receive messages and notifications from the exchanges, interface with external agencies such as clearing firm, generate management, investor and compliance reports, keep track of member account balances etc. EXCHANGE SYSTEMS The core exchange system is the trading platform that accepts orders from members, displays the price quotes and trades, matches buy and sell orders dynamically to fill as many orders as possible and sends status messages and trade notifications to the parties involved in each trade. In addition, exchanges need systems to monitor the transactions, generate reports on transactions, keep track of member accounts, etc. PORTFOLIO MANAGEMENT SYSTEMS These systems allow the investment managers to choose the instruments to invest in, based on the requirements or inputs such as amount to be invested, expected returns, duration (or tenure) of investment, risk tolerance etc. and analysis of price and other data on the instruments and issuers. The term portfolio refers to the basket of investments owned by an



investor. A portfolio of investments allows one to diversify risks over a limited number of instruments and issuers. ACCOUNTING SYSTEMS The accounting systems take care of present value calculations, profit & loss etc. - of investments and funds and not the financial accounts of the firms.

SUMMARY Financial markets facilitate financial transactions, i.e. exchange of financial assets such stocks, bonds, etc. Financial markets bring buyers and sellers in a financial instrument together, thus reducing transaction costs, channeling funds, improving liquidity and provide a transparent price discovery mechanism. Each financial market is segmented into a Primary market, where new instruments are issued and a Secondary market, where the previously issued instruments are bought and sold by investors. Stock markets, bond markets, money markets, foreign exchange markets and derivatives markets are prominent examples of financial markets. Shares (stock) of a company are issued and traded in the stock markets. Bond markets are where bonds such as treasury bonds, treasury notes, corporate bonds, etc. are traded. Money markets, like bonds markets, are also fixed income markets. Instruments traded in money markets have very short tenure. Foreign exchange markets trade in currencies. Derivatives markets trade derivatives, which are complex financial instruments, whose returns are based upon the returns from some other financial asset called as the underlying asset. Price of any financial instrument depends basically on demand and supply, which in turn depend upon multiple different factors for different markets. Each financial instrument has a differing level of inherent risk associated with it. Money market instruments are considered the safest due to their very short tenure. Regulators play a very important role in the development and viability of financial markets. Regulators try to ensure that the markets function in a smooth, transparent manner, that there is sufficient and timely disclosure of information, that the interest of small investors is not compromised by the large investors, and so on, which is critical for overall vibrancy, efficiency and growth of the market and the economy.

1.4

FINANCIAL STATEMENTS



1.4.1

INTRODUCTION TO FINANCIAL ACCOUNTING

Why does the concept of Accounting and Financial Statements exist? Here are two main reasons: 1. The managers of the business will want to know how things are going. They need financial information in order to plan for the future; they need more up-to-date information in order to check whether actual performance is on target. So accounting is the first step in what we call management accounting. 2. There are several other groups of people who may have an interest in the finances of the business (often referred to as 'stakeholders'). The law says that they have a legal right to certain information. The whole process of providing this information (and of maintaining a book-keeping system which is capable of providing it) is known as financial accounting. The stakeholders of any firm could be any or all of the following: 1. Shareholders 2. Employees 3. Management 4. Customers 5. Government 6. Trade Unions and others Question: Who owns the firm - management or shareholders? Answer: Shareholders of course, as they hold shares of the company. However Management personnel/directors of a company are also encouraged to hold shares of the company to align the interest of management and shareholders. ) For Accounting purpose, Company is considered as a Legal Entity that is, a person or organization that has the legal standing to enter into contracts and may be sued for failure to perform as agreed in the contract, e.g., a child under legal age is not a legal entity, while a corporation is a legal entity since it is a person in the eyes of the law. In order that the stakeholders mentioned above understand the financial position of a company, there are standardized financial statements that are prepared. The main ones are: 1. Balance Sheet 2. Income Statement or Profit and Loss Account 3. Cash-Flow statement



Now, let us study them one at a time (why do we need to do that? Well, one of the aims of this course is to ensure that we are familiar with the basic concepts and terms used in Finance. And the above statements are as basic as it gets. SO read on) BALANCE SHEET A Balance sheet is a statement that lists the total assets and the total liabilities of a given business to portray its net worth at a given moment of time. Thus, if we look at any balance sheet, it is As on March 31st 200X (Or whatever the financial year ending date) So, it indicates the health of the firm at a point of time. What are the individual items in a Balance Sheet? First of all its called a balance sheet because the Asset and Liabilities in a Balance sheet balance, meaning they equal each other its as simple as that! An Asset is anything owned by an individual or a business, which has commercial value. Claims against others also qualify as Assets. (That is, if someone owes us something, then it is also an asset, as it actually belongs to us and is of commercial value) A Liability is a debt payable by the firm to its creditors. It represents an economic obligation to pay cash, or provide goods and services, in some future period. (Thus, if we buy a bike on installments, Bike is of course an asset as it has capability to provide us service for next few years, but the loan amount which we need to pay out in installments is a Liability we incur.) The typical heads in a balance sheet are shown below with a sample: Consolidated Statements of Financial Positions (All number in thousands) Assets Current Assets Cash and Cash Equivalents Short Term Investments Receivables Inventory Other Current Assets Total Current Assets Long Term Assets $100 100 200 50 50 500 Total Current Liabilities Long term Liabilities 350 Liabilities Current Liabilities Payables and Accrued Expenses Short Term Loans Debt due in the next 1 year Other Current Liabilities $50 150 100 50



Net Fixed Assets (Land, Properties 200 and Equipments) Intangible Assets Goodwill Other Assets 100 50 50

Long term debt

200

Deferred Liabilities Other Liabilities Total Liabilities Shareholders Equity Equity Retained Earnings

50 100 700

100 100 200

Total Long Term Assets Total Assets

400 900

Total Shareholders Equity

Total Liabilities and Shareholders 900 Equity

Lets look at each item closely:

ASSETS: CURRENT ASSETS Current Assets are those assets of a company that are reasonably expected to be realized in cash, or sold, or consumed in the next one year. Some current assets are listed below: Cash and Cash Equivalents: Cash And Cash Equivalents means all cash, securities, which can be converted into cash at a very short notice, and other near-cash items (E.g. checks, drafts, cash in bank accounts etc). Short Term Investments: All investments, which will be converted in Cash in the next one year. All the assets (bonds etc) with less than one year time to maturity will be accounted under this item (E.g. short term securities). Receivables: Also referred to as Account receivables. This indicates the money due to the firm, for service rendered or goods sold on credit. Inventory: Inventory for companies includes raw materials, items available for sale or in the process of being made ready for sale (work in process). For a stockbroker, it will be the securities bought and held by him, for resale. Other Current Assets: Anything else which could not be categorized in one of the items above but we know that its a current asset can be accounted for here. LONG-TERM ASSETS Long-term assets are those assets that are not consumed during the normal course of business, e.g. land, buildings and equipment, goodwill, etc. They include:



Fixed Assets: Fixed Assets are assets of a permanent nature required for the normal conduct of a business, and which will not normally be converted into cash during the next fiscal period. For example, furniture, fixtures, land, and buildings are all fixed assets. Fixed asset is value of all property, plant, and equipment, net of depreciation. Depreciation We all understand that if we buy a car today, after 5 years of service the value of the car would not be same. We will not be able to sell the car after 5 years at the same price at which we bought the car. This means that assets lose their value as they provide service. This loss of value, or spreading of cost, is called depreciation. Calculating deprecation can get complex, but heres one simple way of calculating depreciation. Say, we know that life of a computer is 3 years and we bought it for $ 3000. So at the end of the 3 years the asset will have a Zero value. What is the true value of the asset at the end of each year? Just depreciate the value of the Asset by $ 1000 (3000/3) each year. Thus: Value of Asset $ (3000-1000)=$ 2000 $1000 $0 End of Year 1 2 3

Usually, instead of the value coming all the way down to zero, it is said to have a scrap value: say, $100. At this point, the asset is removed from the business books, or said to be written off . INTANGIBLE ASSETS: Intangible Asset is an asset that is not physical in nature. Examples are things like copyrights, patents, intellectual property, or goodwill. We can look at more details through an example of Goodwill below. Goodwill Goodwill is that intangible possession which enables a business to continue to earn a profit that is in excess of the normal or basic rate of profit earned by other businesses of similar type. Say, a company such as Hindustan levers, has built up a lot of goodwill over the years. Customers would prefer to buy their products versus an unknown brand. This is an intangible factor, yet worth a lot of money!

OTHER ASSETS: Again, any other asset, which could not be classified under any of the categories above, but one is sure its an asset, can be accounted for here.



LIABILITIES CURRENT LIABILITIES Current Liabilities are amounts, or goods and services, to be paid or executed, within next one year. Payables and Accrued Expenses: A Company might have suppliers who supply on credit, and this is an Account Payable. An accrued expense is an expense that the company has already incurred but company has not paid for it so far. Short Term Loans: All the loans that have to be paid in the next one year. Debt payments due in the next year: Loans of 10-15 years duration are sometimes repaid in installments every year, and so just the money that has to be paid in the next one year would be accounted here. Other Current Liabilities: Any liabilities, which cannot be categorized under any of the headings above. LONG-TERM LIABILITIES Long-term debt: All debt, including bonds, debentures, bank debt, mortgages, deferred portions of long-term debt, and capital lease obligations. Please note that part of the loan that is due only after next one year is indicated here. Deferred Liabilities/Provisions: Deferred, in accounting, is any item where the asset or liability is not realized until a future date, e.g. annuities, charges, taxes, income, etc. So in this case, one knows that there will be some expenses, but the exact amount and dates are not known. Other Liabilities: Any liabilities, which cannot be categorized under any of the headings above. Equity This is basically equity share capital, which is capital raised by an entity through the sale of common shares in the primary market. This is also called share capital. Retained Earnings Retained Earnings are profits of the business that have not been distributed to the owners as of the balance sheet date. The earnings have been "retained" for planned activities such as business expansion - so they actually belong to the owners (shareholders), but have been retained. Quiz: How do the three items above change when company declares dividend? Answer: Nothing changes till the company pays out dividends. Quiz: How do these items change when company pays out dividends? Answer: Retained earnings go down by amount of dividend.



Advanced Quiz: Are stock options same as shares held by employees? Are these captured in these statements? Answer: A stock option is the right of an employee to buy company shares at a pre-specified price, which may be above or below the market price, as on date of the exercising of option. If the option price is below the market price, the employee may buy at the option price & sell at market price & thus realize a profit. If option price is above the market price as on that date, obviously the employee will not prefer to exercise the option. Hence, the options cannot be categorized as shares. However, in some balance sheets, provision may be made for these stock options under the liability head. INCOME (P & L) STATEMENTS Profit And Loss Statement (P&L) is also known as an income statement. It shows business revenue and expenses for a specific period of time (such as the financial year so if we look at any P & L statement, it always specifies a period of time, as: For the Financial Year Ended 31st December 2003. The difference between the total revenue and the total expense is the business net income. A key element of this statement, and one that distinguishes it from a balance sheet, is that the amounts shown on this statement represent transactions over a period of time while the items represented on the balance sheet show information as of a specific date (or point in time). So in engineering terms, Balance sheet has a memory like Flip-flops, while Income statement doesnt have a memory. It is important to understand that for a company Profit need not equal the Cash it has generated during a period. It might so happen that company has provided the service but the client has not yet paid and so company makes a Profit but not Cash. To account for cash generated during a period, companies also report Cash flow statement. A sample P&L statement is shown below. P&L ACCOUNT STATEMENT Revenue Direct Cost Direct Material Direct Labor Gross Profit A B = (C+D) C D E = (A-B)

Operating Expenses (Based on the type of business, some of F = (G+ H+I+J+K) these items would qualify as indirect Cost) Administration G



R&D Marketing and Selling Expenses Any one time expenses (e.g. ex-gratia etc) Other Expenses Operating Income Other Income Other Expenses EBIT (Earnings Before Interest and Taxes) Interest Expenses Profit Before Tax (PBT) Income Taxes Net Income or PAT (Profit after Tax)

H I J K L = (E-F) M N O = (L+M-N) P Q = (O-P) R S= (Q-R)

EPS (Earnings Per Share) P/E Ratio Lets look at each item closely: Revenue

T = S/ Number of shares Market price/T

Revenue is the inflows of assets (may be Cash or Receivables, Remember!) from selling goods or providing services to customers. This is also referred to as the Top line (as it is the top line in the P& L statement!) Direct Cost Direct Cost is that portion of cost that is directly expended in providing a product or service for sale e.g. material and labor.

Gross Profit Gross Profit is one of the key performance indicators. Gross profit shows the relationship between sales and the direct cost of products/services sold. It is measured as indicated in the table above.



Indirect Cost Indirect Cost is that portion of cost that is indirectly expended in providing a product or service for sale (cannot be traced to a given project, in our case, in an economically feasible manner) e.g. rent, utilities, equipment maintenance, etc. Operating Expenses Operating Expenses is all selling and general & administrative expenses. This includes depreciation, but not interest expense. Operating Income Operating Income is revenue less cost of goods sold (Direct and Indirect costs) and related operating expenses that are applied to the day-to-day operating activities of the company. It excludes financial related items (i.e., interest income, dividend income, and interest expense), and taxes. EBIT (Earnings before Interest and Taxes) Its the earnings before any interest or taxes. Interest Expenses Interest expense captures all the finance charges incurred on any borrowed capital. Profit before Tax (PBT) Profit earned before accounting for Taxes. Income Taxes Amount of tax paid. This is a % of PBT. Net Income or PAT (Profit after Tax) This is the profit after all the obligations, which can be distributed to shareholders. This is also referred as the Bottom-line (as this is the bottom line in a P &L statement, or the final profit net of expenses & tax. EPS (Earnings per Share) Earnings per Share (EPS) is the amount of net income (earnings) related to each share; computed by dividing net income by the number of shares outstanding during the period. P/E Ratio Price to Earnings Ratio (P/E) is a performance benchmark that can be used as a comparison against other companies or within the stock's own historical performance. For instance, if a stock has historically run at a P/E of 35 and the current P/E is 12, we may want to explore the



reasons for the drastic change. If we believe that the ratio is too low, we may want to buy the stock. There are a number of other ratios that help analysts to analyze the financial statements of companies to understand the current performance and future prospects; we are not discussing those here. CASH FLOW STATEMENT Statement accounting for all the inflows and outflows of cash is captured in this statement. Why do we need a separate Cash-flow statement? Isnt it covered in Balance sheet or Income statement? All the accounting is done based on the method wherein, revenue and expenses are recorded in the period in which they are earned or incurred regardless of whether cash is received or disbursed in that period. So when a good is sold or some service rendered, it will show in Balance sheet and Income statement, but it will not show in the Cash Flow statement till cash is received for the same. Quiz: How will we explain a scenario where company is reporting a large profit but company doesnt have the cash to pay salary to its employees? Where is the cash going or did it come at all? Answer: It means that the company is selling goods and also making profits but has not received cash payments from its customers! Exercise 1. Day 1: We borrow Rs 100 from a bank for a business to produce t-shirts. How would our balance sheet look like at the end of the day? 2. Day 2: We purchase raw material for your products for Rs 50. How would our balance sheet look like at the end of the day? 3. Day 3 to 29: Workers work with the rented machines to produce the finished goods. The product is ready to be shipped to customer. 4. Day 30: We pay the workers Rs 20 as their salary, pay Rs 10 as the machine rent, pay other expenses such as floor rent, electricity bills etc totaling Rs 10. At the end of the day the product is shipped to the customer. Customer has promised to pay you Rs 120 after checking the quality, which will take 5 days. How would our balance sheet look like at the end of the day? How would our Income statement look like? 5. Day 35: You get Rs 120 from customer. You also get admission in a Business School and so you plan to wind up the business. Prepare all the financial statements (Balance sheet and Profit and loss statement at the end of day 35).



Useful Information: Bank charges 12% simple interest rate. We need to pay tax @ 10% of the net income. Inflation for the period was 5%. Advanced Exercise Infosys has all its revenue in Dollars. Direct cost for the company is 60% of its revenue. Of this 60%, 30% in incurred in dollars (onsite component) while 70% (offshore component) is incurred in rupees. Indirect cost for the company is 20%. Of this 20%, 70% (Selling and Marketing, US infrastructure etc) is incurred in dollars while rest (Indian infrastructure, entertainment etc) is incurred in rupees. By what percentage, will the profit increase/decrease if the rupee appreciates by 1% from its current level of Rs. 50 per dollar? Understanding Cognizants Financial Statements COGNIZANTS BALANCE SHEET

In Millions of USD (except for per share items) Cash & Equivalents Short Term Investments Cash and Short Term Investments Accounts Receivable Trade, Net Receivables - Other Total Receivables, Net Total Inventory Prepaid Expenses Other Current Assets, Total Total Current Assets

As of 2008-12-31

As of 2007-12-31

As of 2006-12-31

As of 2005-12-31

735.07 27.51 762.58 579.64 579.64 125.90 1,468.12

339.85 330.58 670.42 436.46 436.46 135.30 1,242.18 499.03 148.79 45.56 0.00 45.73 1,838.31 36.18 272.34 0.00 32.16 340.68 0.00 0.00

265.94 382.22 648.16 298.48 298.48 93.76 1,040.39 315.69 27.19 20.46 17.78 1,325.98 27.84 200.54 0.00 21.13 249.50 0.00 0.00

196.94 227.06 424.00 176.70 176.70 62.73 663.42 211.72 18.22 16.28 24.99 869.89 16.42 119.29 0.00 18.08 153.79 0.00 0.00

Property/Plant/Equipment 654.44 , Total - Gross Goodwill, Net 154.03 Intangibles, Net 47.79 Long Term Investments 161.69 Other Long Term Assets, 87.67 Total Total Assets 2,374.56 Accounts Payable Accrued Expenses Notes Payable/Short Term Debt Current Port. of LT Debt/Capital Leases Other Current liabilities, Total Total Current Liabilities 39.97 298.17 0.00 49.44 387.58

Long Term Debt Capital Lease Obligations Total Long Term Debt 0.00 Total Debt 0.00



Deferred Income Tax Minority Interest Other Liabilities, Total Total Liabilities

7.29 14.11 408.98

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