2014
COMMERCE
Paper – 201
(Financial Management)
Full Marks: 80
Time – 3 hours
The figures in the margin indicate full marks for the questions.
1. (a) “Without adequate finance no business can survive and without efficient financial management, no business can prosper and grow.” Comment on the statement and outline the role of financial management. (8+8=16)
-> No business can survive in the long run without earning profit. It is rightly said that profit is the biggest motivator for an entrepreneur, so we can say that profit maximization is the main objective of financial management.
Importance of finance to the business
- To Make Profits
A popular phrase, ‘money is for making money,’ explains why finance management in business organizations requires utmost attention. For a business to keep running successfully, the amounts of profits coming in must keep increasing .
- Operational expenses
Meeting the operational needs of an organization is what keeps a business going. Finance for most companies, including Africa businesses , entails some operational costs such as remunerative payments for staff members, raw materials, inventory, interest payments, to mention a few.
- Asset creation
The primary long-term agenda for company owners is to scale up production by increasing the assets of the business. The finance sector allows companies to have a solid saving plan that is not dependent on short-term finances to meet this need. Investing in items such as land, equipment, and machinery will definitely boost the production scale. But it will only happen with intelligent financial management.
- Cash Flow Management
Any business big or small anticipates a large sum of cash flowing in and out of the company. These money transactions are necessary to keep a business going. But without a proper system in place, they can be a great source of problems, particularly legal issues.
- Financial goals
Among other necessary goals for a business set-up, every organization has a set of financial goals. While most involve hitting a certain profit margin over a specified period, financial goals go as far as catering for the overall economic demands and requirements of the nation.
- Managing Unavoidable Risks
Running any company is all about taking risks. Even so, it is not enough to think of your business set up as a risk. Natural phenomena along with human errors can by far be the leading reasons you suffer significant loss in your business. Before that time comes, your financial management techniques will help pulls out a contingency plan that will prepare your company to manage unavoidable risks.
Financial Management is an important functional area of business. The objectives of financial management should, therefore, be consistent with the overall objectives of the business. It is the duty of the top management to lay down the objectives or goals which are to be achieved by the business. In order to make wise financial decisions a clear understanding of the objectives of the business is necessary. Objectives provide a framework within which various decisions relating to investment, financing and dividend are to be taken.
Financing decisions help the management measure which activities should be undertaken and which policies should be followed. The main objective of any firm should be to maximize the economic welfare of its shareholders.
Role of Financial Management
1. Profit Maximization
2. Wealth Maximization/Shareholders’ Value Maximization (SVM)
3. Value Maximization
Profit maximization is used as a standard of financing decisions. According to this approach, a firm should undertake all those activities which add to its profits and eliminate all others which reduce its profits. This objective highlights the fact that all the decisions—financing, dividend and investment, should result in profit maximization.
Wealth maximization approach has been recognized for the evaluation of performance of a business undertaking. It is also known as value maximization or maximization of net present worth. According to this approach, financial management should take such decisions which increase the net present value of the firm.
Value maximization may be defined as the managerial function involved in the appreciation of the long-term market value of an organization. The total value of an organization is comprised of all the financial assets, such as equity, debt, preference shares, and warrants. The total value of an organization increases when the value of its shares increases in the market.
(b) Who discharges the finance function? What are his / her specific responsibilities? (16)
-> Financial activities of a firm is one of the most important and complex activities of a firm. Therefore in order to take care of these activities a financial manager performs all the requisite financial activities.
A financial manager is a person who takes care of all the important financial functions of an organization. The person in charge should maintain a far sightedness in order to ensure that the funds are utilized in the most efficient manner. His actions directly affect the Profitability, growth and goodwill of the firm.
Financial managers are responsible for the financial health of an organization. They produce financial reports, direct investment activities, and develop strategies and plans for the long-term financial goals of their organization.
Following are the main functions of a Financial Manager:
Raising of Funds
In order to meet the obligation of the business it is important to have enough cash and liquidity. A firm can raise funds by the way of equity and debt. It is the responsibility of a financial manager to decide the ratio between debt and equity. It is important to maintain a good balance between equity and debt.
Allocation of Funds
Once the funds are raised through different channels the next important function is to allocate the funds. The funds should be allocated in such a manner that they are optimally used. In order to allocate funds in the best possible manner the following point must be considered
· The size of the firm and its growth capability
· Status of assets whether they are long-term or short-term
- Mode by which the funds are raised
These financial decisions directly and indirectly influence other managerial activities. Hence formation of a good asset mix and proper allocation of funds is one of the most important activity
Profit Planning
Profit earning is one of the prime functions of any business organization. Profit earning is important for survival and sustenance of any organization. Profit planning refers to proper usage of the profit generated by the firm.
Profit arises due to many factors such as pricing, industry competition, state of the economy, mechanism of demand and supply, cost and output. A healthy mix of variable and fixed factors of production can lead to an increase in the profitability of the firm.
Understanding Capital Markets
Shares of a company are traded on stock exchange and there is a continuous sale and purchase of securities. Hence a clear understanding of capital market is an important function of a financial manager. When securities are traded on stock market there involves a huge amount of risk involved. Therefore a financial manger understands and calculates the risk involved in this trading of shares and debentures.
It’s on the discretion of a financial manager as to how to distribute the profits. Many investors do not like the firm to distribute the profits amongst shareholders as dividend instead invests in the business itself to enhance growth. The practices of a financial manager directly impact the operation in capital market.
2. (a) Critically examine the “Comparative Statement and Common-size Statement” as the tools of financial analysis. (8+8=16)
-> Financial statement analysis is the procedure of analysing an enterprise’s financial statements for making decisions for the purposes and to understand the comprehensive health of an organisation. Financial statements document financial information, which must be evaluated through financial statement analysis to become more helpful to shareholders, managers, investors and other interested parties. To put it in other words, the term ‘financial analysis’ comprises both ‘analysis and interpretation’.
Tools of Analysis of Financial Statements :
The most frequently used tools of financial analysis are as follows :
Comparative Statements: These are the statements depicting the financial position and profitability of an enterprise for the distinct timeframe in a comparative form to give a notion about the position of 2 or more periods. It usually applies to the 2 important financial statements, namely, statement of profit and loss and balance sheet outlined in a comparative form. Comparative figures signify the direction and trend of financial position and operating outcomes. This type of analysis is also referred to as ‘horizontal analysis’.
There are two types of comparative statements which are as follows
1. Comparative income statement
2. Comparative balance sheet
Comparative Income Statement
Income statements provide the details about the results of the operations of the business, and comparative income statements provide the progress made by the business over a period of a few years. This statement also helps in ascertaining the changes that occur in each line item of the income statement over different periods.
The following points should be studied when analysing a comparative income statement
1. Compare the increase or decrease in sales with a relative increase in the cost of goods sold
2. Studying the operational profits of the business
3. Overall profitability of the business can be analysed by an increase or decrease in the net profit
Comparative Balance Sheet
Comparative balance sheet analyses the assets and liabilities of business for the current year and also compares the increase or decrease in them in relative as well as absolute parameters.
A comparative balance sheet not only provides the state of assets and liabilities in different time periods, but it also provides the changes that have taken place in individual assets and liabilities over different accounting periods.
The following points should be studied when analysing a comparative balance sheet
1. The present financial and liquidity position (study working capital)
2. The financial position of the business in the long term
3. The profitability of the business
Steps in preparing a comparative balance sheet
Common Size Statements: Common size statements are the statements which signify the association of distinct items of a financial statement with a generally known item by depicting each item as a % of that common item. Such statements allow an analyst to compare the financing and operating attributes of 2 enterprises of distinct sizes in a similar industry. This analysis is also referred to as ‘Vertical analysis.
Types of Common Size Statements
There are two types of common size statements:
Common size income statement
Common size balance sheet
1. Common Size Income Statement
This is one type of common size statement where the sales is taken as the base for all calculations. Therefore, the calculation of each line item will take into account the sales as a base, and each item will be expressed as a percentage of the sales.
Use of Common Size Income Statement
· It helps the business owner in understanding the following points
· Whether profits are showing an increase or decrease in relation to the sales obtained.
· Percentage change in cost of goods that were sold during the accounting period.
· Variation that might have occurred in expense.
· If the increase in retained earnings is in proportion to the increase in profit of the business.
· Helps to compare income statements of two or more periods.
· Recognizes the changes happening in the financial statements of the organisation, which will help investors in making decisions about investing in the business.
2. Common Size Balance Sheet:
A common size balance sheet is a statement in which balance sheet items are being calculated as the ratio of each asset in relation to the total assets. For the liabilities, each liability is being calculated as a ratio of the total liabilities.
Common size balance sheets can be used for comparing companies that differ in size. The comparison of such figures for the different periods is not found to be that useful because the total figures seem to be affected by a number of factors.
Standard values for various assets cannot be established by this method as the trends of the figures cannot be studied and may not give proper results.
(b) Write brief note on: (4×4=16)
(i) Working Capital turnover ratio.
-> Working capital turnover, also known as net sales to working capital, is an efficiency ratio used to measure how the company is using its working capital to support a given level of sales. This ratio shows the relationship between the funds used to finance the company’s operations and the revenues a company generates in return. Working capital turnover measures how efficiently the company is utilizing its working capital to produce a certain level of sales.
In other words, this ratio shows the net sales generated as a result of investing one dollar of working capital.
Working capital is very instrumental in running the day-to-day activities of a business. It is the amount of money that ensures that the business can pay its short term debts and bills like employees’ salaries.
Working capital refers to the cash at hand in excess of current liabilities that the business can use to make required payments of its short term bills. This ensures that everything is operating smoothly. Simply put, it’s that amount in hand in excess of current liabilities.
A high working turnover ratio is an indicator of the efficient utilization of the company’s short-term assets and liabilities to support sales. This means that the company is majorly depending on its working capital to generate revenues. A high ratio indicates that the company is making sales with very little investment.
Conversely, a low ratio implies that the company invests in accounts receivable and inventories to support its operations. This could be associated with the risk of stocks being outdated and accounts receivable being bad debts and being written off.
Working Capital Turnover Ratio Formula
Working Capital Turnover= Net Sales/Average Working Capital Working
Working Capital Turnover Ratio Analysis
Working capital turnover ratio is an efficiency and activity ratio. It’s used to gauge how well a company is utilizing its working capital to generate sales from its working capital. It reveals to the company the number of net sales generated from investing one dollar of working capital. The ratio can as well be interpreted as the number of times in a year working capital is used to generate sales.
As a rule of thumb, the high ratio shows that the management is efficiently utilizing the company’s short term assets. They’re supporting sales. Meanwhile, a low ratio is a sign of power management of the business resulting in the accumulation of inventories and accounts receivable. When the ratio is low, it implies that the goods can’t be traded. Hence, they’re taking longer to be converted into cash leading to sales on credit. Thus, too many accounts receivable are generated. This can become a blow to the company. The inventory becomes outdated and accounts receivable becomes written off as bad debt.
Just like other measures, working capital inventory ratio varies widely across and between industries and companies; therefore, for comparison purposes, compare a company’s working capital turnover ratio against the industry’s average or against their own historical data.
Working Capital Turnover Ratio Conclusion
· Working capital turnover ratio is an analytical tool used to calculate the number of net sales generated from investing one dollar of working capital.
· High working capital turnover ratio is an indicator of efficient use of the company’s short-term assets and liabilities to support sales.
· Low inventory to working capital turnover ratio implies that the company is not generating sales sufficient enough from the working capital available.
· Working capital turnover ratio requires two variables: net sales and average working capital.
· The ratio is interpreted in terms of dollars or time.
(ii) Stock Turnover ratio.
-> Inventory turnover ratio or stock turnover ratio indicates the relationship between “cost of goods sold” and “average inventory”. It indicates how efficiently the firm’s investment in inventories is converted to sales and thus depicts the inventory management skills of the organization.
It is both an activity and efficiency ratio. This ratio helps to determine stock related issues such as overstocking and overvaluation. The stock turnover ratio is calculated as;
Stock Turnover Ratio= Cost of Goods Sold/ Average Inventory
In some cases, the numerator may be “Cost of Revenue from Operations” which is calculated as “Revenue from operations – Gross profit”.
COGS – It can be calculated with either one of these formulas;
· Opening Stock + Purchases + Direct Expenses (*if provided) – Closing Stock
- Net Sales – Gross Profit
Average Inventory – Average of stock levels maintained by a business in an accounting period, it can be calculated as;
- (Opening Stock + Closing Stock)/2
· Stock to include = Raw material + Work in Progress + Finished Goods
Example
Calculate inventory or stock turnover ratio from the below information
Cost of Goods Sold – 6, 00,000
Stock at beginning of period – 2, 00,000, Stock at end of period – 4, 00,000
Average Inventory = (2, 00,000 + 4, 00,000)/2 = 3, 00,000
Stock Turnover Ratio = (COGS/Average Inventory)
= (6, 00,000/3, and 00,000)
=2/1 or 2:1
High Ratio – If the stock turnover ratio is high it shows more sales are being made with each unit of investment in inventories. Though high is favourable, a very high ratio may indicate a shortage of working capital and lack of sufficient inventories.
Low Ratio – A low inventory turnover ratio may indicate unnecessary accumulation of stock, inefficient use of investment, over-investment in inventories, etc. This is a concern for the company as inventory could become obsolete and may result in future losses.
(iii) Debt-Equity ratio.
-> The debt-equity ratio is a measure of the relative contribution of
the creditors and shareholders or owners in the capital employed in
business. Simply stated, ratio of the total long term debt and equity
capital in the business is called the debt-equity ratio.
It can be calculated using a simple formula:
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This financial tool gives an idea of how much borrowed capital (debt) can be fulfilled in the event of liquidation using shareholder contributions. It is used for the assessment of financial leverage and soundness of a firm and is typically calculated using previous fiscal year’s data.
A low debt-equity ratio is favorable from investment viewpoint as it is less risky in times of increasing interest rates. It therefore attracts additional capital for further investment and expansion of the business.
Debt to equity ratio interpretation
Debt to equity ratio helps us in analysing the financing strategy of a company. The ratio helps us to know if the company is using equity financing or debt financing to run its operations.
High DE ratio : A high DE ratio is a sign of high risk. It means that the company is using more borrowing to finance its operations because the company lacks in finances. In other words, it means that it is engaging in debt financing as its own finances run under deficit.
Low DE ratio: This means that the company’s shareholder’s equity is in excess and it does not need to tap its debts to finance its operations and business. The company has more of owned capital than borrowed capital and this speaks highly of the company.
Interpretation:
A high debt to equity ratio, as we have rightly established tells us that the company is borrowing more than using its own money which is in deficit and a low debt to equity ratio tells us that the company is using more of its own assets and lesser borrowings.
Now by definition, we can come to the conclusion that high debt to equity ratio is bad for a company and is viewed negatively by analysts.
Misnomers in the interpretation:
If we look at the debt to equity ratio formula again, DE ratio is calculated by dividing total liabilities by shareholders’ equity. Depending on the nature of industries, a high DE ratio may be common in some and a low DE ratio may be common in others
Capital intensive industries like manufacturing may have a higher DE ratio whereas industries centered around services and technology may have lower capital and growth needs on a comparative basis and therefore may have a lower DE.
Therefore, what we learn from this is that DE ratios of companies, when compared across industries, should be dealt with caution.
(iv) Fixed Assets Turnover ratio.
-> The fixed asset turnover ratio (FAT) is, in general, used by analysts to measure operating performance. This efficiency ratio compares net sales (income statement) to fixed assets (balance sheet) and measures a company’s ability to generate net sales from its fixed-asset investments, namely property, plant, and equipment (PP&E).
The fixed asset balance is used as a net of accumulated depreciation . A higher fixed asset turnover ratio indicates that a company has effectively used investments in fixed assets to generate sales.
Understanding the Fixed Asset Turnover Ratio
The formula for the fixed asset turnover ratio is:
FAT= Net Sales/Average Fixed Assets
Where:
Net Sales=Gross sales, less returns, and allowances
Average Fixed Assets=NABB−Ending Balance/2
NABB=Net fixed assets’ beginning balance
The ratio is commonly used as a metric in manufacturing industries that make substantial purchases of PP&E in order to increase output. When a company makes such significant purchases, wise investors closely monitor this ratio in subsequent years to see if the company’s new fixed assets reward it with increased sales.
Overall, investments in fixed assets tend to represent the largest component of the company’s total assets. The FAT ratio, calculated annually, is constructed to reflect how efficiently a company, or more specifically, the company’s management team, has used these substantial assets to generate revenue for the firm.
Interpreting the Fixed Asset Turnover Ratio
A higher turnover ratio is indicative of greater efficiency in managing fixed-asset investments, but there is not an exact number or range that dictates whether a company has been efficient at generating revenue from such investments. For this reason, it is important for analysts and investors to compare a company’s most recent ratio to both its own historical ratios and ratio values from peer companies and/or average ratios for the company’s industry as a whole.
Though the FAT ratio is of significant importance in certain industries, an investor or analyst must determine whether the company under study is in the appropriate sector or industry for the ratio to be calculated before attaching much weight to it.
Fixed assets vary drastically from one company type to the next. As an example, consider the difference between an Internet company and a manufacturing company. An Internet company, such as Facebook, has a significantly smaller fixed asset base than a manufacturing giant, such as Caterpillar. Clearly, in this example, Caterpillar’s fixed asset turnover ratio is of more relevance and should hold more weight than Facebook’s FAT ratio.
Limitations of Using the Fixed Asset Ratio
Companies with cyclical sales may have worse ratios in slow periods, so the ratio should be looked at during several different time periods. Additionally, management could be outsourcing production to reduce reliance on assets and improve its FAT ratio, while still struggling to maintain stable cash flows and other business fundamentals.
Companies with strong asset turnover ratios can still lose money because the amount of sales generated by fixed assets speak nothing of the company’s ability to generate solid profits or healthy cash flow.
3. (a) Examine the relative suitability of preference shares and equity shares as a source of long-term finance of companies. (8+8=16)
-> Equity Shares
Equity shares are also known as ordinary shares. They are the form of fractional or part ownership in which the shareholder, as a fractional owner, takes the maximum business risk. The holders of Equity shares are members of the company and have voting rights. Equity shares are the vital source for raising long-term capital.
Equity shares represent the ownership of a company and capital raised by the issue of such shares is known as ownership capital or owner’s funds. They are the foundation for the creation of a company.
Equity shareholders are paid on the basis of earnings of the company and do not get a fixed dividend. They are referred to as ‘residual owners’. They receive what is left after all other claims on the company’s income and assets have been settled. Through their right to vote, these shareholders have a right to participate in the management of the company.
Merits of Equity Shares
· Equity capital is the foundation of the capital of a company. It stands last in the list of claims and it provides a cushion for creditors.
· Equity capital provides creditworthiness to the company and confidence to prospective loan providers.
· Investors who are willing to take a bigger risk for higher returns prefer equity shares.
- There is no burden on the company , as payment of dividend to the equity shareholders is not compulsory.
· Equity issue raises funds without creating any charge on the assets of the company.
· Voting rights of equity shareholders make them have democratic control over the management of the company
Limitations of Equity Shares
· Investors who prefer steady income may not prefer equity shares.
· The cost of equity shares is higher than the cost of raising funds through other sources.
· The issue of additional equity shares dilutes the voting power and earnings of existing equity shareholders.
· Many formalities and procedural delays are involved and they are time-consuming processes
Preference Shares
Preference shares are the shares which promise the holder a fixed dividend, whose payment takes priority over that of ordinary share dividends. Capital raised by the issue of preference shares is called preference share capital.
The preference shareholders are in superior position over equity shareholders in two ways: first, receiving a fixed rate of dividend, out of the profits of the company, before any dividend is declared for equity shareholder and second, receiving their capital after the claims of the company’s creditors have been settled, at the time of liquidation . In short, the preference shareholders have a preferential claim over dividend and repayment of capital as compared to equity shareholders.
Dividends are payable only at the discretion of the directors and only out of profit after tax , to that extent, these resemble equity shares. Preference resemble debentures as both bear fixed rate of return to the holder. Thus, preference shares have some characteristics of both equity shares and debentures .
Preference shareholders generally do not enjoy any voting rights. In certain cases, holders of preference shares may claim voting rights if the dividends are not paid for two years or more on cumulative preference shares and three years or more on non-cumulative preference shares. But what are cumulative and non-cumulative preference shares? They are classified below:
Types of Preference Shares
1. Cumulative and Non-Cumulative:
The preference shares that have the right to collect unpaid dividends in the future years, in case the same is not paid during a year are known as cumulative preference shares. Non-cumulative shares, the dividend is not accumulated if it is not paid in a particular year.
2. Participating and Non-Participating:
Preference shares which have a right to participate in the extra surplus of company shares which after dividend at a certain rate has been paid on equity shares are called participating preference shares. These non-participating preference shares do not enjoy such rights of participation in the profits of the company.
3. Convertible and Non-Convertible:
Preference shares that can be converted into equity shares within a specified period of time are known as convertible preference shares. Non-convertible shares are such that cannot be converted into equity shares. intervals say six months or one year.
Merits of Preference Shares
- It does not affect the control of equity shareholders over the management as preference shareholders don’t have voting rights.
· Payment of fixed rate of dividend to preference shares may make a company to announce higher rates of dividend for the equity shareholders in good times.
· Preference shares have reasonably steady income in the form of fixed rate of return and safety of the investment.
· Also, they are suitable for those investors who want a fixed rate of return with low risk.
· Preference shareholders have a preferential right of repayment over equity shareholders in the event of liquidation or bankruptcy of a company.
- Preference capital does not create any sort of charge against the assets of a company.
Limitations of Preference Shares
· The rate of dividend on preference shares is generally higher than the rate of interest on debentures.
· The Dividend on these shares is to be paid only when the company earns a profit, there is no assured return for the investors.
· Preference shares are not preferred by those investors who are willing to take a risk and are interested in higher returns;
· Preference capital dilutes the claims of equity shareholders over assets of the company.
· The dividend paid is not deductible from profits as an expense. Thus, there is no tax saving as in the case of interest on loans.
(b) Define ‘Term Loan’. Discuss its financial objectives. Explain the distinctive features of Term Loan. (2+5+9=16)
-> A term loan is a loan from a bank for a specific amount that has a specified repayment schedule and either a fixed or floating interest rate . A term loan is often appropriate for an established small business with sound financial statements. Also, a term loan may require a substantial down payment to reduce the payment amounts and the total cost of the loan.
Types of Term Loans
Term loans come in several varieties, usually reflecting the lifespan of the loan.
- A short-term loan , usually offered to firms that don’t qualify for a line of credit, generally runs less than a year, though it can also refer to a loan of up to 18 months or so.
- An intermediate-term loan generally runs more than one—but less than three—years and is paid in monthly installments from a company’s cash flow.
- A long-term loan runs for three to 25 years, uses company assets as collateral, and requires monthly or quarterly payments from profits or cash flow. The loan limits other financial commitments the company may take on, including other debts, dividends, or principals’ salaries, and can require an amount of profit set aside for loan repayment.
Features of Term Loans:
Term loan is a part of debt financing obtained from banks and financial institutions.
The basic features of term loan have been discussed below:
1. Security:
Term loans are secured loans. Assets which are financed through term loans serve as primary security and the other assets of the company serve as collateral security.
2. Obligation:
Interest payment and repayment of principal on term loans is obligatory on the part of the borrower. Whether the firm is earning a profit or not, term loans are generally repayable over a period of 5 to 10 years in installments.
3. Interest:
Term loans carry a fixed rate of interest but this rate is negotiated between the borrowers and lenders at the time of dispersing of loan.
4. Maturity:
As it is a source of medium-term financing, its maturity period lies between 5 to 10 years and repayment is made in installments.
5. Restrictive Covenants:
Besides asset security, the lender of the term loans imposes other restrictive covenants to themselves. Lenders ask the borrowers to maintain a minimum asset base, not to raise additional loans or to repay existing loans, etc.
6. Convertibility:
Term loans may be converted into equity at the option and according to the terms and conditions laid down by the financial institutions.
4. (a) Make a comparison between Trade Credit and Bank Credit as sources of short-term financing. (16)
-> Trade Credit is the credit extended by one trader to another for the purchase of goods and services. It facilitates the purchase of supplies without immediate payment and is commonly used by business organizations as a source of short-term financing. Trade credit appears in the records of the buyer of goods as ‘sundry creditors’ or ‘accounts payable’. It is granted prudently to those customers who have reasonable amount of financial standing and goodwill. The volume and period of credit extended depends on factors such as reputation of the purchasing firm, financial position of the seller, volume of purchases, past record of payment and degree of competition in the market. Terms of trade credit may vary from industry to industry and from person to person. As we know, trade is the purchase and sale of goods on profit motive. So, trade credit strictly refers to the routine business activity.
Merits of Trade Credit as a source of short term finance:-
· Trade credit helps a company to finance the accumulation of inventories for meeting the future increase in sales.
· As the trade creditor does not have any rights over the assets of the company, it can mortgage its assets to raise money from other sources.
Demerits of Trade Credit as a source of short term finance:-
· Easily availability of trade credit can result in overtrading, which in turn increases the future liabilities of the buyer.
· The amount of fund that can be generated through trade credit is limited to the financial capacity of the supplier or the creditor.
Bank Credit Commercial banks provide funds for different purposes and for different time periods to firms of all sizes by way of cash credits, overdrafts, term loans, purchase/discounting of bills, and issue of letter of credit. The rate of interest charged by banks depends on various factors such as the characteristics of the firm and the level of interest rates in the economy. The loan is repaid either in lump sum or in installments. Bank credit is not a permanent source of funds and is generally used for medium to short periods. The borrower is required to provide some security or create a charge on the assets of the firm before a loan is sanctioned by a commercial bank.
Merits of Bank credit as a source of short term finance:-
1. Banks maintain secrecy over information related to their customers.
2. Bank credit provides flexibility to the borrower as the borrower can increase or decrease the amount of loan according to the business needs.
Demerits of Bank credit as a source of short term finance:-
1. It is difficult to increase the loan.
2. The term imposed by banks is often very restrictive.
(b) Describe the advantages and disadvantages of unsecured borrowing as a source of short-term finance. (8+8=16)
-> An unsecured loan is a loan that doesn’t require any type of collateral . Instead of relying on a borrower’s assets as security, lenders approve unsecured loans based on a borrower’s creditworthiness. Examples of unsecured loans include personal loans, student loans, and credit cards.
A broad range of finance products are unsecured, and a few of the main ones are explored below.
Unsecured business loan . A loan not backed by collateral, where the decision to lend is based on the creditworthiness of the director or owners of a business and the responsibility to cover a defaulted loan rests on them.
Business cash advance . A loan based on previous debit and card sales, which is repaid weekly as a percentage of future card sales.
Equity crowd funding . A loan borrowed via contributions from multiple lenders, who receive equity in the business along with repayment of their loan.
Debt crowd funding . Similar in structure to equity crowd funding, except that equity is not offered and a personal guarantee is given instead.
Donation crowd funding . Again, similarly structured to equity crowd funding except that lenders donate money solely on their belief in the business they are funding.
Advantages of an unsecured loan
Unsecured finance applications are usually quicker and less complex than their secured equivalents, meaning that capital can often be accessed within a few days. As no assets are required to take out this type of loan, there is reduced risk for the borrower. The involvement of a guarantor means that their credit history will be assessed rather than the borrower’s, allowing unsecured finance to be accessed by those with subpar credit ratings.
Businesses with weaker trading positions are less likely to qualify, as the decision on whether to lend is made against indications that repayment will be possible. This decision is more likely to be in favour of the borrower if a reliable guarantor can be found, but the guarantor’s personal assets are at risk and may be taken if the business that originally borrowed is unable to repay.
Because collateral is not offered, interest rates are usually higher. An unsecured loan without a guarantor will feature even higher interest rates, as the absence of a guarantee that the loan will be repaid in case of default means the borrower must further offset the risk.
Fewer unsecured finance products are regulated by the Financial Conduct Authority (FCA), and those not regulated by the FCA are not overseen by the Financial Ombudsman Service. This may mean less legal recourse is available in the case of a dispute.
Smaller amounts of money are available in unsecured loans, allowing businesses to cover slower periods without committing to lengthy repayment terms that are often associated with secured loans.
Disadvantages of an unsecured loan
Businesses with weaker trading positions are less likely to qualify, as the decision on whether to lend is made against indications that repayment will be possible. This decision is more likely to be in favour of the borrower if a reliable guarantor can be found, but the guarantor’s personal assets are at risk and may be taken if the business that originally borrowed is unable to repay.
Because collateral is not offered, interest rates are usually higher. An unsecured loan without a guarantor will feature even higher interest rates, as the absence of a guarantee that the loan will be repaid in case of default means the borrower must further offset the risk.
Fewer unsecured finance products are regulated by the Financial Conduct Authority (FCA), and those not regulated by the FCA are not overseen by the Financial Ombudsman Service. This may mean less legal recourse is available in the case of a dispute.
5. (a) Write explanatory note on : (6+5+5=16)
(i) Options.
-> Options are a type of derivative, and hence their value depends on the value of an underlying instrument. The underlying instrument can be a stock, but it can also be an index, a currency, a commodity or any other security.
Now that we have understood what options are, we will look at what an options contract is. An option contract is a financial contract which gives an investor a right to either buy sell an asset at a pre-determined price by a specific date. However, it also entails a right to buy, but not an obligation.
When understanding option contract meaning, one needs to understand that there are two parties involved, a buyer (also called the holder), and a seller who is referred to as the writer.
When the Chicago Board Options Exchange was set up in 1973, modern options came into being. In India, the National Stock Exchange (NSE) introduced trading in index options on June 4, 2001.
Features of an option contract
1. Premium or down payment: The holder of this type of contract must pay a certain amount called the ‘premium’ for having the right to exercise an options trade. In case the holder does not exercise it, s/he loses the premium amount. Usually, the premium is deducted from the total payoff, and the investor receives the balance.
2. Strike price: This refers to the rate at which the owner of the option can buy or sell the underlying security if s/he decides to exercise the contract. The strike price is fixed and does not change during the entire period of the validity of the contract. It is important to remember that the strike price is different from the market price. The latter changes during the life of the contract.
3. Contract size: The contract size is the deliverable quantity of an underlying asset in an options contract. These quantities are fixed for an asset. If the contract is for 100 shares, then when a holder exercises one option contract, there will be a buying or selling of 100 shares.
4. Expiration date: Every contract comes with a defined expiry date. This remains unchanged until the validity of the contract. If the option is not exercised within this date, it expires.
5. Intrinsic value: An intrinsic value is the strike price minus the current price of the underlying security. Money call options have an intrinsic value.
6. Settlement of an option: There is no buying, selling or exchange of securities when an options contract is written. The contract is settled when the holder exercises his/her right to trade. In case the holder does not exercise his/her right till maturity, the contract will lapse on its own, and no settlement will be required.
7. No obligation to buy or sell: In case of option contracts, the investor has the option to buy or sell the underlying asset by the expiration date. But he is under no obligation to purchase or sell. If an option holder does not buy or sell, the option lapses.
Types of options
Now that it is clear what options are, we will take a look at two different kind of option contracts- the call option and the put option.
Call option
A call option is a type of options contract which gives the call owner the right, but not the obligation to buy a security or any financial instrument at a specified price (or the strike price of the option) within a specified time frame.
To buy a call option one needs to pay the price in the form of an option premium. As mentioned, it is upon the discretion of the owner on whether he wants to exercise this option. He can let the option expire if he deems it unprofitable. The seller, on the other hand, is obliged to sell the securities that the buyer desires. In a call option, the losses are limited to the options premium, while the profits can be unlimited.
Let us understand a call option with the help of an example. Let us say an investor buys a call option for a stock of XYZ company on a specific date at Rs 100 strike price and expiry date is a month later. If the price of the stock rises anywhere above Rs 100, say to Rs 120 on the expiration day, the call option holder can still buy the stock at Rs 100.
If the price of a security is going to rise, a call option allows the holder to buy the stock at a lower price and sell it at a higher price to make profits.
Call options are further of 2 types
In the money call option: In this case, the strike price is less than the current market price of the security.
Out of the money call option: When the strike price is more than the current market price of the security, a call option is considered as an out of the money call option.
Put options
Put options give the option holder the right to sell an underlying security at a specific strike price within the expiration date. This lets investors lock a minimum price for selling a certain security. Here too the option holder is under no obligation to exercise the right. In case the market price is higher than the strike price, he can sell the security at the market price and not exercise the option.
Let us take an example to understand what a put option is. Suppose an investor buys a put option of XYZ company on a certain date with the term that he can sell the security any time before the expiration date for Rs 100. If the price of the share falls to below Rs 100, say to Rs 80, he can still sell the stock at Rs 100. In case the share price rises to Rs 120, the holder of the put option is under no obligation to exercise it.
If the price of a security is falling, a put option allows a seller to sell the underlying securities at the strike price and minimise his risks.
Like call options, put options can further be divided into in the money put options and out of the money put options.
In the money put options: A put option is considered in the money when the strike price is more than the current price of the security.
Out of the money put options: A put option is out of the money if the strike price is less than the current market price.
Advantages of options
Now that we have understood what options are, we will look into some of the advantages of options.
1. Low cost of entry: The first advantage of options is that it allows the investor or trader to take a position with a small amount as compared to stock transactions. If you are buying actual stocks, you have to shell out a large sum of money which would be equal to the price of each stock multiplied into the number of stocks you buy.
The other option is to buy call options of the same stock, which will cost much lower. However, if share prices go up in the way you have predicted, you would benefit just as much in terms of percentage as if you had shelled out money to buy the actual stock. In this case, you would have to pay less out of your pocket but reap the same benefits.
2. Hedging against risks: Options are an excellent way of protecting your stocks portfolio. Buying options is actually like buying insurance for your stock portfolio and minimizing your exposure to risk. If the price of the underlying security for a call option does not rise above the strike price when the option expires, your option becomes useless, and you lose all the money you paid up front. However, the premium you end up paying is the maximum limit of your risk. Otherwise, in the case of the above example, if the price of a security falls to Rs 80 from a strike price of Rs 100, you would have lost Rs 20 per share. With the option, you lose just the premium amount, which is much lower.
3. Flexibility: Options gives the investor the flexibility to trade for any potential movement in an underlying security. As long as the investor has a view regarding how the price of a security will move shortly, he can use an options strategy. If an investor feels that the price of a security is likely to rise, he can buy a call option and fix the price of the security at a certain level. If the price of the underlying security goes up, he can purchase the securities at the strike price and then sell it at the market price to make profits. On the other hand, if an investor feels that the price of a particular security is going to fall, he can buy a put option for a certain strike price. Even if the price of the security falls below the strike price, he can still sell the securities at the strike price and lock a specific price for selling the security. Options thus work in all kinds of market conditions.
Disadvantages of options
Trading in options also come with a set of drawbacks. Let us take a look.
Lower liquidity: One of the most significant disadvantages of options is that they are not liquid as not many people trade in the options market. Due to low liquidity, it is not easy to buy and sell options. This could often mean buying at a higher rate and selling at a lower rate as compared to other more liquid investment options.
Risk: As we have seen that the risk in case of options is limited to the options premium. However, if the movement in the price of the security is not favourable, an investor stands to lose the entire option premium.
Complicated: Options are a complicated investment tool for beginners. Even for some advanced investors, investing in options can be a challenging prospect. One needs to take a call on the price movement of a particular security and the time by which this price movement will occur. Getting both right can be tough.
(ii) Futures.
-> Futures are derivative financial contracts that obligate the parties to transact an asset at a predetermined future date and price. The buyer must purchase or the seller must sell the underlying asset at the set price, regardless of the current market price at the expiration date.
Underlying assets include physical commodities or other financial instruments. Futures contracts detail the quantity of the underlying asset and are standardized to facilitate trading on a futures exchange . Futures can be used for hedging or trade speculation.
Futures—also called futures contracts—allow traders to lock in the price of the underlying asset or commodity . These contracts have expiration dates and set prices that are known upfront. Futures are identified by their expiration month. For example, a December gold futures contract expires in December.
Traders and investors use the term “futures” in reference to the overall asset class. However, there are many types of futures contracts available for trading including:1
· Commodity futures such as crude oil, natural gas, corn, and wheat
· Stock index futures such as the S&P 500 Index
· Currency futures including those for the euro and the British pound
· Precious metal futures for gold and silver
· U.S. Treasury futures for bonds and other products
Pros
· Investors can use futures contracts to speculate on the direction in the price of an underlying asset.
· Companies can hedge the price of their raw materials or products they sell to protect from adverse price movements.
· Futures contracts may only require a deposit of a fraction of the contract amount with a broker.
Cons
· Investors have a risk that they can lose more than the initial margin amount since futures use leverage.
· Investing in a futures contract might cause a company that hedged to miss out on favorable price movements.
· Margin can be a double-edged sword, meaning gains are amplified but so too are losses.
(iii) Swap.
-> A swap is a derivative contract between two parties that involves the exchange of pre-agreed cash flows of two financial instruments. The cash flows are usually determined using the notional principal amount (a predetermined nominal value). Each stream of the cash flows is called a “leg.”
Introduced in the late 1980s, swaps are a relatively new type of derivative. Even though relatively new, their simplicity, coupled with their extensive applications, makes them one of the most frequently traded financial contracts.
Corporate finance professionals may use swap contracts to hedge risk and minimize the uncertainty of certain operations. For example, sometimes projects can be exposed to exchange rate risk and the Company’s CFO may use a currency swap contract as a hedging instrument.
Unlike futures and options, swaps are not traded on exchanges but over-the-counter . In addition, counterparties in swaps are usually companies and financial organizations and not individuals, because there is always a high risk of counterparty default in swap contracts.
Some financial institutions usually participate as the market makers of swap markets. The institutions, which are also known as swap banks, facilitate the transactions by matching counterparties.
Types of Swaps
Modern financial markets employ a wide selection of such derivatives, suitable for different purposes. The most popular types include:
1. Interest rate swap
Counterparties agree to exchange one stream of future interest payments for another, based on a predetermined notional principal amount. Generally, interest rate swaps involve the exchange of a fixed interest rate for a floating interest rate.
2. Currency swap
Counterparties exchange the principal amount and interest payments denominated in different currencies. These contracts swaps are often used to hedge another investment position against currency exchange rate fluctuations.
3. Commodity swap
These derivatives are designed to exchange floating cash flows that are based on a commodity’s spot price for fixed cash flows determined by a pre-agreed price of a commodity. Despite its name, commodity swaps do not involve the exchange of the actual commodity.
4. Credit default swap
A CDS provides insurance from the default of a debt instrument. The buyer of a swap transfers to the seller the premium payments. In case the asset defaults, the seller will reimburse the buyer the face value of the defaulted asset, while the asset will be transferred from the buyer to the seller. Credit default swaps became somewhat notorious due to their impact on the 2008 Global Financial Crisi s
Applications of Swaps
Nowadays, swaps are an essential part of modern finance. They can be used in the following ways:
1. Risk hedging
One of the primary functions of swaps is the hedging of risks. For example, interest rate swaps can hedge against interest rate fluctuations, and currency swaps are used to hedge against currency exchange rate fluctuations.
2. Access to new markets
Companies can use swaps as a tool for accessing previously unavailable markets. For example, a US company can opt to enter into a currency swap with a British company to access the more attractive dollar-to-pound exchange rate, because the UK-based firm can borrow domestically at a lower rate.
(b) Discuss about the emerging derivatives market structure in India. (16)
-> Apart from traditional financial markets, two markets are emerging, namely the derivatives market has come into recently and the banc assurance market, which is like to emerge in an important way once banks start undertaking insurance business derivatives in the Indian financial markets are of recent origin barring trade related forward contracts in the forex market. Futures markets in the commodity segment, however, have existed for a long time. Recently, over-the counter (OTC) as well as exchange traded derivatives have been introduced, marking an important development in the structure of financial markets in India. Forward contracts in the forex market have also been liberalized. Exchange traded derivatives tend is more standardized and offer greater liquidity than OTC contacts, which are negotiated between counterparties and tailored to meet the needs of the parties to the contract. Exchange traded derivatives also offer centralized limits on individual positions and have formal rules for risk and burden sharing.
In India, OTC derivatives, viz. Interest Rate Swaps (IRS) and Forward Rate Agreements (FRAS) were introduced in July 1999, while one exchange trade derivative. Viz, Stock Index. Futures were introduced by the two largest stock exchanges in June 2000. The FRA is an off-balance sheet contract between. two parties under which one party agrees on the start date (or trade date) that on a specified future date (the settlement date) that party, rt, the party that agrees, would lodge a notional deposit with the other for a specified sum of money for a specified period of time (the FRA period) at a specified rate interest (the contract rate) The party that has agreed to make the notional deposit has, thus, sold the FRA to the other party who has bought it. The IRS is a contract between two counterparties for exchanging interest payment for a specified period based on a notional principal amount. The notional principal is used to calculate interest payments but is not exchanged. Only interest payments are exchanged. The IRS and FRA were introduced with a view to deepening the money market as also to enable banks, Primary Dealers and financial institutions to hedge interest rate risks. The IRS has emerged as the more popular of the two instruments in the Indian market, accounting for nearly all of the 928 outstanding deals, amounting to Rs. 12,620 crore of notional principal as on November 17, 2000. The overnight call money rates and the forex forward have emerged as the most popular benchmark rates.
A resident of India who had borrowed foreign exchange in accordance with the FEMA, may enter into an interest rate swap or currency swap o coupon swap or foreign currency option or interest rate cap/collar or Forward Rate Agreement (FRA) contract with an authorized dealer (AD) in India or with a branch outside India of an authorized dealer fro hedging his loan exposure and unwinding from such hedges provided that (1) the contract does not involve rupee, (u) foreign currency borrowing has been duly approved, (ii) the notional principal amount of the hedge does not exceed the outstanding amount of the loan, and (iv) the maturity of the hedge does not exceed the un-expired maturity of the underlying loan. As resident in India can enter legally into a foreign exchange derivative contract without the prior permission of the Reserve Bank. Among the non-residents, while FIls may enter into a forward contract with rupees as one of the currencies with an AD in India, non-resident Indians and Overseas Corporate Bodies could take forward cover with an AD to hedge (1) dividend due on shares held in India, (ii) balances in FCNR (B) and NR (E) A, and (iii) the amount of investment made under portfolio scheme. The Reserve Bank may also consider allowing residents to hedge their commodity price risk (including gold but excluding oil and petroleum products (subject to certain conditions.
This market has emerged as an important segment of the forex market in India in the recent years. It comprises customers, such as, corporates, exporters, importers, and individuals. Authorised Dealers (Ads) and the Reserve Bank. Of late, FIls have emerged as major participants in this segment. The marker operates from major centres with Mumbai accounting for bulk of the transactions. Till February 1992, forward contract were permitted only against trade related exposures and these contract could not be cancelled except where the underlying transactions failed to materialize. In March 1992, in order to provide operational freedom to corporate entitles, unrestricted booking and cancellation of forward contracts for all genutne exposures, whether trade related or not, were permitted. At present, the forward contracts market is active up to six months where two-way quotes are available. The maturity profile has recently elongate with quotes available up 10 one year. With the gradual opening up of the capital account, forward premium is now increasingly getting aligned with the interest rate differential. Importers and exporters also influence the forward market in many ways. Besides, banks are allowed to grant foreign Though the Futures & Options segment provides a nation-wide market, Mumb leads the city-wise distribution of contracts traded at 49.08 per cent followed by Delhi (including Ghaziabad) at 24.38 per cent Kolkata (including Howrah) at 12 per cent, and others accounted for balance share of trading. The others include cities such as Kochi, Erukulam, Parur, Kalamasserry, Always at 2.44 per cent each, Ahmedabad (2.25 per cent), Chennai (2.01 per cent), Hyderabad, Secunderabad and Kukatpally at 1.54 per cent and others at 5.80 per cent.
If there is a winner of the current bull run on the bourses, it is undoubtedly the infantile derivatives segment. In the battle for turnover, the derivatives segment has overshadowed the long-established cash market.
Today, in less than three years, the derivatives segment has only overtaken the traditional cash market, but has also emerged as an ideal hedging mechanism in the equities market. The derivatives market was able to beat the cash market in terms of monthly turnover for the first time in February 2003. Then the derivatives segment of the equity market clocked a total monthly turnover of Rs. 49,395 crore compared with the total cash market’s Rs 48,289 crore. By July 2003 the derivatives segment has recorded a turnover of Rs. 109,850 crore, while the cash market segment has been pushed behind with a turnover of Rs. 78,878 crore. The average daily turnover in the derivatives market has touched Rs. 4,776 crore against the cash market turnover of Rs. 3,429 crore. For the past six months (except in the month of May 2003), the monthly volume in the derivatives segment has been higher than in the cash market.
The growing volume turnover indicates a healthy sign. The derivatives segments has brought in a lot of liquidity and depth to the market, and the mind-boggling turnover statistics of the derivatives segment speak for themselves. But why are derivatives such a big hit in Indian market? Generally, the reasons cited are: (i) The derivatives products-index futures, index options, stock futures and stock options provide a carry forward facility for investors to take a position (bullish or bearish) on an index or a particular stock for period ranging from one to three months; (ii) They provide a substitute for the infamous badla system; (ul) The current daily settlement in the cash market has left no room for speculation. The cash market has turned into a day market, leading to increasing attention to derivatives; (iv) Unlike the cash of full payment or delivery, investors don’t need much funds to buy derivatives products. By paying a small margin, one can take a position in stocks or market index: (v) The derivatives volume is also picking up in anticipation of reductions of contract size and finally everything works in a rising market. Unquestionably, there is also a lot of trading interest in the derivatives market.
Futures are more popular in the Indian market as compared to options. The popularity of stock futures can be traced to their similarity to the earlier badla system of carrying forward of trades. Stock futures encourage speculation in the capital market and with speculation being an integral part of the market; the popularity of the product is not a surprise. Also stock futures have the advantage of giving higher exposure by paying a small margin. Also stock futures product like index futures and stock futures are easy to understand as compared to options product. Options’ being more complicated product is nor very much popular in the market if the compare futures, stock futures are much more population as compared to index futures. Starting off with a measly turnover of Rs. 2,811 crore. in November 2001, the stock futures turnover jumped to Rs. 14,000 crore by March 2002, Rs. 32,752 crore in May 2003 and Rs. 70,515 crore in July 2003 Similarly, index futures started its turnover journey with Rs. 35 crore-figure way back in June 2000. The trading interest picked up steadily and jumped to Rs. 524 crore in March 2001, Rs. 1,309 crore in June 2001, Rs. 2747 crore in February 2002, Rs. 3,500 crore in November 2002 and Rs. 14,743 crore in July 2003. Infact, the stock futures were a hit right from their launch. It is important to note that the Securities & Exchange Board of India introduced stock futures in November 2001 after it launched all the other derivative products and now it accounts for nearly 65% of total volumes. In the month of July alone, stock futures considered to be the riskiest of the lot recorded a turnover of Rs. 70,515 crore followed by stock options, index futures and index options.
However, contrary to international experience, the volumes have been so far low in the Indian derivatives market. SEBI’s Technical Group on New Derivative Products has recently. examined this issue, and made the following recommendations: (i) In order to generate volume, the system of sub-brokers be used for trading in derivatives market; (ii) In order to facilitate free arbitrage between cash and derivatives market, financial institutions and mutual funds may be permitted to short sell in the cash market. Such short sale may, however, be restricted to the extent of corresponding exposure in the derivatives market. Moreover, such transactions can also be permitted through a separate dedicated fund; (iii) Arbitage between cash and futures market will also help in between price discovered in both the markets.
RBI has allowed FIls to trade in derivatives market, subject to the condition that the overall open position of the FII shall not exceed 100 per cent of market value of the concerned FII’s total investment. Managed future funds should be permitted to take position in the derivatives market without having any exposure in the cash market. Also, FIls intending to invest funds in the cash market should also be permitted to take long position in the futures market to hedge their transactions.
SEBI and RBI should jointly examine the issuesconcerning trading in derivatives by Fls and FIls.
In development countries, one important character of insurance business and of long-term life insurance, in particular, is that insurance policies is seen as a possible source of competition for the banking industry, as the insurance industry developes on a competitive basis. There are, however, other considerations, that point to the possible complement rites and synergies between the insurance and banking business.
The most important source of complementarily arises due to the critical role that banks could play in distributing and marketing of insurance products. So, far, direct branch network LIC, GIC and its subsidiaries together with their agents have been instrumental in marketing of insurance products in India. With further simplification of insurance products, however, the vast branch network and the depositor base of commercial banks are expected to play an important role in marketing insurance products over the counter. The eagerness on the part of several banks and NBFCs to enter into insurance business following the opening up of the industry to private participation reflects this emerging process.
The present interest of banks to enter into insurance business also mirrors the global trend. In Europe the synergy between banking and insurance has given rise to the concept of ‘bancasssurance a package of financial services that can fulfill both banking and insurance needs. In France, for example, over half of the insurance products are sold through banks. In the US, banks lease space to insurers and retail products of multiple insurers, in the way the shops sell products. The institutional framework within which this functional overalaps are taking place has been varied floatating of separate insurance companies by banks, banks’ buying stakes in existing insurance companies, and swap of shares and mergers. Insurance companies have also sought to acquire stakes in some banks.
In India, the Reserve Bank, in recognition of the symbiotic relationship between banking and the insurance industries, has identified three routes of banks’ participation in the insurance business, riz, (i) providing fee-based insurance services without risk participation, (ii) investigating in an insurance company for providing infrastructures and services support and (iii) setting up of a separate joint-venture Insurance company with risk participation. The third route, due to its risk aspects, involves compliance to stringent entry norms. Further, the bank has to maintain an ‘arms length’ relationship between its banking business and its insurance outfit. For banks entering into insurance business with risk participation, the prescribed entity (viz. separate joint-venture company) also enables to avoid possible regulatory overlaps between the Reserve Bank and the Government/IRDA. The joint-venture insurance company would be subjected entirely to the IRDA/Government regulations.
Besides commercial banks, rural cooperative credit institutions are also envisaged as an important vehicle for distributing insurance products in under-served rural areas. The Task Force to Study the Co-operative Credit System and Suggest. Measures for its, Strengthening noted that this could have the attendant benefit of portfolio diversification for these institutions.
