What is 'Financial accounting' circulate among creditors and investors).

The content of the

statement includes Revenue, expense, Comprehensive
Scope and importance of Financial Accounting
income and Cost of Goods sold (COGS).
Financial Accounting

Introduction
Balance Sheet
It is a primary responsibility of a registered company to
A balance sheet serves as an evidence of a company’s
review the performances, progress and needs for
credibility. The Contents of this sheet include Assets,
improvement of the firm over a financial year. This helps the
Liabilities and Equity. The assets can either be current or
organization to assess the overall economic condition,
fixed based on their convertibility, tangible or intangible
diagnose and resolve issues at once. This is precisely why
based on the existence and operating or non-operating. The
accounting plays an inevitable role in maintaining the records
Revenues can be current or non-current. The difference
and statistics, concerning the transactions of a company
between the two is that the former is short term like
every year. The status of the expenses, information
interests, loans and the latter is long term like taxes and
management and reports need to be filed promptly to save
bonds. An equity denotes the net value of a company from
confusions and efforts that might be uncalled for, later. The
the stocks and investments. A shareholder’s equity can be
role of a financial Accountant is crucial in such
positive (where assets exceed the liabilities) or negative
documentations.
(where the liabilities exceed the assets).

What is Financial Accounting?

Cashflow Statement
Financial Accounting is the process of documenting,
A Cashflow Statement is a record of liquidity, retained cash
analyzing and reporting every transaction of a business or an
possession and indication of changes in assets, liabilities or
organization, in order to assess the financial health and
equity, if any. There are three sections in this statement
stability of the same. There are a set of guidelines to be
namely, Operating activities, Investments and Financial
followed according to the Financial Accounting Standards
activities.
Board (FASB), US. These are also known as Generally
Accepted Accounting Principles (GAAP), formulated to
provide ease, credibility and uniformity to the accounting
Cashflow of Operating activities records the amount payable
processes across companies.
in wages to the employees, interests, taxes and transactions
regarding the same.

The records of the transactions are done using the Double-

entry method where an amount is entered twice as credit
Cashflow of Investments include the records of transactions
and debit. For example, there is a receipt of a loan of $10000
in purchases of assets or loans, profits and losses made for
dollars from a bank. This gets entered as a credit in the
investing purposes.
account and also marked as the amount payable. Therefore,
a balance of credit and debit is attained.

Financial Activities of Cash flow shows the repayment of

debts, repurchases of stocks, equity and dividends.
Types of Financial Statements

Income Statement
An Income Statement is a document of Revenues, Expenses,
Profits and Losses that large businesses generate in a period
of time. The other names of this documentation are ‘Profit
and Loss statement’, ‘Net Income Statement’ and ‘Statement
of Earnings’. It is crucial in tracking the scopes of growth,
analyzing the highs and lows in data and taking actions to fix
them. An income statement is used internally (among the
directors, managers and employees) and externally (to
Statement of Changes in equity
This document is drafted to assist all the shareholders,
investors to understand and make decisions regarding every
movement in equity. The statement has notes of opening
and closing value of the equity and all the net income,
dividends and changes of owners and accounts that happen
in between. This is also called the ‘Statement of Retained
Earnings’.

Financial Vs Management Accounting
Managerial accounting is the one done in the view of
notifying the managers, directors and authorities of an
organization regarding the everyday operations, present and
future trends in the market, assumptions and plans to be
made for the future. The audience is internal. However,
financial accounting is a documentation of every transaction
for the audience outside the organization as well like
competitors, investor and bankers. It has strict guidelines to
be followed according to GAAP whereas managerial
accounting has no mandatory guidelines.
Types of Financial Accounting
There are two types of accounting that one needs to be
aware of. The first one is the Cash Accounting where the
transaction entered are only recorded upon the receipt of
the cash. There is no clarity if there was any revenue or
expense generated in between. This is applicable only in
small businesses where there is no requirement of any
statement, a few transactions are to be recorded, it has
limited fixed capital and few employees. Though the single-
entry method is easy to maintain and transparent in liquidity,
it is considered to be not accurate and is not accredited by
Companies Act.
The second method is the Accrual Accounting which works
on two principles, revenue recognition and matching
revenue. It records every transaction digitally. The revenue
earned but amount not received will find its place in the
asset account whereas the expense occurred and cash not
paid cases will find their places in the liabilities account. This
is the most accurate and detailed form of accounting
followed by every business operating in a large scale.
Importance of Financial Accounting
Financial accounting is important to track and analyze
performances and transactions of a business over a period of
time.
The transparency and reliability of accounting is crucial in
evaluating management policies and creating budgets.
It is used to compare reports so that stakeholders and
investors can decipher and use the data to make better
decisions in the future.
It provides clarity in internal and external communication
regarding the sources and destinations of finances in the
company.
Which is better in Cash Vs Accrual accounting?
The Accrual method of accounting is more accurate and
detailed whereas the cash method is simple yet misses
details. If the business is getting bigger, it is wise to opt
accrual accounting.
What is the scope of Financial Accounting?
Financial accounting is an inevitable part of business
auditing. Every company or business is mandated to file
statements. It is sure to bring more technological and
analytical advances in the field of accounts.
What is financial accounting definition and example?
Financial Accounting is the process of recording,
summarizing and reporting transactions and revenue-
expense generations in a time period. For example, investors
or sponsors need to verify an account statement before
showing interest in associating with the business. So, it is
important to analyze and report the business transactions to
give and have a better understanding.
What are the principles of Financial accounting?
The principles of financial accounting are objectivity,
recognition of revenue and expense, matching and
consistency.
What is the difference between income statement and
balance sheet?
An income statement is a record of revenue, expense, gains
and losses whereas the balance sheet is that of assets,
liabilities and equity.
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Financial Accounting - concepts and conventions,
classification of accounts
What Is an Accounting Convention?
Accounting conventions are guidelines used to help
companies determine how to record certain business
transactions that have not yet been fully addressed by
accounting standards. These procedures and principles are
not legally binding but are generally accepted by accounting
bodies. Basically, they are designed to promote consistency
and help accountants overcome practical problems that can
arise when preparing financial statements.
KEY TAKEAWAYS
Accounting conventions are guidelines used to help
companies determine how to record business transactions
not yet fully covered by accounting standards.
They are generally accepted by accounting bodies but are
not legally binding.
If an oversight organization sets forth a guideline that
addresses the same topic as the accounting convention, the
accounting convention is no longer applicable.
There are four widely recognized accounting conventions:
conservatism, consistency, full disclosure, and materiality.
Understanding an Accounting Convention
Sometimes, there is not a definitive guideline in the
accounting standards that govern a specific situation. In such
cases, accounting conventions can be referred to.
Accounting is full of assumptions, concepts, standards, and
conventions. Concepts such as relevance, reliability,
materiality, and comparability are often supported by
accounting conventions that help to standardize the financial
reporting process.
In short, accounting conventions serve to fill in the gaps not
yet addressed by accounting standards. If an oversight
organization, such as the Securities and Exchange
Commission (SEC) or the Financial Accounting Standards
Board (FASB) sets forth a guideline that addresses the same
topic as the accounting convention, the accounting
convention is no longer applicable.
1
2
The scope and detail of accounting standards continue to
widen, meaning that there are now fewer accounting
conventions that can be used. Accounting conventions are
not set in stone, either. Instead, they can evolve over time to
reflect new ideas and opinions on the best way to record
transactions.
Accounting conventions are important because they ensure
that multiple different companies record transactions in the
same way. Providing a standardized methodology makes it
easier for investors to compare the financial results of
different firms, such as competing ones operating in the
same sector.
That said, accounting conventions are by no means flawless.
They are sometimes loosely explained, presenting
companies and their accountants with the opportunity to
potentially bend or manipulate them to their advantage.
Accounting Convention Methods
There are four main accounting conventions designed to
assist accountants:
Conservatism: Playing it safe is both an accounting principle
and convention. It tells accountants to err on the side of
caution when providing estimates for assets and liabilities.
That means that when two values of a transaction are
available, the lower one should be favored. The general
concept is to factor in the worst-case scenario of a firm’s
financial future.
Consistency: A company should apply the same accounting
principles across different accounting cycles. Once it chooses
a method it is urged to stick with it in the future, unless it
has a good reason to do otherwise. Without this convention,
investors' ability to compare and assess how the company
performs from one period to the next is made much more
challenging.
Full disclosure: Information considered potentially important
and relevant must be revealed, regardless of whether it is
detrimental to the company.
Materiality: Like full disclosure, this convention urges
companies to lay all their cards on the table. If an item or
event is material, in other words important, it should be
disclosed. The idea here is that any information that could
influence the decision of a person looking at the financial
statement must be included.
Areas Where Accounting Conventions Apply
Accounting conservatism may be applied to inventory
valuation. When determining the reporting value of
inventory, conservatism dictates that the lower of historical
cost or replacement cost should be the monetary value.
Accounting conventions also dictate that adjustments to line
items should not be made for inflation or market value. This
means book value can sometimes be less than market value.
For example, if a building costs $50,000 when it is
purchased, it should remain on the books at $50,000,
regardless of whether it is worth more now.
Estimations such as uncollectible accounts receivables and
casualty losses also use the conservatism convention. If a
company expects to win a litigation claim, it cannot report
the gain until it meets all revenue recognition principles.
However, if a litigation claim is expected to be lost, an
estimated economic impact is required in the notes to the
financial statements. Contingent liabilities such as royalty
payments or unearned revenue are to be disclosed, too.
Rules and principles governing Double Entry Book-keeping
system
A double-entry bookkeeping system is where a
corresponding entry is made for every transaction, i.e. debits
and credits. The basis of the double-entry bookkeeping
system is that every transaction has two parts and affects
two ledger accounts. The double-entry system of
bookkeeping deals with two or more accounts for every
business transaction.
For example, if a company enters into a transaction of
borrowing money from a bank, there will be two entries as
an asset and a liability. This is because it will increase the
assets for the cash balance account and also increase the
liability for the loan payable account.
Thus, all financial transactions have an opposite and equal
entry in at least two different accounts. The double-entry
system of bookkeeping is widely used, and it includes
detailed descriptions of the services and products, expenses,
income, bad debt, loans, etc.
One of the fundamental equations of accounting is – Assets =
Liability + Equity. The total of both sides of the equation
should be the same. If the total assets are not equal to the
total liabilities plus capital, then there is a mistake in the
books of accounts. Thus, every transaction has two entries,
and if the liabilities increase, then the assets must also
increase for the books to be balanced.
Principles of Double-Entry System of Bookkeeping
The principles to be followed while recording the double-
entry system of bookkeeping are as follows:
Debit is written to the left, credit on the right
Every debit must have a corresponding credit
Debit receives the benefit, and credit gives the benefit
There are rules to be kept in mind while posting the double-
entry transactions in the bookkeeping process. The following
are the rules for the different types of accounts:
For Personal Accounts: Debit the receiver, credit the giver
For Real Account: Debit what comes in, credit what goes out
For Nominal Account: Debit all the expenses, credit all the
incomes
Personal Accounts are general ledger accounts related to
persons like individuals, associations and firms. The Real
Accounts are general ledger accounts connected with assets
and liabilities other than individuals and people. The
Nominal Accounts are general ledger accounts relating to all
expenses, incomes, gains and losses.
Journal Entries of Double-Entry System of Bookkeeping
Every transaction entered in a journal involves a debit entry
in one account and a credit entry in another account. Thus,
every transaction should be recorded in two accounts. The
transaction recorded in two accounts reflect the debit in the
account that receives value and credit in the other account
that has given value.
The main rule for the double-entry system entry is ‘debit the
receiver and credit the giver’. The debit entry for a
transaction will be on the left side of the general journal,
while the credit entry will be on the right side of the journal.
The total of debits and credits should be equal for the
transactions to be balanced.
The following table shows an example of the double-entry of
transactions in a journal.
Advantages of Double-Entry System of Bookkeeping
Every business needs to have a bookkeeping system. Though
small companies might opt for a single-entry system of
bookkeeping, it is necessary for the companies with more
than one employee or that has debts, inventory or several
accounts to have a double-entry bookkeeping system. The
advantages of the double-entry system of bookkeeping are
as follows:
Complete financial picture
The business whose transactions are huge should maintain a
double-entry bookkeeping system. This is because double-
entry bookkeeping helps to prepare crucial financial reports
like an income statement and balance sheet. It gives
complete information about all the transactions compared to
the single-entry system, as every transaction consists of a
source and destination.
Better financial decisions
The double-entry system helps companies maintain their
accounts in detail, which helps control the business. In
addition, it shows how profitable and financially strong
various parts of the business are and thus helps to make
better financial decisions.
The detailed records of accounts maintained under the
double-entry system can also be used for comparison
purposes. The details of the previous year can be compared
with the details of the current year, and any deviations found
during comparison can be worked on.
Reduces bookkeeping errors
The assets and liabilities plus equity in the balance sheet of
the double-entry bookkeeping system should be equal. If
they are not equal, the entries in the books are wrong and
indicate that the journal entries are wrong. Thus, the double-
entry system ensures accuracy in the books of accounts and
the final balance sheet. In addition, it helps accountants to
reduce mistakes by being accurate.
Preferred by statutory bodies and banks
The double-entry system is more transparent and complete.
It helps businesses to gain investors and obtain credit easily.
The reports prepared by the double-entry system of
bookkeeping allow banks and investors to get a complete
and accurate picture of the business’s financial health. The
Income Tax Department prefers this system of bookkeeping.
The statutory bodies governing businesses such as Registrar
of Companies, SEBI, RBI, etc., also accept the double-entry
system of bookkeeping.
Journal, Ledger ,
A journal is a chronological (arranged in order of time) record
of business transactions. A journal entry is the recording of a
business transaction in the journal. A journal entry shows all
the effects of a business transaction as expressed in debit(s)
and credit(s) and may include an explanation of the
transaction. A transaction is entered in a journal before it is
entered in ledger accounts. Because each transaction is
initially recorded in a journal rather than directly in the
ledger, a journal is called a book of original entry.
A ledger (general ledger) is the complete collection of all the
accounts and transactions of a company. The ledger may be
in loose-leaf form, in a bound volume, or in computer
memory. The chart of accounts is a listing of the titles and
numbers of all the accounts in the ledger. The chart of
accounts can be compared to a table of contents. The groups
of accounts usually appear in this order: assets, liabilities,
equity, dividends, revenues, and expenses. Think of the chart
of accounts as a table of contents of a textbook. It provides
direction as to what exactly will be found in the financial
statement preparation.
Individual accounts are in order within the ledger. Each
account typically has an identification number and a title to
help locate accounts when recording data. For example, a
company might number asset accounts, 100-199; liability
accounts, 200-299; equity accounts, 300-399; revenue
accounts, 400-499; and expense accounts, 500-599. We use
this numbering system in this text. The uniform chart of
accounts used in the first 11 chapters appears in a separate
file at the end of the text. You should print that file and keep
it handy for working certain problems and exercises.
Companies may use other numbering systems. For instance,
sometimes a company numbers its accounts in sequence
starting with 1, 2, and so on. The important idea is that
companies use some numbering system.
A trial balance is a listing of all accounts (in this order: asset,
liability, equity, revenue, expense) with the ending account
balance. It is called a trial balance because the information
on the form must balance. We will illustrate this later in the
chapter.
Steps in recording business transactions
Source documents, such as bills received from suppliers for
goods or services received, bills sent to customers for goods
sold or services performed, and cash register tapes provide
the evidence that a business transaction occurred. After
recognizing a business event as a business transaction, we
analyze it to determine its increase or decrease effects on
the assets, liabilities, equity, dividends, revenues, or
expenses of the business. Then we translate these increase
or decrease effects into debits and credits.
The information in the source document serves as the basis
for preparing a journal entry. Then a firm posts (transfers)
that information to accounts in the ledger.
What Is a Cash Book?
A cash book is a financial journal that contains all cash
receipts and disbursements, including bank deposits and
withdrawals. Entries in the cash book are then posted into
the general ledger.
1
KEY TAKEAWAYS
A cash book is a subsidiary of the general ledger in which all
cash transactions during a period are recorded.
The cash book is recorded in chronological order, and the
balance is updated and verified on a continuous basis.
Larger organizations usually divide the cash book into two
parts: the cash disbursement journal and the cash receipts
journal.
A cash book differs from a cash account in that it is a
There are numerous reasons why a business might record
transactions using a cash book instead of a cash account.
Daily cash balances are easy to access and determine.
Mistakes can be detected easily through verification, and
entries are kept up to date, as the balance is verified daily. By
contrast, balances in cash accounts are commonly reconciled
at the end of the month after the issuance of the monthly
bank statement.
Recording in a Cash Book
All transactions in a cash book have two sides: debit and
credit. All cash receipts are recorded on the left-hand side as
a debit, and all cash payments are recorded by date on the
right-hand side as a credit. The difference between the left
and right sides shows the balance of cash on hand, which
should be a net debit balance if cash flow is positive.
The cash book is set up in columns. There are three common
versions of the cash book: single column, double column,
and triple column. The single-column cash book shows only
receipts and payments of cash. The double-column cash
book shows cash receipts and payments as well as details
about bank transactions. The triple column cash book shows
all of the above plus information about purchase or sales
discounts.
A typical single column cash book will have these four
column headers: “date,” “description,” “reference” (or “folio
number”), and “amount.” These headers are present for
both the left side showing receipts and the right side
showing payments. The date column is the date of the
transaction.
Preparation of financial statement and Profit & Loss Account,
The accounting process ends with the preparation of the
financial statement. The information about the financial
position of any company is provided with the help of
Financial Statements. The main objective of preparing the
3. Cost of Materials Consumed:
financial statement is to present a true and fair view of the
financial performance and position. Accounting data is Cost of Materials Consumed = Opening Stock of Materials +
summarised in such a way that the profitability of the Net Purchases – Closing Stock of Materials
business is clearly visible. Financial Statements also serve as
an information tool for all the parties concerned with the
firm. To guarantee consistency in reporting, these 4. Purchases of Stock-in-Trade:
statements; which include an income statement, balance
sheet, and statement of cash flows, must be prepared in The Purchases of Stock-in-Trade consist of Net Purchases.
accordance with predetermined and established accounting
principles and conventions.
5. Changes in Inventories of Finished Goods, Work-in-
Progress, and Stock-in-Trade:
What is Profit and Loss Account? Changes in Inventories of Finished Goods, Work-in-Progress,
It is a financial statement of an organization that helps in and Stock-in-Trade = Opening Stock – Closing Stock
determining the loss incurred or profit earned by the
business during the financial or accounting year. In simple
terms, Profit and Loss Account is a summary of an
organization’s expenses and revenues and ultimately
calculates the net figure of the business in terms of profit or
loss. If the revenues of an organization are more than its 6. Employee Benefit Expenses:
expenses, it is known as Net Profit. However, if the revenues
It consists of Wages, Salaries, Staff Welfare Expenses like
of an organization are less than its expenses, it is known as
Canteen Expenses, and Contributions of Provident Fund, and
Net Loss. The Profit and Loss Account collects information
other staff welfare funds.
from Trial Balance and other given transactions.

7. Depreciation and Amortisation Expenses:

Format of Profit and Loss Account:
It consists of depreciation and amortisation expenses of the
company.

8. Finance Costs:
General instructions for preparation of Profit and Loss
Finance Cost is the amount of interest paid by the company
Account:
on its borrowings.
1. Revenue from Operations:

The revenue earned from business operations comes under

Revenue from Operations. For example, Net Sales, Sale of
Scrap, Trading Commission Received, and Revenue from
Services.
2. Other Income:
The revenue that is not earned from business operations
comes under Other Income. It is classified under three
categories; viz., Rent Received, Interest and Dividend
Received, and Net Gain/Loss on the Sale of Investments.
9. Other Expenses:
Other expenses consist of expenses other than the ones that
are mentioned above. For example, Telephone Expenses,
Selling and Distribution Expenses, Rent and Taxes, Loss on
Sale of Fixed Assets/Investments, Advertisement Expenses,
Bad Debts, Provision for Bad and Doubtful Debts, and Cash
Discount Allowed.
In short, the balance sheet is a financial statement that
provides a snapshot of what a company owns and owes, as
well as the amount invested by shareholders. Balance sheets
can be used with other important financial statements to
conduct fundamental analysis or calculate financial ratios.
KEY TAKEAWAYS
A balance sheet is a financial statement that reports a
company's assets, liabilities, and shareholder equity.
The balance sheet is one of the three core financial
statements that are used to evaluate a business.
It provides a snapshot of a company's finances (what it owns
and owes) as of the date of publication.
The balance sheet adheres to an equation that equates
assets with the sum of liabilities and shareholder equity.
Fundamental analysts use balance sheets to calculate
financial ratios.
1:10
An Introduction To The Balance Sheet
How Balance Sheets Work
The balance sheet provides an overview of the state of a
company's finances at a moment in time. It cannot give a
sense of the trends playing out over a longer period on its
own. For this reason, the balance sheet should be compared
with those of previous periods.
1 sheet. The assets should always equal the liabilities and
Investors can get a sense of a company's financial wellbeing
by using a number of ratios that can be derived from a
balance sheet, including the debt-to-equity ratio and the
acid-test ratio, along with many others. The income
statement and statement of cash flows also provide valuable
context for assessing a company's finances, as do any notes
or addenda in an earnings report that might refer back to the
balance sheet.
1 vary widely by industry, and the same terms can have
The balance sheet adheres to the following accounting
equation, with assets on one side, and liabilities plus
shareholder equity on the other, balance out:
Assets
=
Liabilities
+
Shareholders’ Equity
Assets=Liabilities+Shareholders’ Equity
This formula is intuitive. That's because a company has to
pay for all the things it owns (assets) by either borrowing
money (taking on liabilities) or taking it from investors
(issuing shareholder equity).
If a company takes out a five-year, $4,000 loan from a bank,
its assets (specifically, the cash account) will increase by
$4,000. Its liabilities (specifically, the long-term debt account)
will also increase by $4,000, balancing the two sides of the
equation. If the company takes $8,000 from investors, its
assets will increase by that amount, as will its shareholder
equity. All revenues the company generates in excess of its
expenses will go into the shareholder equity account. These
revenues will be balanced on the assets side, appearing as
cash, investments, inventory, or other assets.
Balance sheets should also be compared with those of other
businesses in the same industry since different industries
have unique approaches to financing.
Special Considerations
As noted above, you can find information about assets,
liabilities, and shareholder equity on a company's balance
shareholder equity. This means that the balance sheet
should always balance, hence the name. If they don't
balance, there may be some problems, including incorrect or
misplaced data, inventory or exchange rate errors, or
miscalculations.
1
Each category consists of several smaller accounts that break
down the specifics of a company's finances. These accounts
different implications depending on the nature of the
business. But there are a few common components that
investors are likely to come across.
What Does a Company Balance Sheet Tell You?
Theresa Chiechi {Copyright} Investopedia, 2019.
Components of a Balance Sheet
Assets
Accounts within this segment are listed from top to bottom
in order of their liquidity. This is the ease with which they can
be converted into cash. They are divided into current assets,
which can be converted to cash in one year or less; and non-
current or long-term assets, which cannot.
Here is the general order of accounts within current assets:
Cash and cash equivalents are the most liquid assets and can
include Treasury bills and short-term certificates of deposit,
as well as hard currency.
Marketable securities are equity and debt securities for
which there is a liquid market.
Accounts receivable (AR) refer to money that customers owe
the company. This may include an allowance for doubtful
accounts as some customers may not pay what they owe.
Inventory refers to any goods available for sale, valued at the
lower of the cost or market price.
Prepaid expenses represent the value that has already been
paid for, such as insurance, advertising contracts, or rent.
Long-term assets include the following:
Long-term investments are securities that will not or cannot
be liquidated in the next year.
Fixed assets include land, machinery, equipment, buildings,
and other durable, generally capital-intensive assets.
Intangible assets include non-physical (but still valuable)
assets such as intellectual property and goodwill. These
assets are generally only listed on the balance sheet if they
are acquired, rather than developed in-house. Their value
may thus be wildly understated (by not including a globally
recognized logo, for example) or just as wildly overstated.
Liabilities
A liability is any money that a company owes to outside
parties, from bills it has to pay to suppliers to interest on
bonds issued to creditors to rent, utilities and salaries.
Current liabilities are due within one year and are listed in
order of their due date. Long-term liabilities, on the other
hand, are due at any point after one year.
Current liabilities accounts might include:
Current portion of long-term debt is the portion of a long-
term debt due within the next 12 months. For example, if a
company has a 10 years left on a loan to pay for its
warehouse, 1 year is a current liability and 9 years is a long-
term liability.
Interest payable is accumulated interest owed, often due as
part of a past-due obligation such as late remittance on
property taxes.
Wages payable is salaries, wages, and benefits to employees,
often for the most recent pay period.
Customer prepayments is money received by a customer
before the service has been provided or product delivered.
The company has an obligation to (a) provide that good or
service or (b) return the customer's money.
Dividends payable is dividends that have been authorized for
payment but have not yet been issued.
Earned and unearned premiums is similar to prepayments in
that a company has received money upfront, has not yet
executed on their portion of an agreement, and must return
unearned cash if they fail to execute.
Accounts payable is often the most common current liability.
Accounts payable is debt obligations on invoices processed
as part of the operation of a business that are often due
within 30 days of receipt.
Long-term liabilities can include:
Long-term debt includes any interest and principal on bonds
issued
Pension fund liability refers to the money a company is
required to pay into its employees' retirement accounts
Deferred tax liability is the amount of taxes that accrued but
will not be paid for another year. Besides timing, this figure
reconciles differences between requirements for financial
reporting and the way tax is assessed, such as depreciation
calculations.
Some liabilities are considered off the balance sheet,
meaning they do not appear on the balance sheet.
Shareholder Equity
Shareholder equity is the money attributable to the owners
of a business or its shareholders. It is also known as net
assets since it is equivalent to the total assets of a company
minus its liabilities or the debt it owes to non-shareholders.

Retained earnings are the net earnings a company either
reinvests in the business or uses to pay off debt. The
remaining amount is distributed to shareholders in the form
of dividends.
Treasury stock is the stock a company has repurchased. It can
be sold at a later date to raise cash or reserved to repel a
hostile takeover.
Some companies issue preferred stock, which will be listed
separately from common stock under this section. Preferred
stock is assigned an arbitrary par value (as is common stock,
in some cases) that has no bearing on the market value of
the shares. The common stock and preferred stock accounts
are calculated by multiplying the par value by the number of
shares issued.
Additional paid-in capital or capital surplus represents the
amount shareholders have invested in excess of the common
or preferred stock accounts, which are based on par value
rather than market price. Shareholder equity is not directly
related to a company's market capitalization. The latter is
based on the current price of a stock, while paid-in capital is
the sum of the equity that has been purchased at any price.
Par value is often just a very small amount, such as $0.01.
2 drawbacks. Because it is static, many financial ratios draw on
Importance of a Balance Sheet
Regardless of the size of a company or industry in which it
operates, there are many benefits of a balance sheet,
Balance sheets determine risk. This financial statement lists
everything a company owns and all of its debt. A company
will be able to quickly assess whether it has borrowed too
much money, whether the assets it owns are not liquid
enough, or whether it has enough cash on hand to meet
current demands.
Balance sheets are also used to secure capital. A company
usually must provide a balance sheet to a lender in order to
secure a business loan. A company must also usually provide
a balance sheet to private investors when attempting to
secure private equity funding. In both cases, the external
party wants to assess the financial health of a company, the
creditworthiness of the business, and whether the company
will be able to repay its short-term debts.
Managers can opt to use financial ratios to measure the
liquidity, profitability, solvency, and cadence (turnover) of a
company using financial ratios, and some financial ratios
need numbers taken from the balance sheet. When analyzed
over time or comparatively against competing companies,
managers can better understand ways to improve the
financial health of a company.
Last, balance sheets can lure and retain talent. Employees
usually prefer knowing their jobs are secure and that the
company they are working for is in good health. For public
companies that must disclose their balance sheet, this
requirement gives employees a chance to review how much
cash the company has on hand, whether the company is
making smart decisions when managing debt, and whether
they feel the company's financial health is in line with what
they expect from their employer.
Limitations of a Balance Sheet
Although the balance sheet is an invaluable piece of
information for investors and analysts, there are some
data included in both the balance sheet and the more
dynamic income statement and statement of cash flows to
paint a fuller picture of what's going on with a company's
business. For this reason, a balance alone may not paint the
full picture of a company's financial health.
A balance sheet is limited due its narrow scope of timing.
The financial statement only captures the financial position
of a company on a specific day. Looking at a single balance
sheet by itself may make it difficult to extract whether a
company is performing well. For example, imagine a
company reports $1,000,000 of cash on hand at the end of
the month. Without context, a comparative point,
knowledge of its previous cash balance, and an
understanding of industry operating demands, knowing how
much cash on hand a company has yields limited value.
Different accounting systems and ways of dealing with
depreciation and inventories will also change the figures
posted to a balance sheet. Because of this, managers have
some ability to game the numbers to look more favorable.
Pay attention to the balance sheet's footnotes in order to
determine which systems are being used in their accounting
and to look out for red flags.
Last, a balance sheet is subject to several areas of
professional judgement that may materially impact the
report. For example, accounts receivable must be continually
assessed for impairment and adjusted to reflect potential
uncollectible accounts. Without knowing which receivables a
company is likely to actually receive, a company must make
estimates and reflect their best guess as part of the balance
sheet.
Example of a Balance Sheet
The image below is an example of a comparative balance
sheet of Apple, Inc. This balance sheet compares the
financial position of the company as of September 2020 to
the financial position of the company from the year prior.
Apple Balance Sheet
Apple Balance Sheet.
In this example, Apple's total assets of $323.8 billion is
segregated towards the top of the report. This asset section
is broken into current assets and non-current assets, and
each of these categories is broken into more specific
accounts. A brief review of Apple's assets shows that their
cash on hand decreased, yet their non-current assets
increased.
This balance sheet also reports Apple's liabilities and equity,
each with its own section in the lower half of the report. The
liabilities section is broken out similarly as the assets section,
with current liabilities and non-current liabilities reporting
balances by account. The total shareholder's equity section
reports common stock value, retained earnings, and
accumulated other comprehensive income. Apple's total
liabilities increased, total equity decreased, and the
combination of the two reconcile to the company's total
assets.
Why Is a Balance Sheet Important?
The balance sheet is an essential tool used by executives,
investors, analysts, and regulators to understand the current
financial health of a business. It is generally used alongside
the two other types of financial statements: the income
statement and the cash flow statement.
Balance sheets allow the user to get an at-a-glance view of
the assets and liabilities of the company. The balance sheet
can help users answer questions such as whether the
company has a positive net worth, whether it has enough
cash and short-term assets to cover its obligations, and
whether the company is highly indebted relative to its peers.
What Is Included in the Balance Sheet?
The balance sheet includes information about a company’s
assets and liabilities. Depending on the company, this might
include short-term assets, such as cash and accounts
receivable, or long-term assets such as property, plant, and
equipment (PP&E). Likewise, its liabilities may include short-
term obligations such as accounts payable and wages
payable, or long-term liabilities such as bank loans and other
debt obligations.
Who Prepares the Balance Sheet?
Depending on the company, different parties may be
responsible for preparing the balance sheet. For small
privately-held businesses, the balance sheet might be
prepared by the owner or by a company bookkeeper. For
mid-size private firms, they might be prepared internally and
then looked over by an external accountant.
Public companies, on the other hand, are required to obtain
external audits by public accountants, and must also ensure
that their books are kept to a much higher standard. The
balance sheets and other financial statements of these
companies must be prepared in accordance with Generally
Accepted Accounting Principles (GAAP) and must be filed
regularly with the Securities and Exchange Commission (SEC).
3
What Are the Uses of a Balance Sheet?
A balance sheet explains the financial position of a company
at a specific point in time. As opposed to an income
statement which reports financial information over a period
of time, a balance sheet is used to determine the health of a Turnover indicates how effectively a firm manages resources
company on a specific day. at its disposal to generate sales.

Profitability indicates the efficiency with which a firm

manages resources.
A bank statement is often used by parties outside of a
company to gauge the company's health. Banks, lenders, and Debt indicates the extent to which a firm is financed by debt.
other institutions may calculate financial ratios off of the
Liquidity Ratios
balance sheet balances to gauge how much risk a company
carries, how liquid its assets are, and how likely the company Click below to read more about the common liquidity ratios:
will remain solvent.

The current ratio

A company can use its balance sheet to craft internal
decisions, though the information presented is usually not as The quick ratio
helpful as an income statement. A company may look at its Turnover Ratios
balance sheet to measure risk, make sure it has enough cash
on hand, and evaluate how it wants to raise more capital Click below to read more about the common turnover ratios:
(through debt or equity).

Inventory turnover ratio

What Is the Balance Sheet Formula? Asset turnover ratio
A balance sheet is calculated by balancing a company's Profitability Ratios
assets with its liabilities and equity. The formula is: total
assets = total liabilities + total equity. Click below to read more about the common profitability
ratios:

Total assets is calculated as the sum of all short-term, long-

term, and other assets. Total liabilities is calculated as the Profit margin ratio
sum of all short-term, long-term and other liabilities. Total
Gross profit margin ratio
equity is calculated as the sum of net income, retained
earnings, owner contributions, and share of stock issued. Debt Ratios
=========================================
Click below to read more about the common debt ratios:
Classification of Ratios

One of the ways in which financial statements can be put to

work is through ratio analysis. Ratios are simply one number
divided by another; as such they may or may not be
meaningful. In finance, ratios are usually two financial
statement items that may be related to one another and may
provide the prudent user a good deal of information.
Of the myriad of ratios that could be generated, some will be
more meaningful than others. Generally, ratios are divided
into four areas of classification that provide different kinds of
information: liquidity, turnover, profitability, and debt.
Debt to equity
Evaluations
Remember, ratios are just one number divided by another
and as such really don’t mean much. The trick is in the way
ratios are analyzed and used by the decision-maker. A good
strategy is to compare ratios to some sort of benchmark,
such as industry averages, to what a company has done in
the past, or both.
Comparisons

Once ratios are calculated, an analyst needs some

Liquidity ratios indicate a firm’s ability to meet its maturing benchmarks to find out where the company stands at that
short-term obligations. particular point. Useful benchmarks are industry
comparisons and company trends.

It may be useful to compare a company to certain industry
averages to get a feel for how the company is performing. In
this case, it is necessary to obtain industry performance
measures. There are a number of sources for industry
figures.
Commercial Sources – A number of companies publish
information on industry comparisons. Among these sources
are private credit reporting agencies such as Dun &
Bradstreet and RMA – The Risk Management Association.
Rating agencies such as Moody’s and Standard & Poor’s also
provide industry information.
Government Sources – There are a number of government
sources of helpful industry information, such as the U.S.
Industrial Outlook and Quarterly Financial Reports.
Trade Associations – Many industries have trade associations
or industry groups that regularly publish information for and
about members.
This overview was developed by Dr. Sharon Garrison.
No adaptation of its content is permitted without
permission.
Finance is the lifeline of every business as it helps in the
overall conduct, growth, and expansion of a business. It is
next to impossible to conduct a business without finance.
Therefore, it is imperative and unavoidable to thoroughly
understand the working of business finance. In the
subsequent sections of this article, we’ll cover – what is
business finance, what is financial management, and various
other aspects of business finance.
Meaning of Business Finance
Business finance is the cornerstone of every organization. It
refers to the corpus of funds and credit employed in a
business. Business finance is required for purchasing assets,
goods, raw materials and for performing all other economic
activities. Precisely, it is required for running all the business
operations.
To understand what business finance is, we must know that
business finance includes activities concerning the
acquisition and conservation of capital funds for meeting an
organization’s financial needs and objectives. The importance
of business finance is evident from the fact that business
finance is required to undertake every business operation
successfully.
The amount of capital that is pooled by a business owner
into their company is often not enough to meet the financial
needs of a company. Herein, the importance of business
finance and its management rises even more. Consequently,
business owners along with their teams look out for various
other ways to generate funds.
A business may require additional funds for anything ranging
from buying plant or apparatus, raw materials or further
development. Different types of business finance are:
Fixed Capital
Working Capital
Diversification
Technology upgrading
Importance of Business Finance
Here are some reasons why business finance is important for
all organizations:
Maximization of wealth
Business finance ensures that a shareholder’s wealth is
maximized. It is also important to understand that wealth
maximization is different from profit maximization. Wealth
maximization is holistic and ensures the growth of an
organization.
Ensure constant availability of money
For any business to survive, it should be in optimum financial
condition. This includes the availability of funds at the time
they are needed. Unless there are enough funds, the
business may not be able to function properly.
Attaining optimum capital structure
This requires a perfect combination of shares and
debentures. This way the organization will be able to
maintain a perfect balance and not give away too much
equity.
Effective utilization of funds
This is another reason for the high importance of business
finance and its efficient utilization. A business should be able
to cut down unnecessary costs and not invest funds in assets
that are not required. An exhaustive course in financial
management, diploma in banking and finance or any other
course related to finance can give your career in financial
management a head start. Or, if you are already in the field,
it can give your career the necessary boost.
What is Financial Management in Businesses?
Now that you know all about what business finance is and its
importance, it’ll be easier for you to understand financial
management.
Financial management can be defined as the activities
involving planning, raising, controlling, and administering
money that is used in the business. Financial management
involves procuring funds for buying fixed assets, raw
materials, and working capital. Now that we know what
financial management is, it is also important to understand
that proper financial management helps businesses supply
better products and services to customers besides offering
other benefits.
Goals & objectives of financial management
Objectives of Financial Management
A financial manager is responsible for making the decisions
to bring effective financial management to the organization.
His/her decisions should be gainful for the shareholders as
well as the company. So the decisions which increase the
value of the share in the market are considered to be good
and fruitful. Increased value of shares fulfills many other
objectives also but it does not means that the manager
should use manipulative activities to raise the prices of the
shares. This boom must come with the growth of the
organization, with the increase in profits, and with the
satisfaction of all the parties which are directly or indirectly
associated with the firm.
Some of the prime objectives of financial management are as
follows:
1. Profit Maximization
A business is set up with the main aim of earning huge
profits. Hence, it is the most important objective of financial
management. The finance manager is responsible to achieve
optimal profit in the short run and long run of the business.
The manager must be focused on earning more and more
profit. For this purpose, he/she should properly use various
methods and tools available.
Objectives of Financial Management
2. Wealth Maximization
Shareholders are the actual owners of the company. Hence,
the company must focus on maximizing the value or wealth
of shareholders. The finance manager should try to distribute
maximum dividends among the shareholders to keep them
happy and to improve the goodwill of the company in the
financial market. The declaration of dividend and payout
policy is decided with the help of financial management. A
proper dividend policy related to the declaration of dividends
or retaining the company's profit for future growth and
development is part of dividend decisions. But this is based
on the performance of the company and the amount of
profit earned. Better performance means a higher value of
shares in the financial market. In nutshell, the finance
manager focuses on maximizing the value of shareholders.
Objectives of Financial Management
3. Maintenance of Liquidity
With the help of proper financial management, the manager
can easily monitor the regular supply of liquidity in the
company. But it is not as easy as it sounds. To maintain the
proper cash flow, the manager must keep an eye over all the
inflows and outflows of money to reduce the risk of
underflow and overflow of cash. The finance manager is
responsible to maintain an optimal level of liquidity in the
organization. Healthy cash flow means a higher possibility of
survival and success of the business. Because it helps the
business to deal with uncertainty, timely payment of dues,
getting cash discounts, making day-to-day payments without
delays, etc.
Objectives of Financial Management
4. Proper Estimation of Financial Requirements
Financial management also helps the finance manager in
estimating the proper financial needs of the company. This
means the estimations related to the requirement of capital
to start or run a business, the need for fixed and working
capital of the company, etc., can be done with effective
management of finance. If this management will not be
present in the company then there will be a higher possibility
of having a shortage or surplus of finance. For this
estimation, a financial manager checks various factors like
9. Creating Reserves
the technology used by the organization, the number of
employees working, the scale of operations, and the legal The business environment is full of uncertainty such as
requirements of the company to run its business. sudden changes in customers' preferences, climate change,
natural calamity, change in technology, etc. To overcome
such unplanned issues, the company should have a sufficient
5. Proper Mobilization amount in the form of reserves. The company can create
reserves over the year by having an optimal dividend payout
Financial management helps in the effective utilization of
policy. The company should also keep some part of profits in
sources of finance. It means without wasting them and
the form of reserves. The reserves are not only helpful in
getting the maximum benefit from the available resources.
dealing with unwanted situations but also to expand the
The finance manager is responsible for managing the
business and face contingencies in the future. This benefit
different sources of funds such as shares, debentures, bonds,
can only be taken if the company has effective management
loans, etc. So, after estimating the financial requirements,
of finance.
the manager must decide which source of the funds he/she
should use to avail the maximum benefit.

Objectives of Financial Management

6. Proper Utilization of Financial Resources 10. Decreases the Cost of Capital

With proper financial management, the organization can
make optimum utilization of financial resources. To achieve
this, a financial manager has various tools that he/she can
use. They include managing receivables, better management
of inventory, and effective payment policy in hand. This will
not only save the finance of the organization but will also
reduce the wastage of other resources.
This objective includes measuring the cost of capital, risk
evaluation, and calculating the approximate profits out of a
particular project. Financial managers are responsible for the
effective investments of available funds in the current or
fixed assets to get the maximum benefits or ROI.
Objectives of Financial Management

11. Decreases Operating Risk

Objectives of Financial Management
7. Improved Efficiency
Financial management is also beneficial in increasing the
efficiency of all sections and departments of the
organization. If the finance is effectively distributed to all the
departments then they will work efficiently. It will support
the company to achieve its targets easily which will be
further helpful for the growth of the entire company.
There are lots of risks and uncertainties that a financial
manager has to face in the day-to-day operations of the
business. Financial management helps in reducing these
issues and gives the solutions to deal with the problems. It
can avoid the high-risk allocation of capital for the expansion
and growth of the business. Other than this, FM also tells
how the decisions can be taken with a proper consultancy.

12. Balanced Structure

Objectives of Financial Management
Financial management also provides a balanced capital
8. Meeting Financial Commitments with Creditors structure to the company. In other words, it brings a proper
balance between the various sources of capital such as loans,
Financial management is helpful in the timely payment of
equity, bonds, retained earnings, etc. This balance is required
dues to the creditors. The financial manager can list out the
for flexibility, liquidity, and stability in the organization as
creditors, their due amount, and due date from the financial
well as the economy.
accounts and can make their payments on time. This will
increase the goodwill of the company in the market and
creditors will also provide the goods to the company on
13. Developing Financial Scenarios
credit without having any problem. So, if there will be strong
management of finance then the company will be able to
meet the financial commitments with creditors easily.
With the help of financial management, financial scenarios
can be developed. It can be done by forecasts and the
current state of the company. But for this purpose, the
financial manager has to assume a wide range of possible
outcomes as per the current and future market conditions.
14. Measure Your Success
The prime motive of any organization is to earn huge profits.
So, we can say that the success of a company is based on its
revenue. Financial management not only helps in earning
more revenue but also in measuring the success of the
company. With proper financial reports or accounts, the
organization can compare its current year's performance
with the previous year's performance.
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Objectives of Financial Management
Other than this, the financial manager can also compare the
performance of the organization with the performance of the
competitors in the market. Such information motivates the
management team as well as all the employees to work
harder for the company's growth.
15. Optimizing Marketing Activities
Marketing plays a huge role in the revenue of a firm. A
company advertises its products or services through different
means of marketing. But marketing is a department that
demands more funds. So, before investing in any advertising
campaign, it is a must to figure out what return the company
can get from investing in that campaign. And if the program
is not giving the expected returns to the company then it
should be optimized or temporarily stopped. That's why the
financial manager should check the reports prepared by the
marketing department regarding the returns from any
advertising campaign and then he/she should manage and
allocate the funds by keeping the results in mind.
16. Business Survival
In this era of high competition, it is not easy for a company to
survive in the market and earn profits. Hence, the finance
manager should take the big decisions carefully after
consulting with the experts.
Objectives of Financial Management
If the company follows perfect financial management then it
can get the benefits of all the given objectives which will be
helpful in the long-run survival of the business with a higher
turnover and goodwill.
Here's an overview of typical financing sources:
1. Personal investment
When borrowing, you invest some of your own money—
either in the form of cash or collateral on your assets. This
proves to your banker that you have a long-term
commitment to your project.
2. Love money
This is money loaned by a spouse, parents, family or friends.
A banker considers this as "patient capital", which is money
that will be repaid later as your business profits increase.
When borrowing love money, you should be aware that:
family and friends rarely have much capital
they may want to have equity in your business—be sure you
don’t give this away
a business relationship with family or friends should never be
taken lightly
3. Venture capital
The first thing to keep in mind is that this funding source is
not necessarily for all entrepreneurs. Right from the start,
you should be aware that venture capitalists are looking for
technology-driven businesses and companies with high-
growth potential in sectors such as information technology,
communications, and biotechnology.
Venture capitalists take an equity position in the company to
help it carry out a promising but higher risk project. This
involves giving up some ownership or equity in your business
to an external party. Venture capitalists also expect a healthy
return on their investment, often generated when the
business starts selling shares to the public. Be sure to look
for investors who bring relevant experience and knowledge
to your business.
BDC has a venture capital team that supports leading-edge
companies strategically positioned in a promising market.
Like most other venture capital companies, it gets involved in
start-ups with high-growth potential, preferring to focus on
major interventions when a company needs a large amount
of financing to get established in its market.
4. Angels
Angels are generally wealthy individuals or retired company
executives who invest directly in small firms owned by
others. They are often leaders in their own field who not only
contribute their experience and network of contacts but also
their technical and/or management knowledge.
Angels tend to finance the early stages of the business with
investments in the order of $25,000 to $100,000.
Institutional venture capitalists prefer larger investments, in
the order of $1 million.
In return for risking their money, they reserve the right to
supervise the company's management practices. In concrete
terms, this often involves a seat on the board of directors
and an assurance of transparency.
Angels tend to keep a low profile. To meet them, you have to
contact specialized associations or search websites on
angels. The National Angel Capital Organization, the
Canadian International Angel Investors and Anges Québec
can put entrepreneurs in touch with angels.
Learn more about finding angel investors for your business.
5. Crowdfunding
Crowdfunding is a form of fundraising where a business asks
the public for a contribution, usually in exchange for equity in
the company.
It usually entails a private company asking large numbers of
people for small contributions. This differs from the more
conventional practice of raising money through angel
investors or venture capitalists, where a handful of actors
inject larger sums into your business.
In return for investing in your business, supporters will
receive equity, albeit with less liquidity than what do would
get with public stocks. There are also more relaxed rules
governing crowdfunding than IPOs.
There are various forms of crowdfunding, including:
Equity crowdfunding, where, in exchange for their money,
investors receive shares in a company or the right to a
portion of revenues or profits from a specific product.
Debt crowdfunding, where investors lend their money to a
company at relatively high interest rates, thus mitigating
their overall lending risk by spreading a large amount of
money in small increments across a large number of loans.
Donation/rewards-based crowdfunding, where a company
sets a fundraising target and asks for donations—in exchange
for some kind of token or receipt of the eventual product or
service to be developed.
6. Business Incubators
Business incubators (or "accelerators") generally focus on the
high-tech sector by providing support for new businesses in
various stages of development. However, there are also local
economic development incubators, which are focused on
areas such as job creation, revitalization and hosting and
sharing services.
Commonly, incubators will invite future businesses and other
fledgling companies to share their premises, as well as their
administrative, logistical, and technical resources. For
example, an incubator might share the use of its laboratories
so that a new business can develop and test its products
more cheaply before beginning production.
Generally, the incubation phase can last up to two years.
Once the product is ready, the business usually leaves the
incubator’s premises to enter its industrial production phase
and is on its own.
Businesses that receive this kind of support often operate
within state-of-the-art sectors such as biotechnology,
information technology, multimedia, or industrial technology.
Businesses that were supported by an incubator have a
better success rate over five years.
7. Grants and subsidies
It’s not always easy to bring innovations to light so
government agencies provide aid to Canadian companies.
You may have access to this funding to help cover expenses,
such as research and development, marketing, salaries,
equipment and productivity improvement.
Technically, a grant is a sum of money conditionally given to
your business that you don’t have to repay. However, you’re
bound legally to use it under the terms of the grant, or
otherwise you may be asked to repay it. As well, once you
are granted money from one government source, it is not
uncommon to receive further funding from the source if you
meet program requirements.
Criteria
Getting grants can be tough. There may be strong
competition and the criteria for awards are often stringent.
Generally, most grants require you to match the funds you
are being rewarded and this amount varies greatly,
depending on the granter. For example, a research grant may
require you to find only 40% of the total cost.
Generally, you will need to provide:
a detailed project description, including location
an explanation of the benefits of your project
a detailed work plan with full costs
details of relevant experience and background on key
managers
completed application forms when appropriate
Most reviewers will assess your proposal based on the
following criteria:
Significance
Approach
Innovation
Assessment of expertise
Need for the grant
Some of the problem areas where candidates fail to get
grants include:
The research/work is not relevant.
Ineligible geographic location.
Applicants fail to communicate how their ideas will be
addressed.
The proposal makes without a strong rationale.
The research plan is unfocused.
There is an unrealistic amount of work.
Funds are not matched.
The Government of Canada’s Business Benefits Finder
provides sources of financing, including government grants
and subsidies.
8. Loans
Loans are the most commonly used source of funding for
small and medium sized businesses. Consider the fact that all
lenders offer different advantages, whether it’s personalized
service or customized repayment. It's a good idea to shop
around and find the lender that meets your specific needs.
In general, start-ups have a harder time accessing loans than
do established businesses. Entrepreneurs with a solid
business plan and a good credit rating are more likely to be
able to access loans.
Long Term financing- shares
Bonds
Long-term capital may be raised either through borrowing or
by the issuance of stock. Long-term borrowing is done by
selling bonds, which are promissory notes that obligate the
firm to pay interest at specific times. Secured bondholders
have prior claim on the firm’s assets. If the company goes out
of business, the bondholders are entitled to be paid the face
value of their holdings plus interest. Stockholders, on the
other hand, have no more than a residual claim on the
company; they are entitled to a share of the profits, if there
are any, but it is the prerogative of the board of directors to
decide whether a dividend will be paid and how large it will
be.
Long-term financing involves the choice between debt
(bonds) and equity (stocks). Each firm chooses its own capital
structure, seeking the combination of debt and equity that
will minimize the costs of raising capital. As conditions in the
capital market vary (for instance, changes in interest rates,
the availability of funds, and the relative costs of alternative
methods of financing), the firm’s desired capital structure
will change correspondingly.
The larger the proportion of debt in the capital structure
(leverage), the higher will be the returns to equity. This is
because bondholders do not share in the profits. The
difficulty with this, of course, is that a high proportion of
debt increases a firm’s fixed costs and increases the degree
of fluctuation in the returns to equity for any given degree of
fluctuation in the level of sales. If used successfully, leverage
increases the returns to owners, but it decreases the returns
to owners when it is used unsuccessfully. Indeed, if leverage
is unsuccessful, the result may be the bankruptcy of the firm.
Long-term debt
There are various forms of long-term debt. A mortgage bond
is one secured by a lien on fixed assets such as plant and
equipment. A debenture is a bond not secured by specific
assets but accepted by investors because the firm has a high
credit standing or obligates itself to follow policies that
ensure a high rate of earnings. A still more junior lien is the
subordinated debenture, which is secondary (in terms of
ability to reclaim capital in the event of a business
liquidation) to all other debentures and specifically to short-
term bank loans.
More From Britannica history of Europe: Growth of banking
and finance
Periods of relatively stable sales and earnings encourage the
use of long-term debt. Other conditions that favour the use
of long-term debt include large profit margins (they make
additional leverage advantageous to the stockholders), an
expected increase in profits or price levels, a low debt ratio, a
price–earnings ratio that is low in relation to interest rates,
and bond indentures that do not impose heavy restrictions
on management.
Stock
Equity financing is done with common and preferred stock.
While both forms of stock represent shares of ownership in a
company, preferred stock usually has priority over common
stock with respect to earnings and claims on assets in the
event of liquidation. Preferred stock is usually cumulative—
that is, the omission of dividends in one or more years
creates an accumulated claim that must be paid to holders of
preferred shares. The dividends on preferred stock are
usually fixed at a specific percentage of face value. A
company issuing preferred stock gains the advantages of
limited dividends and no maturity—that is, the advantages of
selling bonds but without the restrictions of bonds.
Companies sell preferred stock when they seek more
leverage but wish to avoid the fixed charges of debt. The
advantages of preferred stock will be reinforced if a
company’s debt ratio is already high and if common stock
financing is relatively expensive.
If a bond or preferred stock issue was sold when interest
rates were higher than at present, it may be profitable to call
the old issue and refund it with a new, lower-cost issue. This
depends on how the immediate costs and premiums that
must be paid compare with the annual savings that can be
obtained.
Earnings and dividend policies
The size and frequency of dividend payments are critical
issues in company policy. Dividend policy affects the financial
structure, the flow of funds, corporate liquidity, stock prices,
and the morale of stockholders. Some stockholders prefer
receiving maximum current returns on their investment,
while others prefer reinvestment of earnings so that the
company’s capital will increase. If earnings are paid out as
dividends, however, they cannot be used for company
expansion (which thereby diminishes the company’s long-
term prospects). Many companies have opted to pay no
regular dividend to shareholders, choosing instead to pursue
strategies that increase the value of the stock.
Companies tend to reinvest their earnings more when there
are chances for profitable expansion. Thus, at times when
profits are high, the amounts reinvested are greater and
dividends are smaller. For similar reasons, reinvestment is
likely to decrease when profits decline, and dividends are
likely to increase.
Companies having relatively stable earnings over a period of
years tend to pay high dividends. Well-established large firms
are likely to pay higher-than-average dividends because they
have better access to capital markets and are not as likely to
depend on internal financing. A firm with a strong cash or
liquidity position is also likely to pay higher dividends. A firm
with heavy indebtedness, however, has implicitly committed
itself to paying relatively low dividends; earnings must be
retained to service the debt. There can be advantages to this
approach. If, for example, the directors of a company are
concerned with maintaining control of it, they may retain
earnings so that they can finance expansion without having
to issue stock to outside investors. Some companies favour a
stable dividend policy rather than allowing dividends to
fluctuate with earnings; the dividend rate will then be lower
when profits are high and higher when profits are
temporarily in decline. Companies whose stock is closely
held by a few high-income stockholders are likely to pay
lower dividends in order to lower the stockholders’ individual
income taxes.
In Europe, until recently, company financing tended to rely
heavily on internal sources. This was because many
companies were owned by families and also because a highly
developed capital market was lacking. In the less-developed
countries today, firms rely heavily on internal financing, but
they also tend to make more use of short-term bank loans,
microcredit, and other forms of short-term financing than is
typical in other countries.
Convertible bonds and stock warrants
Companies sometimes issue bonds or preferred stock that
give holders the option of converting them into common
stock or of purchasing stock at favourable prices. Convertible
bonds carry the option of conversion into common stock at a
specified price during a particular period. Stock purchase
warrants are given with bonds or preferred stock as an
inducement to the investor, because they permit the
purchase of the company’s common stock at a stated price at
any time. Such option privileges make it easier for small
companies to sell bonds or preferred stock. They help large
companies to float new issues on more favourable terms
than they could otherwise obtain. When bondholders
exercise conversion rights, the company’s debt ratio is
reduced because bonds are replaced by stock. The exercise
of stock warrants, on the other hand, brings additional funds
into the company but leaves the existing debt or preferred
stock on the books. Option privileges also permit a company
to sell new stock at more favourable prices than those
prevailing at the time of issue, since the prices stated on the
options are higher. Stock purchase warrants are most
popular, therefore, at times when stock prices are expected
to have an upward trend. (See also stock option.)
Growth and decline
Mergers
Companies often grow by combining with other companies.
One company may purchase all or part of another; two
companies may merge by exchanging shares; or a wholly
new company may be formed through consolidation of the
old companies. From the financial manager’s viewpoint, this
kind of expansion is like any other investment decision; the
acquisition should be made if it increases the acquiring firm’s
net present value as reflected in the price of its stock.
The most important term that must be negotiated in a
combination is the price the acquiring firm will pay for the
assets it takes over. Present earnings, expected future
earnings, and the effects of the merger on the rate of
earnings growth of the surviving firm are perhaps the most
important determinants of the price that will be paid.
Current market prices are the second most important
determinant of prices in mergers; depending on whether
asset values are indicative of the earning power of the
acquired firm, book values may exert an important influence
on the terms of the merger. Other, nonmeasurable, factors
are sometimes the overriding determinant in bringing
companies together; synergistic effects (wherein the net
result is greater than the combined value of the individual
components) may be attractive enough to warrant paying a
price that is higher than earnings and asset values would
indicate.
The basic requirements for a successful merger are that it fit
into a soundly conceived long-range plan and that the
performance of the resulting firm be superior to those
attainable by the previous companies independently. In the
heady environment of a rising stock market, mergers have
often been motivated by superficial financial aims.
Companies with stock selling at a high price relative to
earnings have found it advantageous to merge with
companies having a lower price–earnings ratio; this enables
them to increase their earnings per share and thus appeal to
investors who purchase stock on the basis of earnings.
Some mergers, particularly those of conglomerates, which
bring together firms in unrelated fields, owe their success to
economies of management that developed throughout the
20th century. New strategies emphasized the importance of Sources of Funds
general managerial functions (planning, control,
Business simply cannot function without money, and the
organization, and information management) and other top-
money required to make a business function is known as
level managerial tasks (research, finance, legal services, and
business funds. Throughout the life of business, money is
technology). These changes reduced the costs of managing
required continuously. Sources of funds are used in activities
large, diversified firms and prompted an increase in mergers
of the business. They are classified based on time period,
and acquisitions among corporations around the world.
ownership and control, and their source of generation.

When a merger occurs, one firm disappears. Alternatively,

Learn more about Sources of Financing Business here.
one firm may buy all (or a majority) of the voting stock of
another and then run that company as an operating
subsidiary. The acquiring firm is then called a holding
company. There are several advantages in the holding Classification of Sources of Funds
company: it can control the acquired firm with a smaller source: kvinsvalsura
investment than would be required in a merger; each firm
remains a separate legal entity, and the obligations of one
are separate from those of the other; and, finally,
stockholder approval is not necessary—as it is in the case of
a merger. There are also disadvantages to holding
companies, including the possibility of multiple taxation and
Read more about Equity Shares and Preference Shares here.
the danger that the high rate of leverage will amplify the
earnings fluctuations (be they losses or gains) of the
operating companies.
Browse more Topics under Sources Of Business Finance

Commercial Banks and Financial Institutions

Reorganization
When a firm cannot operate profitably, the owners may seek
to reorganize it. The first question to be answered is whether
the firm might not be better off by ceasing to do business. If
the decision is made that the firm is to survive, it must be
put through the process of reorganization. Legal procedures
are always costly, especially in the case of business failure;
both the debtor and the creditors are frequently better off
settling matters on an informal basis rather than through the
courts. The informal procedures used in reorganization are
(1) extension, which postpones the settlement of
outstanding debt, and (2) composition, which reduces the
amount owed.
Commercial Paper
Debentures
Equity Shares and Preference Shares
Lease Finance and Public Deposits
International Financing and Choice of Source of Funds
Meaning, Nature and Significance of Business Finance
Retained Earning, Trade Credit and Factoring
Period Basis Sources
On the basis of the period, the different sources of funds can
be classified into three parts. Which are:

If voluntary settlement through extension or composition is

not possible, the matter must be taken to court. If the court
Long-term sources fulfil the financial requirements of a
decides on reorganization rather than liquidation, it appoints
business for a period more than 5 years. It includes various
a trustee to control the firm and to prepare a formal plan of other sources such as shares and debentures, long-term
reorganization. The plan must meet standards of fairness and
borrowings and loans from financial institutions. Such
feasibility; the concept of fairness involves the appropriate
financing is generally required for the procurement of fixed
distribution of proceeds to each claimant, while the test of
assets such as plant, equipment, machinery etc.
feasibility relates to the ability of the new enterprise to carry
the fixed charges resulting from the reorganization plan. Medium-term sources are the sources where the funds are
required for a period of more than one year but less than
debentures, term loans, lease & hire purchase,
five years. The sources of the medium term include
borrowings from commercial banks, public deposits, lease
financing and loans from financial institutions.
Short-term sources: Funds which are required for a period
not exceeding one year are called short-term sources. Trade
credit, loans from commercial banks and commercial papers
are the examples of the sources that provide funds for short
duration.
Short-term financing is very common for the financing of
present assets such as inventories and account receivables.
Seasonal businesses that must build inventories in terms of
future prospects of selling requirements often need short-
term financing for the interim period between seasons.
Wholesalers and manufacturers with a major portion of their
assets used in inventories or receivables also require a large
number of funds for a short period.
Learn more about International Financing and Choice of
Sources of Funds here in detail.
Ownership Basis Sources
On the basis of ownership, the sources can be classified into
Owner’s funds and Borrowed funds. Owner’s funds mean
funds which are procured by the owners of a business, which
may be a sole entrepreneur or partners or shareholders of a
business. It also includes profits which are reinvested in the
business. The owner’s capital remains invested in the
business for a longer duration and is not required to be
refunded during the life period of the business.
This capital forms the base on which owners gain their right
of control of management in the business. Some
entrepreneurs may not like to dilute their ownership rights in
the business and others may believe in sharing the risk.
Equity shares and retained earnings are the two important
sources from where owner’s funds can be obtained.
Borrowed funds refer to the funds raised with the help of
loans or borrowings. This is the most common type of source
of funds and is used the majority of the time. The sources for
raising borrowed funds include loans from commercial
banks, loans from financial institutions, issue of debentures,
public deposits and trade credit.
These sources provide funds for a specific period, on certain
terms and conditions and have to repay the loan after the
expiry of that period with interest. A fixed rate of interest is
paid by the borrowers on such loans. Often it does put a lot
of burden on the business as payment of interest is to be
made even when the earnings are low or when the loss is
incurred. These institutions don’t take into consideration the
activities of business after the loan is given. Generally,
borrowed funds are provided on the security of some assets
of the borrower.
Generation Basis Sources
The way of classifying the sources of funds is whether the
funds are generated from within the organization or from
external sources of the organization. Internal sources of
funds are those that are generated inside the business. A
business, for example, can generate funds internally by
speeding collection of receivables, disposing of surplus
inventories and increasing its profit. The internal sources of
funds can fulfil only limited needs of the business.
Whereas, External sources of funds are the sources that lie
outside an organization, such as suppliers, lenders, and
investors. When a large amount of money is needed to be
raised, it is generally done through the external sources.
External funds may be costly as compared to those raised
through internal sources.
In some cases, business is required to mortgage its assets as
security while obtaining funds from external sources. The
issue of debentures, borrowing from commercial banks and
financial institutions and accepting public deposits are some
of the examples of external sources of funds commonly used
by business organizations.
Read the Significance of Business Finance here.
Solved Question for You
Q: How can a business generate funds internally?
Answer: A business can generate funds internally by
speeding collection of receivables, disposing of surplus
inventories and increasing its profit.
The deposits that are raised by organisations directly from
the public are known as public deposits. Public deposits are
beneficial to both medium and short-term financial
requirements of a business. The acceptance of public
deposits is regulated by the Reserve Bank of India.
Merits of Public deposit:
(i) The procedure of obtaining deposits is simple and easy.
(ii) Cost of public deposits is generally lower than the cost of
borrowings from banks and financial institution.
(iii) It does not usually create any charge on the assets of the
company. The assets can be used as security for raising loans
from other sources
(iv) The depositors do not have voting rights and hence the
control of the company is not reduced.
Demerits:
(i) New companies generally find it difficult to raise funds
through public deposits
(ii) It is an unreliable source of finance as the public may not
respond when the company needs money
(iii) Collection of public deposits may prove difficult,
particularly when the size of deposits required is large.
Retained earnings: When a portion of the net earnings is
retained in the business for the future use, this is known as
retained earnings. Generally, a company does not distribute
all its earnings amongst the shareholders as dividends. They
kept it as is a source of internal financing or self-financing.
Merits
i. Retained earnings are a permanent source of funds
available to an organisation.
ii. It does not involve any explicit cost in the form of interest,
dividend or floatation cost.
iii. As the funds are generated internally, there is a greater
degree of freedom and flexibility.
iv. It enhances the capacity of the business to absorb
unexpected losses.
v. It may lead to an increase in the market price of the equity
shares of a company.
Limitations
i. Excessive ploughing back may cause dissatisfaction
amongst the shareholders as they would get lower
dividends.

ii. It is an uncertain source of funds as the profits of the
business are fluctuating.
iii. The opportunity cost associated with these funds is not
recognized by many firms. This may lead to sub-optimal use
of the funds.
What is a Bond?
A bond is one of the fixed income investment products that
represents a loan given to a borrower by the investors. The
investors get interest income in return for the money they
lent. A bond includes details of the loan like the date when
the principal payment is due, the interest and the terms of
interest payments.
These are issued by the government, corporates,
municipalities, and states to find their projects. Also, they
pay regular interest to bondholders. If this financial
instrument is held until maturity, the lender (investor) gets
back the principal amount. Alternatively, the investors can
sell it in the secondary market at a higher price and make a
profit.
Bond investment has certain risks too. The borrowers can
default. There are chances that the company which issued
them might not repay back at the time of maturity. Also,
bond yields can fluctuate according to the change in bond
prices. In a rising interest rate regime, the bond prices may
fall. The coupon payments become unattractive to the
investors as they can sell the existing bond with a low
coupon rate and rather invest in another bond with a high
coupon rate. In a falling interest rate regime, the bond prices
can increase, causing the bond yield to fall. This is because
the investor would want to profit from the price increase and
sell the bond. Leading to lower yields form bonds.
Who are the issuers of a bond?
Institutions primarily use bonds to borrow money. The
issuers of a bond are:
Government: Government raises funds to sponsor roads,
dams, schools and other infrastructure projects. Therefore,
government institutions at all levels need funds to complete
projects and hence raise funds through bonds.
Corporations: Businesses or corporations often borrow
money to grow their business. The browning can be for
buying equipment and property, for research and
development, to undertake profitable projects, etc. Large
corporations usually need far more money than what a bank
can typically lend.
With bonds, individual investors assume the role of a lender.
Hence, thousands of investors lend a portion of the capital to
the borrower. Also, the public debt market enables lenders
to buy and sell bonds in the secondary market.
Learn: Difference Between Primary Vs Secondary Market
How does a bond work?
Bond is a debt security that is one of the popular asset
classes known to investors apart from stocks (equities) and
cash and cash equivalents.
They are issued by corporations or governments to fund a
new project or refinance an existing project. Hence helping
them in raising money for future projects or ongoing
projects. This instrument can be issued directly to investors
in the market. These are publicly traded in the market.
Alternatively, they can be issued privately and are traded
only over-the-counter (OTC) and are circulated privately.
When the borrower issues bonds to the lender, an
agreement is made between both the parties. The issuer of
the bond promises to pay back the principal on the maturity
date. The issuer also pays interest on the money borrowed
(coupon payment) throughout the tenure of the loan period.
The bond‘s face value is mostly INR 1,000. The issuer will fix
the coupon rate. However, the market price or issue price
will depend on the credit quality of the borrower, holding
period until maturity, and the coupon rate.
A bond includes details of the amount borrowed, date of
maturity on which the money will be paid back to the
investor, and details of coupon payments, including the
coupon rate. Once the bonds are issued, investors or
bondholders are entitled to receive interest annually or semi-
annually. And upon maturity, will receive the face value
(principal amount). However, this is only valid when the
bondholder holds it until maturity.
There is no compulsion that one has to hold the bond until
maturity. When interest rates fall, and prices increase, the
investor can sell it to earn profits. The bondholder will stop
receiving coupon payments once they sell the bond.
Moreover, the issuer of the bonds can buy back the bonds in
case of a decline in interest rates or if the credit rating of the
borrower has improved. Then the issuer will reissue new
bonds at a lower cost. This is because, the higher the credit
quality, lower will be the interest rate. This way, the bond
issuer can reduce their debt obligation.
Features of a Bond
All bonds share certain characteristics. They include the
following:
Face value: The worth of the bond upon maturity. It is also
the base amount on which interest is calculated.
Coupon rate: The interest rate on the bond paid by the
issuers of the bond to the investors. Coupon payments are
made annually or semi-annually.
Coupon dates: The dates on which the investors receive the
coupon payment.
Maturity date: The date on which the bond issuer pays back
the face value of the bond to the investor. It indicates
repayment of the loan taken.
Issue price: The price at which the bond is initially sold to the
investor by the issuer. In other words, it is the price at which
investors buy them. When the interest rate rises, the issue
price will go down. Similarly, the issue price will go up when
the bond rates (interest rates) fall.
Bond duration: Duration measures the sensitivity of a bond‘s
price to the interest rate changes. It is not an indicator of the
length of time until maturity.
Credit quality: Credit quality is one of the principal
determinants of a coupon rate. If the issuer of the bond has a
low credit rating, the default risk is greater, and as a result,
these bonds pay more interest. The credit rating agencies
frequently keep updating the ratings of a bond. Usually,
bonds issued by the governments are very stable and are
considered to be the highest quality. These are called
investment-grade bonds. On the other hand, bonds that are
not investment grade, but are not in default, are known as
high yield or junk bonds. These junk bonds have a high risk of
default in the future. Also, to compensate for the risk,
investors demand higher coupon payments.
Time to maturity: Certain bonds have long maturity dates.
Hence, they tend to pay higher interest rates. A high-interest
rate is paid because the bondholder is exposed to inflation
risk and interest rate risk for an extended period. As interest
rates change the value of bond and bond portfolio will either
rise or fall.
What are Different Bond Categories
Primarily there are four categories of bonds that are sold in
the market.
1. Government Bonds
Government bonds are issued by the Central and State
Government of India. The Reserve Bank of India manages
and regulates them. These include:
bills that mature within less than one year
notes that mature between one to 10 years
bonds that mature in more than ten years
Since the Government of India issues them, the credit risk or
default risk is almost nil. Government bonds are considered
to be the safest type of investment options to earn regular
interests and principal on maturity. However, the long term/
duration bonds are exposed to inflation risk.
2. Municipal Bonds
Municipal bonds are another type of government bonds
issued by municipalities or government bodies. In
comparison to government bonds, municipal bonds carry
higher risk. However, the chances of a state government or a
municipality going bankrupt or defaulting their payments are
very low. But they suffer from inflation risk. Also, these are
tax free bonds.
3. Corporate Bonds
Companies issue corporate bonds. Companies issue them
because the bond market offers debt at a lower interest rate
and favourable terms. Hence most companies prefer issuing
bonds over bank loans. The corporate sector represents a
large portion of the bond market. They pay higher yields
than government bonds. However, they suffer from inflation
risk, interest rate risk and credit risk.
4. Asset Backed Securities
Asset-backed securities ABS are bonds issued by banks and
other financial institutions. Banks usually bundle cash flows
from a pool of assets and offer them as asset backed
securities to investors. One of the most common ABS is a
mortgage loan pool of a bank. The bank offers mortgage
backed securities.
Types of Bonds
Following are the types of bonds:
Traditional bond: A traditional bond allows the bondholder
to withdraw the entire principal amount at one upon the
bond’s maturity.
Callable bond: A callable option is an option exercised by the
bond issuer. When an issuer calls out their right to redeem
the bond before its maturity is called a callable bond. An
issuer can convert a high debt bond to a low debt bond
through a callable bond.
Fixed rate bond: Bonds whose coupon rate remains constant
through the tenure of the bond.
Floating rate bond: Bonds whose coupon rate varies during
the tenure of the bond.
Putable bond: Puttable bonds are those where an investor
sells their bonds and gets the money back before the date of
maturity.
Mortgage bond: Mortgage bonds are ABS bonds. These types
of bonds are often backed by securities. For example, they
can be backed by real estate companies and equipment.
Zero coupon bond: Zero coupon bond is a bond with a zero
coupon rate. The bond issuer pays only the principal amount
to the investor on maturity. They do not make any coupon
payments. However, they are issued at a discount to their par
value. The bondholder generates returns once the issuer
repays the amount at face value.
Serial bond: In a serial bond, is the one where the issuer pays
back the loan amount to the investors in small amounts
every year. This is to reduce the final debt obligation on the
issuer.
Extendable bond: An extendable bond allows the investor to
extend the maturity period.
Convertible bond: A convertible bond allows the bondholder
to convert their debt into equity (stock) at some point.
However, it depends on conditions like share price. These are
suitable for companies as the interest outflow becomes
lower. The investors can benefit from this when they can
make a profit from the upside in the stock. However, this
only happens when the project is successful.
Dynamic Bonds: Dynamic bond funds are open-ended debt
mutual funds that invest across duration. They follow a
dynamic approach in terms of the maturity of securities in
the portfolio. One of the main objectives of dynamic bond
funds is to provide optimal returns in both falling and rising
interest rate scenarios.
Pricing of bonds
The bonds have a face value and issue price. Most of the
time, these two differ and are not the same. The face value is
what the bondholder gets back at the time of maturity.
However, the issue price depends on the credit rating of the
borrower, coupon payment and holding period until
maturity. Investors buy at issue price, and they are paid back
the face value if held until maturity.
A bondholder can hold it until maturity or can sell it off
before maturity. The price at which the bondholder sells it
depends on the interest rates prevailing at that time. The
price of the bond is subject to fluctuations based on the
interest rate changes. When the market interest rate rises,
the price falls. When the interest rates go down, the prices
rise. And sometimes, these prices fluctuate dramatically,
causing the bondholder to sell them.
The interest rate of a corporate bond is determined by the
short term interest rate of a government bond. When the
bond is first issued, the investor is indifferent to a corporate
bond and government bond as both will have similar interest
rates.
However, when the bond rates of the government bond fall,
the corporate bonds will be more attractive to the investors.
And the investors will bid up for the prices of the corporate
bond until it trades at a premium. With excessive buying, the
prices go up and both the bond rates normalize.
Similarly, when the interest of the government bond shoots They can provide stability of returns to an investment
up, the corporate bonds become less attractive and will be portfolio. However, investors can simply choose good debt
sold. The prices of these bonds fall until the interest rate mutual funds which invest in bonds to invest in this sub-asset
normalizes. class in a simplified manner.

Explore: What is Yield Curve? Discover More

What is YTM? Corporate Bonds

Yield to maturity (YTM) is one of the ways to price bonds. It is Floating Rate Bonds
the total expected return for an investor if the bond is held
Mortgage Bonds
to maturity. YTM is the long term yield of the bond but is
expressed as an annual rate. Yield to maturity is similar to Covered Bonds
the internal rate of return (IRR). However, all the proceeds
must be reinvested at a constant rate, and it must be held Collable Bonds
until maturity, which is not the case with the internal rate of Puttable Bonds
return (IRR).
Sovereign Gold Bonds

Fixed Rate Bond

YTM can be a complex concept to understand and calculate.
However, it is a very useful tool that helps in evaluating the Zero Coupon Bond
attractiveness of one bond relative to the other. Tax Free Bonds

Government Bonds
YTM accounts for the time value of money. It factors all the Green Bonds
present values of future cash flows from an investment. This
usually is equated to the current market price. However, this Convertable Bonds
is based on the assumption that all the proceeds are
State Development Bonds
reinvested back at a constant rate, and the investment is held
until maturity. Non-convertible Bonds

For a zero coupon bond, the YTM is calculated using the
formula below:
bond ytm formula
However, most of the bonds in the market pay an interest
(coupon payment). Hence to estimate YTM, one can also use
a trial and error basis. When the price, coupon rate and face
value of the bond are known, then the YTM can be estimated
by trial and error basis. The formula below will help in
calculating the same.
Meaning
• Short term finance refers to financing
needs for a small period normally less
than a year. In businesses, it is also
known as working capital financing. This
type of financing is normally needed
because of uneven flow of cash into the

business, the seasonal pattern of

bond price formula business, etc.
Conclusion Financial needs of the organization:-
Bond is a debt security (fixed income investment). They have 1) Long term – for a period of 5 to 10 years.
a considerably lower risk than equities. To diversify their
portfolios, certain investors can consider to invest in bonds. For acquiring fixed assets
2) Medium term – 1 to 5 years. Intercorporate deposits

Expenditure for publicity • Companies can borrow funds from another co.

3) Short term – 0 to 1 year. Known as who have surplus fund for a period of six

working capital requirements. months.

Investments in current assets like stock, • Interest depend upon the amount and time

debtors etc period.

Short term sources of fund Certificate of deposits - CD

ØTrade credit • A certificate of deposit is a document of

ØCommercial banks title to a term deposit

ØFixed deposits for a period of one year • There is prescribed rate on such fund.

ØAdvance received from customers • Issuer is not required to encash before

ØVarious short term provisions the maturity date. But it is freely

Trade credit transferable.

• Credit granted by the suppliers of goods Features of Certificate Deposit

for a period of 15 to 90 days. • It can be issued by banks and financial institutions

• It is one of the good source of fund • Denomination is rupees one lac o multiplications.

because there is no extra cost up to the • Maturity period is 7 days to one year

period. • Genarally issued at discount

Commercial banks • It is freely transferable

• Bank advance meant for not only for • It is issued in demat form.

earning profit but also for socioeconomic development. Public deposits

• Banks usually, advances granted on the • A co. can accept deposits from public

share security of some tangible assets maximum upon 35% of its paid up capital

like gold, etc. and reserve.

Forms of bank advances • Period is 6 months to 3 years

• Loans – entire advance is disbursed as the Commercial Paper - CP

transfer of current account of the borrower on • CP was introduced in india in 1990.

the basis of security. • It is an unsecured promissory note issued

• Overdraft – facility to withdraw excess of by the co. who is financially sound and a

credit balance in their current a/c. listed co. for a period of 91 to 180 days.

• Clean overdraft – based on the personal • It is generally issued at discount

security Features of Commercial Paper

• Cash credit – same as loan except interest is • The tangible net worth of issuing co.

paid on used amount should be less than rupees four crore

• It is usually issued in multiples of Rs.5 lac.
• It is in the form of unsecured promissory
note
• Minimum credit rating is required from
CRISIL
• Its maturity is less than one year
Factoring
• It is a financial service rendered by a
factor wherein a business organization
sells its accounts receivables to a
factoring firm and gets cash from the
factor, and the factor assumes
responsibility of collecting dues from the
concerned parties.
Types of factoring
• Recourse factoring – any loss of bad debts will
be borne by the business firm.
• Non-recourse factoring – loss of bad debt will
be met by factor.
• Domestic factoring – if factoring is for
domestic sales
• Export factoring – if factor’s bank is situated in
exporter’s country.
What Is Commercial Paper?
Commercial paper is an unsecured, short-term debt
instrument issued by corporations. It's typically used to
finance short-term liabilities such as payroll, accounts
payable, and inventories. Commercial paper is usually issued
at a discount from face value. It reflects prevailing market
interest rates.
Commercial paper involves a specific amount of money that
is to be repaid by a specific date. Minimum denominations
are $100,000. Terms to maturity extend from one to 270
days. They average 30 days.
1
2
KEY TAKEAWAYS
Commercial paper is a form of unsecured, short-term debt.
It's commonly issued by companies to finance their payrolls,
payables, inventories, and other short-term liabilities.
Maturities on commercial paper range from one to 270 days,
with an average of around 30 days.
Commercial paper is issued at a discount and matures at its
face value.
The minimum denomination of commercial paper is
$100,000 and it pays a fixed rate of interest that fluctuates
with the market.
1:42
Commercial Paper
Understanding Commercial Paper
Commercial paper was first introduced over 150 years ago
when New York merchants began to sell their short-term
obligations to dealers in order to access capital needed to
cover near-term obligations. These dealers, or middlemen,
purchased the paper, (also known as promissory notes) at a
discount from their par value. They then sold the paper to
banks and other investors. The merchants would repay the
investors an amount equal to the par value of the note.
3
Commercial paper is not backed by any form of collateral,
making it unsecured debt. It differs from asset-backed
commercial paper (ABCP), a class of debt instrument backed
by assets selected by the issuer. In either case, commercial
paper is only issued by firms with high ratings from credit
rating agencies. These firms can easily find buyers without
having to offer a substantial discount (at a higher cost to
themselves) for the debt issue.
Commercial paper is issued by large institutions in
denominations of $100,000 or more. Other corporations,
financial institutions, and wealthy individuals, are usually
buyers of commercial paper.
Marcus Goldman, the founder of investment bank Goldman
Sachs, was the first dealer in the money market to purchase
commercial paper. His company became one of the biggest
commercial paper dealers in America following the Civil War.
4
Types of Commercial Paper
There are four types of commercial paper: promissory notes,
drafts, checks, and certificates of deposit (CDs).
Promissory Notes
Promissory notes, or, simply, notes, are debt instruments
written by one party to another that promise to pay a
specific amount of money by a certain date. Notes are a
common way for companies to issue commercial paper.
Drafts
A draft is a written agreement between three parties: a bank
(the drawer), a payer (the drawee), and a payee. The bank
instructs the commercial paper issuer to pay the lender
(payee) a specific amount of money at a specific time.
Checks
Checks are paid on demand by a bank rather than by a
certain time. They are the fastest way to issue commercial
paper. For this type of commercial paper, the issuing
company instructs a bank to give the payee a specific amount
of money instantly.
Certificates of Deposit
A certificate of deposit is exactly what the name implies: a
bank receipt, or certificate, that asserts that the bank has
received a sum of money deposited by an investor. It agrees
to pay back this money plus interest at a specific time in the
future. The CD also states the interest rate to be paid and the
maturity date.
Commercial Paper Terms
Issuer
The issuer of commercial paper is the entity that is creating
the short-term debt to fund their short-term cash needs. As
mentioned earlier, most issuers are large corporations with
strong credit, as the issuer may demonstrate a high
probability of being able to pay back debt especially in the
short-term.
Term/Maturity
The maturity of commercial paper designates how long the
debt is outstanding for the issuer. Commercial paper often a
term up to 270 days, though companies often issue
commercial paper with a maturity of 30 days. At the end of
the maturity period, the commercial paper is technically due,
and the issuer is now liable to return investor capital (though
they may choose to simply re-issue more commercial paper).
Secured/Unsecured
Commercial paper is often unsecured, which means there is
no collateral for the debt the issuing company is taking on. If
the issuing company goes bankrupt, holders of the issuer's
commercial paper may not have recourse in receiving funds.
The idea is because commercial paper's maturity is so short
and the credit worthiness of issuers is higher, the debt does
not need backing by corporate assets.
Discount/Face Value
Commercial paper is issued at face value, meaning a debt
instrument has a value to it often in denominations of
$100,000. Instead of paying interest, commercial paper is
instead often issued at a discount, or a price that less than
face value. When the commercial paper reaches maturity,
the investor will receive the face value amount of the
instrument even though they paid a lower discount amount.
Liquidity
Commercial paper is often tied to liquidity, the measurement
of well a company's short-term cash flows will be able to
cover its short-term debt. Therefore, issuers often create
commercial paper to increase their liquidity as it may need
cash in the short-term. On the other hand, buyers of
commercial paper may not need cash right away, so they are
willing to buy and hold the instrument to increase their cash
on hand in the future.
Commercial paper is just like bonds, though each instrument
has its own unique characteristics.
Advantages and Disadvantages of Commercial Paper
Advantages
A major benefit of commercial paper is that it does not need
to be registered with the Securities and Exchange
Commission (SEC) as long as it matures in no more than nine
months, or 270 days.
This makes it a cost-effective and a simple means of
financing. Although maturities can go as long as 270 days
before coming under the purview of the SEC, maturities for
commercial paper average about 30 days.
1 inventory. Current liabilities include wages, taxes, interest
Commercial paper is also easier to deal with compared to
the effort, time, and money involved in getting a business
loan.
It offers issuers the advantage of lower interest rates while it
offers investors a low risk of default.
Commercial paper provides an effective way for investors to
diversify portfolios.
Disadvantages
Companies must have extremely good credit to issue
commercial paper. So, it doesn't offer access to capital for all
institutions.
What's more, the proceeds from this type of financing can
only be used on current assets or inventories. They are not
allowed to be used on fixed assets, such as a new plant,
without SEC involvement.
Low interest rates for issuers mean low rates of return for
investors. Also, due to the large minimum denomination of
$100,000, commercial paper typically isn't directly available
to smaller investors. However, they can invest indirectly
through companies that buy commercial paper.
Concept of working Capital, significance, types
Working Capital: Meaning, Importance and Types
What is Working Capital?
Working capital is an indicator of the short-term financial
position that measures the overall efficiency of an
organization. It is calculated by subtracting current liabilities
from current assets and listed directly in its balance sheet.
Current assets mean the money kept in a bank and assets
that can be converted into cash in case if any situation arises.
Current liabilities represent debt that an individual will pay
within the prescribed year. Finally, working capital is the
money left after subtracting liabilities from an individual's
money in the bank.
Current assets consist of cash, accounts receivable, and
owed.
In broader terms, working capital is also used to measure the
company’s financial health. If there is a larger difference
between what a company owns and what an individual owns
for the short-term, the business will be healthier.
If the company owes more than they own, they will have
negative working capital, and their business might get closed.
Why Is Working Capital Essential?
The sole purpose of using working capital is to fund
operations, meet the short-term obligation, and continue to
have sufficient working capital. It’s continuously paying its
employees and suppliers to meet other obligations like taxes
and interest payments even if they have any cash flow
challenges.
Working capital is also used to fuel business growth without
incurring debt. If the company does not want to take a loan,
they can qualify easily for loans or other forms of credit
because of their positive working capital.
Several financial teams have mainly two goals in their mind:
1) To have a clear goal and view of how much cash is on hand
at any given time
2) To work with multiple businesses and to maintain enough
working capital to cover liabilities.
Types Of Working Capital
The types of working capital are mainly divided into different
parts:
Gross Working Capital
Gross working capital is the total value of the company’s
current assets. Current assets include cash, receivables,
short-term investments, and especially market securities.
The Gross working capital does not showcase the current
liabilities. Gross working capital can be executed by
calculating the difference between the existing assets and
current liabilities.
The difference remaining is the actual working capital that
the company has to meet its obligations.
Net Working Capital
Networking capital is the difference between the current
assets and current liabilities of the company. If the
company’s assets are more than current liabilities, it
indicates a positive working capital, and the company is in a
financial position to meet its obligations.
However, if the company’s assets are less than current
liabilities, it indicates a negative working capital, and the
company is facing financial distress.
The key difference between gross and net working capital is
that gross working capital will always be a positive value. In
contrast, networking capital can either be a negative or
positive value.
Permanent Working Capital
Permanent working capital is the minimum amount of capital
required to carry on the operations without interruption or
difficulty.
For example, a company will need minimum cash to keep the
operations smooth and running; here, the minimum amount
of money required will act as permanent working capital.
Regular Working Capital
Regular working capital is the amount of funds businesses
require to fund its day to day operations. For example, cash
needed for making payment of wages, raw materials, salaries
comes under regular working capital.
Reserve Margin Working Capital
Apart from conducting day-to-day activities, a business may
need some amount of capital to face unforeseen
circumstances. Reserve margin working capital is nothing,
but the money kept aside apart from the regular working
capital. These funds are held separately against unexpected
events like floods, natural calamities, storms, etc.
Variable Working Capital
Variable working capital can be defined as the capital
invested for a temporary period in the business. Variable
working capital is also called fluctuating working capital.
Such capital differs with respect to changes in the business
assets or the size of the business. Furthermore, variable
capital is subdivided into two parts:
1) Seasonable Variable Working Capital
Seasonable variable working capital is the amount of capital
kept aside to meet the seasonal demand if the business is
running seasonally.
2) Special Variable Working Capital
Special variable working capital is the temporary rise in the
working capital due to any unforeseen or occurrence of a
special event.
What Happens If The Company Has Low Working Capital?
If the company has low working capital, it means that it is
dealing with low current assets and more current liabilities.
On the other hand, a low net capital does not indicate that
company is dealing with losses.
Working capital reflects short-term financial health and
lower financial health means the company has invested
major chunks of money into something that may give higher
returns to them.
If a company has completed its financial obligations with
insufficient working capital, it means that it is reliable and
can manage finance optimally.
Negative working capital means the current assets are less
than current liabilities, and it can even lead to bankruptcy if
it is continued for several months or years.
Working capital and cash flow are two important financial
metrics that every business keeps a close watch on. The
significance of working capital and cash flow cannot be
overstated. These two financial metrics help businesses
evaluate whether they can withstand a market downturn or
not.

In simple terms, working capital is defined as the liquidity
level of a company to meet its day-to-day and short-term
expenses. There are various benefits of working capital for a
company, from paying employees and vendors to planning
for future needs.
The significance of working capital for a business is
remarkably high. As such, working capital meaning is related
to the lifeblood of a business.
This article will explain working capital and its importance in
detail.
Working Capital Meaning
A business needs to understand the working capital
definition from an operational perspective. Working capital
meaning entails the liquidity of a business and its short-term
financial health. The working capital definition also refers to
a company’s ability to utilize its assets efficiently on a day-to-
day basis.
Working Capital Definition
As a financial metric, working capital is defined as current
assets minus the current liabilities of a company. Current
assets include cash, inventory, and accounts receivable.
Current liabilities include wages, accounts payable, and
interest owed.
A positive working capital meaning implies that a company
manages to pay its bills and has sufficient funds to make
sound investments. If you see the positive working capital
definition, it aids business growth over the short term. While
a negative working capital meaning entails a struggle to
finance its daily operations, indicating a financial issue.
Working Capital Management Meaning
Working capital management meaning entails a strategy
applied by companies to monitor their assets and liabilities
to maintain sufficient cash flow to meet short-term
obligations.
Working capital management meaning also entails aiming to
reduce the operating cycle, maintain liquidity by freeing cash
from the balance sheet and reduce external sources of
financing working capital requirements. Working capital
management helps a company optimize the use of its assets
and liabilities for effective business operations.
Adequate working capital management meaning entails that
they can meet their day-to-day operating expenses and
short-term obligations productively and efficiently.
After we explain the concept of working capital, we will talk
about the advantages and disadvantages of working capital.
Explain the significance of working capital
The following are 4 importance of working capital:
1. Manage liquidity
Businesses need sufficient cash (liquidity) for their day-to-day
running. Working capital advantage is that it helps fulfill this
need. By evaluating their working capital requirements, the
finance department gets a clear idea of their financial
position. They thus can arrange for the funds accordingly,
thereby ensuring adequate liquidity and cash flow for daily
operations. Otherwise, liquidity issues could impact a
company’s operations and brand image.
2. Earn short-term profit
Sometimes, a company may have excess funds. On
evaluating the working capital,if the company has a high
current assets ratio, then it means it has more funds than its
working capital requirements. The excess funds can be
invested by the company to earn short-term profits.
3. Aids decision making
Working capital is important for a business as it helps
undertake sound decisions. Working capital helps calculate
the day-to-day fund requirements. It helps the company
evaluate its existing fund situation. A company can thus
decide effectively on the amount and source of funds.
Availing of a working capital loan means, a businesscan
effectively manage to tide over any insufficiency in its
working capital requirement to fund its daily operations.
 Insufficient working capital, meaning liquidity issues, could
impact business credibility.
4. Value addition to business

An adequate working capital implies a company has cash and

cash equivalents to meet its day-to-day operations and short- Ways to increase working capital
term obligations. It improves the creditworthiness of the
Even after understanding the advantages of working capital,
business in the market. It ensures better bargaining power
a business may not be able to maintain it. Some of the ways
and improved profitability. It adds value to the business,
to increase working capital are stated below.
enhancing its chance of achieving broader organizational
goals.

With the importance of working capital being explained, it is
necessary to evaluate the advantages and disadvantages of
working capital.
Advantages of sufficient working capital
· Take loans
A business can take a working capital loan, meaning it is used
to finance everyday business operations. If you see the
working capital loan meaning, it typically entails a tenure
ranging from 6 to 48 months.

Proper working capital management ensures adequate funds

for financing daily business operations and short-term · Reduce expenses
obligations. Key working capital advantages for a business
are:
Operational efficiency can be achieved by reducing expenses
wherever possible to maintain adequate working capital
Helps maintain solvency for a company by managing an loans, meaning a business has to work in a planned way.
uninterrupted process cycle.

Prompt payment to suppliers helps improve the goodwill and

creditworthiness of the business. · Manage Inventory

Suppliers may provide cash discounts for timely payment of

bills. It helps reduce costs, thereby improving profits. Maximize inventory management process by reducing raw
Helps businesses avail loans based on improved material and finished goods overstocking.
creditworthiness in the market.

Helps efficiently manage any sudden financial crisis or · Automate Receivables Process
market volatility.

Helps divert excess funds to productive ventures to generate

more profits for the business. Automation will help improve cash flow from operations and
reduce fund usage from other sources for daily business
Helps manage company expenses and bills like staff salary, operations.
taxes, and other expenses.

There arethus various working capital advantages. Positive

working capital can help businesses turn favorable market · Sell illiquid assets
conditions into an advantage for them. Especially in terms of
better business prospects and deals.
Selling illiquid assets will help improve the cash position
within the business.
· Improves overall business efficiency and
competitiveness
Conclusion
We hope you understand the significance of working capital Current Liabilities
adequacy and how it plays a significant role in any business.
Current Liabilities are the obligations of the business that are
Working capital advantages include improved profitability
due within one operating cycle or a year, whichever is
and creditworthiness. Businesses can easily avail of working
greater. Such liabilities are paid off by either using the
capital loans. A working capital loan meaning entails a type
current assets of the business or by creating other current
of business loan that lenders offer to meet daily business
liabilities.
operational expenses.

What is Working Capital?

Therefore, Current Liabilities include:
Working capital is defined as the excess of current assets
over current liabilities . It forms a part of the aggregate
capital of the business. Now, a business needs working
Accounts Payable
capital to fund its short term obligations. Typically, firms with
an optimum level of working capital indicate efficiency in Notes Payable
managing its operations. This further enables the firm to pay
for its short-term dues and day-to-day operational expenses. Current Portion of Long Term Debt

Accrued Liabilities

Therefore, working capital is a measure of business’ liquidity Unearned Revenues

position, operational efficiency, and short-term financial Types of Working Capital
soundness.
Depending upon the Periodicity & concept working capital
can be classified as below:
Hence, working capital can be put into the following
equation:
Permanent Working Capital

Regular Working Capital

Working Capital = Current Assets – Current Liabilities
Reserve Margin Working Capital

Variable Working Capital

So, let’s have a look at what forms current assets and current
liabilities of a business in order to understand the above Seasonal Variable Working Capital
equation. Special Variable Working Capital

Gross Working Capital

Current Assets Net Working Capital
Current Assets are the assets of the business that can be Permanent Working Capital
easily converted into cash within a year or normal operating
cycle of the business, whichever is greater. These assets It is that portion of the working capital that remains
typically include: permanently tied up in current assets to undertake business
activity uninterruptedly. In other words, permanent working
capital is the least amount of current assets needed to carry
Cash and cash equivalents out business effortlessly. Thus, it is also known as fixed
working capital.
Inventory

Accounts Receivable
The amount of fixed working capital required by a business
Marketable Securities depends upon the size and the growth of the business. For
Prepaid Expenses instance, minimum cash or stock required by a firm to
undertake the operational activities of the business.Now,
Other Liquid Assets
permanent working capital can be further subdivided into
two categories:
Regular Working Capital
This is defined as the least amount of capital required by a
business to fund its day-to-day operations of a business.
Examples include payment of salaries and wages and
overhead expenses for the processing of raw materials.
Reserve Margin Working Capital
Apart from day-to-day activities, a business may need some
amount of capital for unforeseen circumstances. Reserve
Margin Working Capital is nothing but the amount of capital
kept aside apart from the regular working capital. These pool
of funds are kept separately for unforeseen circumstances
such as strikes, natural calamities, etc
Variable Working Capital
This can be defined as the working capital invested for a
temporary period of time in the business. For this reason, it
is also called as fluctuating working capital. Such a capital
varies with respect to the change in the size of the business
or changes in the assets of the business.
Further, variable working capital is subdivided into two
categories
Seasonal Variable Working Capital
This refers to the increased amount of working capital a
business needs during the peak season of the year. A
business may even have to borrow funds to meet its working
capital needs. Such a working capital specifically meets the
demands of business having a seasonal nature.
Special Variable Working Capital
Supplementary working capital may also be required by a
business to undertake exceptional operations or unforeseen
circumstances. The capital required for such circumstances is
termed as special variable working capital. Funds needed to
finance marketing campaigns, unforeseen events like
accidental fires, floods, etc.
Gross Working Capital
This refers to the aggregate amount of funds invested in the
current assets of the business. In other words, Gross Working
Capital is the total of the current assets of the business.
These include:
Cash
Accounts Receivable
Inventory
Marketable Securities and
Short-Term Investments
Gross Working Capital used alone neither shows the
complete picture of the short-term financial soundness. Nor
does it showcase the operational efficiency of the business.
Current assets should be compared with the current
liabilities to get a better understanding of a business’s
operational efficiency. That is, how efficiently a business
utilizes its short term assets to meet its day-to-day cash
requirements.
Net Working Capital
Net Working Capital is the amount by which current assets
exceed the current liabilities of a business. Thus, the working
capital equation is defined as the difference between current
assets and current liabilities. Where current assets refer to
the sum of cash, accounts receivable, raw material and
finished goods inventory. Whereas, current liabilities include
accounts payable.
The amount of working capital in a business is the indicator
of liquidity, operational efficiency and short-term financial
soundness of the business. Businesses having adequate
working capital typically have the ability to invest and grow.
On the other hand, businesses having insufficient working
capital have higher odds of going bankrupt. This is because of
their inability to pay for their short-term obligations, thus
making it difficult for them to grow.
Factors Determining Working Capital
1. Nature and Size of Business
The working capital need of a business depends a great deal
on its nature and size. Let’s consider various types of
businesses to understand how the nature of business
impacts its working capital requirements.
When it comes to trading firms, they require less amount of
money to be invested in fixed assets . However, a huge pool
of funds needs to be invested in the form of working capital.
On the other hand, retail stores must keep a large quantity of
inventory to meet the diversified and continuous needs of its
customers.
Similarly, the need for working capital in manufacturing firms
varies between small to a substantial amount. This working
capital amount depends upon the type of business a firm is
into. Likewise, public utility firms require less working capital
but invest heavily in fixed assets. This is because they have
cash sales only and supply services over products. Hence,
they have fewer funds blocked in current assets such as
debtors and inventories.
Finally, the size of the business also impacts the working
capital needs of the business. Firms with large scale
operations need more working capital as compared to
smaller firms.
2. Business Cycle
Business cycle too has a significant impact on the working
capital needs of a business. During the boom phase of the
business cycle, businesses typically tend to expand thus
requiring additional working capital. These periods of
increased business activity require additional funds to meet
the time lag between collection and sales. Further, funds are
also needed to purchase additional raw material needed to
produce additional goods for increased sales.
Not only that, the peak period leads to the increased prices
of raw material and increased wages. Thus, additional funds
are needed to provide for such operational expenses.
In contrast, there is lesser demand leading to both the
decline of production and sale of goods during periods of
depression. Thus, less amount of working capital is required
by the business to carry out its operational activities.
3. Production Cycle
Production cycle, also known as the operating cycle, is the
time difference between the conversion of raw materials into
final products. This too impacts the working capital
requirements of a business to a greater extent.
Businesses with longer production cycles need more working
capital to fund its operational activities. Therefore, firms
adopt various measures to reduce their production cycle in
order to minimize their working capital requirements.
4. Seasonal Fluctuations
There are certain businesses that are seasonal in nature. This
means there is a high demand for their goods during a
specific period of the year. In such cases, inventory of raw
material needs to be purchased during a specific period of
time. This is done so that goods are produced and are
offered for sale when they are needed.
Thus, the need for inventory increases during this period as
compared to the other periods of the year. Therefore,
businesses need additional funds to purchase inventories
during the specific time of the year. As a result, the
seasonality of business impacts the working capital
requirements of the business.
5. Operational Efficiency
Various businesses operate on different operational
efficiencies. Thus, the operational efficiency of a business
depends upon various factors. These include:
Short production cycles that involve less time to convert raw
material into finished goods
Achieving sales quickly
The shorter debt collection period
Thus, businesses with increased operational efficiency are
required to invest a lesser amount of funds in working
capital. In contrast, businesses that have lesser operational
efficiency need more funds to be invested in working capital.
Here is an infographic that explains what is working capital
and working capital cycle in an easy to understand way.
What is a Working Capital Management Strategy?
Broadly, there are three working capital management
strategies – conservative, hedging and aggressive. The
effectiveness of these three approaches depends on risk and
profitability.
Conservative
The conservative strategy relies on long-term financial
instruments to source funds for fixed assets, permanent
working capital and part of the temporary working capital.
Since long-term finances are impervious to the risk of
interest rate fluctuations, these prove to be low risk. As there
is “no pain, no gain,” such finances also have low profitability.
Hedging
Hedging or maturity matching utilizes long term funding
sources to finance long-term assets and a portion of the
permanent working capital. Here, the temporary working
capital will be funded by short term finances such as trade
credit, short term loan. Financing of fixed assets such as
machinery and infrastructure will be fulfilled through long
term funding. This strategy poses moderate risk and
profitability.
Aggressive
Where the aggressive strategy is concerned, long-term funds
are used to finance fixed assets and part of the permanent
working capital. The remaining portion of the permanent
working capital and the temporary working capital will be
financed through short term funding sources. This poses a
high risk, but increased profitability since the finance cost of
short-term funds are comparatively low, and at the same
time those could be affected by market trends and interest
rate fluctuations.
How to Plan an Effective Working Capital Management
Strategy
Factors such as interest rates, market demand for business
output, economic status, currency rate, and seasons (or
market trends) greatly impact working capital management.
Inter-connections between these aspects make managing
working capital an intricate affair that requires a great deal of
attention. For instance, the pandemic has pushed the global
economy into a recession, resulting from border closures, the
collapse of trade and travel bans.
Consequently, market demand, interest and currency rates
too, have taken a hit as trading has come to a cease. As a
result, companies are now navigating through uncharted
territories to recover from this situation.
Let’s take a look at the steps that need to be followed to
create a result-oriented working capital management
strategy.
Analyze Current and Future Funding Requirements
The first step in building a successful working capital
management plan is to analyze your future long and short
term funding requirements. While rent, utilities, payroll, and
supplier payments are classified under short term funding
needs; upgrading of machinery and equipment, purchasing
real estate for the company and other expansion activities
require long term capital. Therefore, an analysis of your
current and future funding needs is essential when preparing
the organization’s working capital strategy.
Short Term and Long Term Funding Needs - Working Capital
Management
An analysis of the short and long term funding needs
Imagine Scenarios and How Your Company Might Navigate
Through Those
We are living in a Volatile, Uncertain, Complex and
Ambiguous (VUCA) environment. Therefore, it is important
to pay close attention to market trends and the status of the
industry and economy. Perform a SWOT analysis to
understand potential growth opportunities and threats. For
instance, if the company had to halt operations due to a
possible lockdown (due to pandemic or any other factor), are
there sufficient funds available to meet payroll requirements
and supplier payments? Or what available funding sources
could power an expansion opportunity?
Once you have identified the opportunities and threats, you
can conduct scenario and shock analysis to determine how
well the organization would face such a circumstance.
SWOT Analysis - Working Capital Management capital requirement. With KredX businesses can utilise their
unpaid invoices to avail working capital within 24 -72 hours*.
SWOT Analysis (click on the template to edit it online)

Evaluate Your Working Capital Funding Sources

Factors That Help To Determine Required Working Capital:
Review your current cash accounts, trade receivables and
inventories to ensure that the funds at hand are adequate to These are among the top factors that help businesses
meet the organization’s working capital requirements. determine their working capital requirements -
Diversify where necessary; you may either opt for a short
term loan to bridge capital shortfalls or short term
investments to gain an additional income. It is also advisable Factors
to hold the company’s cash and investments in at least two
different institutions to ensure access to credit in tough
economic conditions. Description

Review Account Payables and Receivables Sales

Go digital. Introduce online or electronic payment methods
for your products or services to eliminate any delays in trade
receivables. Enhancing customer convenience in terms of A significantly high sales volume generates high revenue
payment will also result in improving the demand and overall which means the working capital required is not much.
consumer satisfaction. Consider the 5Cs method before
approving credit to a customer so that the chances of them
being turned into bad debtors will be considerably less. Duration of Operating Cycle

As for account payables, implement a process or schedule for The longer it takes a business to convert current assets into
cash and cheque payments to suppliers which will be subject cash and cash equivalents, the more will be the required
to an approval process. This will eliminate ad hoc payments working capital.
while streamlining the payment procedure.

Type of Business
Make Wise Strategic Management Decisions

What works best for a company obviously depends on the

Trading businesses require relatively high working capital
strategic decisions made by the organization with regards to
when compared to manufacturing businesses.
its operations and assets. However, managing its working
capital is an art that every business entity should master to
survive in any industry.
Terms of credit
--------------------------------------

What is Working Capital Requirement?

Businesses that extend longer terms of credit to customers
In simple words, working capital requirement can be
are often in need of more working capital.
described as the amount of money a firm would need to
bridge the gap between its accounts payable and accounts
receivable. It is essentially the amount a business requires to
keep its operations afloat. Inventory turnover

In the case of working capital deficit, businesses can use their Stagnant or slow turnover of extensive inventories results in
a higher working capital requirement.
outstanding invoices and avail funds to meet their working
Seasonal variation Based on this formula, businesses can estimate their working
capital requirement easily. For instance, if the current assets
of a firm exceed its current liabilities, it indicates that the
Businesses that are dependent on specific seasons may need firm has surplus working capital. Notably, items like cash
more working capital. commitments, non-trade receivable and old or wasted
inventory are excluded or adjusted during the working
capital requirement calculation.
Production technology

Example of Working Capital Requirement Calculation:

Usually, labour-intensive businesses require more capital Suppose the current assets of Mr Kumar’s business stands at
than a business which needs the use of machines. Rs. 25000, while current liabilities amount to Rs. 45000.

Contingencies Using the formula -

A provision to meet the changes in demand and products’ Working capital = Current assets - Current liabilities
price.

= Rs. (25000 - 45000)

How To Compute A Company’s Working Capital
Requirement?

The formula for calculating working capital requirement is = - (Rs. 20000)

given by -

Since the outcome is negative, it indicates Mr Kumar’s

Working Capital formula = Current Assets - Current Liabilities business has a deficit in working capital. It means that his
firm’s immediate liquidity is not enough to optimise everyday
functions.
Here, current assets include these following -

Some of the effective ways of reducing working capital gap

Cash in hand include -

Cash equivalent

Company inventory Quick collection of accounts receivables

Accounts receivable Reducing inventory cycle

Pre-paid liabilities Reducing credit terms

Here, current liabilities include these following - Increasing sales volume

However, to meet your working capital requirement

immediately and to keep operational activities continuous,
Accounts payable you can opt for alternative solutions like invoice discounting
Notes payable services from KredX.

Income tax owed In virtually every decision they make, executives today
consider some kind of forecast. Sound predictions of
Immediate debts demands and trends are no longer luxury items, but a
Dividends necessity, if managers are to cope with seasonality, sudden
changes in demand levels, price-cutting maneuvers of the
competition, strikes, and large swings of the economy.
Forecasting can help them deal with these troubles; but it
can help them more, the more they know about the general
principles of forecasting, what it can and cannot do for them
currently, and which techniques are suited to their needs of
the moment. Here the authors try to explain the potential of
forecasting to managers, focusing special attention on sales
forecasting for products of Corning Glass Works as these
have matured through the product life cycle. Also included is
a rundown of forecasting techniques.
To handle the increasing variety and complexity of
managerial forecasting problems, many forecasting
techniques have been developed in recent years. Each has its
special use, and care must be taken to select the correct
technique for a particular application. The manager as well
as the forecaster has a role to play in technique selection;
and the better they understand the range of forecasting
possibilities, the more likely it is that a company’s forecasting
efforts will bear fruit.
The selection of a method depends on many factors—the
context of the forecast, the relevance and availability of
historical data, the degree of accuracy desirable, the time
period to be forecast, the cost/benefit (or value) of the
forecast to the company, and the time available for making
the analysis.
These factors must be weighed constantly, and on a variety
of levels. In general, for example, the forecaster should
choose a technique that makes the best use of available
data. If the forecaster can readily apply one technique of
acceptable accuracy, he or she should not try to “gold plate”
by using a more advanced technique that offers potentially
greater accuracy but that requires nonexistent information
or information that is costly to obtain. This kind of trade-off
is relatively easy to make, but others, as we shall see, require
considerably more thought.
Read more about
Six Rules for Effective Forecasting
Furthermore, where a company wishes to forecast with
reference to a particular product, it must consider the stage
of the product’s life cycle for which it is making the forecast.
The availability of data and the possibility of establishing
relationships between the factors depend directly on the
maturity of a product, and hence the life-cycle stage is a
prime determinant of the forecasting method to be used.
Our purpose here is to present an overview of this field by
discussing the way a company ought to approach a
forecasting problem, describing the methods available, and
explaining how to match method to problem. We shall
illustrate the use of the various techniques from our
experience with them at Corning, and then close with our
own forecast for the future of forecasting.
Although we believe forecasting is still an art, we think that
some of the principles which we have learned through
experience may be helpful to others.
Manager, Forecaster & Choice of Methods
A manager generally assumes that when asking a forecaster
to prepare a specific projection, the request itself provides
sufficient information for the forecaster to go to work and do
the job. This is almost never true.
Successful forecasting begins with a collaboration between
the manager and the forecaster, in which they work out
answers to the following questions.
1. What is the purpose of the forecast—how is it to be used?
This determines the accuracy and power required of the
techniques, and hence governs selection. Deciding whether
to enter a business may require only a rather gross estimate
of the size of the market, whereas a forecast made for
budgeting purposes should be quite accurate. The
appropriate techniques differ accordingly.
Again, if the forecast is to set a “standard” against which to
evaluate performance, the forecasting method should not
take into account special actions, such as promotions and
other marketing devices, since these are meant to change
historical patterns and relationships and hence form part of
the “performance” to be evaluated.
Forecasts that simply sketch what the future will be like if a
company makes no significant changes in tactics and strategy
are usually not good enough for planning purposes. On the
other hand, if management wants a forecast of the effect
that a certain marketing strategy under debate will have on
sales growth, then the technique must be sophisticated
enough to take explicit account of the special actions and
events the strategy entails.
Techniques vary in their costs, as well as in scope and
accuracy. The manager must fix the level of inaccuracy he or
she can tolerate—in other words, decide how his or her
decision will vary, depending on the range of accuracy of the
forecast. This allows the forecaster to trade off cost against
the value of accuracy in choosing a technique.
For example, in production and inventory control, increased
accuracy is likely to lead to lower safety stocks. Here the
manager and forecaster must weigh the cost of a more
sophisticated and more expensive technique against
potential savings in inventory costs.
Exhibit I shows how cost and accuracy increase with
sophistication and charts this against the corresponding cost
of forecasting errors, given some general assumptions. The
most sophisticated technique that can be economically
justified is one that falls in the region where the sum of the
two costs is minimal.
--------------------------------------------
CONCEPT OF TIME VALUE
Money has time value. In simpler terms, the value of a
certain amount of money today is more valuable than its
value tomorrow. It is not because of the uncertainty involved
with time but purely on account of timing. The difference in
the value of money today and tomorrow is referred to as the
time value of money.
Money has time value because of the following reasons:
Risk and Uncertainty
Future is always uncertain and risky. Outflow of cash is in our
control as payments to parties are made by us. There is no
certainty for future cash inflows. Cash inflows are dependent
on our Creditor, Bank etc. As an individual or firm is not
certain about future cash receipts, it prefers receiving cash
now.
Inflation:
In an inflationary economy, the money received today, has
more purchasing power than the money to be received in
future. In other words, a rupee today represents a greater
real purchasing power than a rupee a year after.
Consumption:
Individuals generally prefer current consumption to future
consumption.
Investment opportunities:
An investor can profitably employ a rupee received today, to
give him a higher value to be received tomorrow or after a
certain period of time. Thus, the fundamental principle
behind the concept of time value of money is that, a sum of
money received today, is worth more than if the same is
received after a certain period of time. For example, if an
individual is given an alternative either to receive Rs.10,000
now or after one year, he will prefer Rs. 10,000 now. This is
because, today, he may be in a position to purchase more
goods with this money than what he is going to get for the
same amount after one year.
Thus, the concept of time value of money is a vital
consideration in making financial decisions.
Discounting and Compounding
PrintPrint
Compounding
In order to compare different alternatives in an economic
evaluation, they should have the same base (equivalent
base). Compound interest is a method that can help applying
the time value of money. For example, assume you have 100
dollars now and you put it in a bank for interest rate of 3%
per year. After one year, the bank will pay you 100+100*0.03
=$103
. Then, you will put the 103 dollars in the bank again for
another year. One year later, you will have 103+103*0.03
=$106.09
. If you repeat this action over and over, you will have:
After one year: 100+100*0.03 =100*(1+0.03)=$103 After
second year: 103+103*0.03 =100*(1+0.03) +100*(1+0.03)
*0.03 = 100*(1+0.03)*(1+0.03)=100*(1+0.03)2=$106.09
After third year: 106.09+106.09*0.03=100*(1+0.03)2
+100*(1+0.03)2 *0.03 =100*(1+0.03)2 *(1+0.03)=
100*(1+0.03)3=$109.27 After fourth year: 109.27 +109.27 have the same base. Otherwise, different alternatives can’t
*0.03 =100*(1+0.03)3+100*(1+0.03)3 *0.03 = 100*(1+0.03)3 be compared.
*(1+0.03)=100*(1+0.03)4=$112.57

Which can be written as:

Assume you temporarily worked in a project, and in the end
(which is present time), you are offered to be paid 2000
dollars now or 2600 dollars 3 years from now. Which
After first year: P+Pi=P(1+i)After second year: P(1+i)+ P(1+i)i
payment method will you chose?
=P(1+i)(1+i)=P(1+i)2After third year: P(1+i)2+P(1+i)2i
=P(1+i)2(1+i)=P(1+i)3After forth year: P(1+i)3+P(1+i)3i
=P(1+i)3(1+i)=P(1+i)4
In order to decide, you need to know how much is the value
In general: of 2600 dollars now, to be able to compare that with 2000
dollars. To calculate the present value of a money occurred in
the future, you need to discount that to the present time and
The value of money after nth period of time can be to do so, you need discount rate. Discount rate, i, is the rate
calculated as: that money is discounted over the time, the rate that time
adds/drops value to the money per time period. It is the
interest rate that brings future values into the present when
F = P(1+i)n considering the time value of money. Discount rate
represents the rate of return on similar investments with the
(Equation 1-1) same level of risk.
Which F is the future value of money, P is the money that
you have at the present time, and i is the compound interest
rate. So, if the discount rate is i=10% per year, it means the value
of money that you have now is 10% higher next year. So, if
you have P dollars money now, next year you will have P+iP
Example 1-1: =P(1+i)

Assume you put 20,000 dollars (principal) in a bank for the and if you have F dollars money next year, your money is
interest rate of 4%. How much money will the bank give you equivalent to F/(1+i)
after 10 years? dollars at present time.

F=P(1+i)n =20,000*(1+0.04)10=20,000*1.48024=29604.8 Going back to the example, considering the discount rate of
So the bank will pay you 29604.8 after 10 years. 10%:

Discounting We can calculate the present value of $2600 occurred 3 years

from now by discounting it year by year back to the present
In economic evaluations, “discounted” is equivalent to time:
“present value” or “present worth” of money. As you know,
the value of money is dependent on time; you prefer to have
100 dollars now rather than five years from now, because Value of 2600 dollars in the 2nd years from now
with 100 dollars you can buy more things now than five years =2600/(1+0.1)=2363.64
from now, and the value of 100 dollars in the future is
equivalent to a lower present value. That's why when you
take loan from the bank, the summation of all your Value of 2600 dollars in the 1st years from now
installments will be higher than the loan that you take. In an =(2600/(1+0.1))/(1+0.1)=2600/[(1+0.1)2]=2148.76
investment project, flow of money can occur in different time
intervals. In order to evaluate the project, time value of
money should be taken into consideration, and values should
Value of 2600 dollars at the present time
=((2600/(1+0.1))/(1+0.1))/(1+0.1)=2600/[(1+0.1)3]=1953.42
So, it seems at the discount rate of i=10%, present value of
2600 dollars in 3 years equals 1953.42 dollars, and you are
better off, if you accept the 2000 dollars now.
With the following fundamental equation, present value of a
single sum of money in any time in the future can be
calculated. It means a single sum of money in the future can
be converted to an equivalent present single sum of money,
knowing the interest rate and the time. This is called
discounting.
P=F[1/(1 + i)n]
Equation 1-2
P: Present single sum of money.
F: A future single sum of money at some designated future
date.
n: The number of periods in the project evaluation life (can
be year, quarter or month).
i: The discount rate (interest rate).
Example 1-2:
Assuming the discount rate of 10 %, present value of 100
dollars which will be received in 5 years from now can be
calculated as:
F=100 dollarsn =5i =0.1P=F[1/(1 + i)n]= 100[1/(1 +
0.1)5]=62.1
You can see how time and discount rate can affect the value
of money in the future. 62.1 dollars is the equivalent present
sum that has the same value of 100 dollars in five years
under the discount rate of 10%
---------------------------------------------
What Is the Future Value of a Single Amount?
The value of a current single amount taken to a future date
at a specified interest rate is called the future value of a
single amount.
In this case, “future value” means the amount to which the
investment will grow at a future date if interest is
compounded. The single amount refers to a lump sum
invested at the beginning of a period (e.g., year 1) and left
intact for all periods.
Explanation
To explain the concept of the future value of a single
amount, let’s start with the table below.
Simple vs Compound Interest
In this table, we see what the future amount of $10,000
invested at 12% annual interest for three years would be,
given a certain compounding pattern. This is an example of
determining the future value of a single amount.
There were no additional investments or interest
withdrawals. These future value or compound interest
calculations are important in many personal and business
financial decisions.
Example
Suppose a company is interested in determining the worth of
a $50,000 investment after 5 years if interest is compounded
semi-annually versus quarterly, or what rate of return must
be earned on a $10,000 investment if $18,000 is needed in 7
years.
Both situations are problems where the solution is to
determine the future value of a single amount.
One way to solve problems of this type is to construct tables
similar to the one shown above. However, this method is
time-consuming and not very flexible.
Mathematical formulas can also be used. For example, the
tables used above to determine the accumulated amount of
a single amount at different compounded rates are based on
the formula described in the next section.
Formula for Accumulated Amount at Different Compounded
Rates
Accumulated Amount FormulaIn this formula, the variables 1.40493, which means that $1 invested today at 12% will
are defined as follows: accumulate to $1.405 at the end of 3 years.

p = Principal amount Because we are interested in $10,000 rather than $1, we just
multiply the factor of 1.40493 by $10,000 to determine the
i = Interest rate
future value of the principal amount.
n = Number of compounding periods

In the example of the amount of $10,000 compounded

The amount is $14,049.30, which, except for a slight
annually for 3 years at 12%, the $14,049.28 can be
rounding error, is the same as we found in the table.
determined by the following calculation:

We can generalize the use of the future value table with the
= $10,000(1 + .12)3
following formula:

= $14,049.28
Accumulated amount = Factor (from the table) x Principal

However, one of the simplest methods is to use tables that

= 1.40493 x $10,000
give the future value of $1 at different interest rates and for
different periods.

= $14,049.30

Essentially, these tables interpret the above mathematical

formula for various interest rates and compounding periods
This formula can be used to solve a variety of related
for a principal amount of $1.
problems.

Once the amount for $1 is known, it is easy to determine the

For example, as we noted above, you may be interested in
amount for any principal by multiplying the future amount
determining what rate of interest must be earned on a
for $1 by the required principal amount. Many hand
$10,000 investment if you want to accumulate $18,000 at
calculators also have function keys that can be used to solve
the end of 7 years.
these types of problems.

Or you may want to know the number of years an amount

To illustrate, the table below shows the future value of $1 for
must be invested in order to grow to a certain amount. In all
10 periods with interest rates ranging from 2% to 15%.
these cases, we have two of the three items in the formula,
and we can solve for the third.

Determining Future Value of a Single Amount

Interest Compounded More Often Than Annually

Continuing with the same example, suppose we now want to Interest is usually compounded more often than once per
determine the future value of $10,000 at the end of 3 years if year. In these situations, we simply adjust the number of
interest is compounded annually at 12%. interest periods and the interest rate.

To solve this, we can check the 12% column in the table until For example, to work out what $10,000 will be worth after 3
we come to 3 interest periods. The factor from the table is years if interest is compounded quarterly at an annual rate of
12%, we simply check the 3% column until we reach 12
periods (see Table 1.1).
Table For Future Value of a Single Amount
Table 1.1
The factor is 1.42576. Using the general formula, the
accumulated amount is $14,257.60, which is determined as
follows:
Accumulated amount = Factor x Principal
= 1.42576 x $10,000
= $14,257.60
Determining the Number of Periods or the Interest Rate
There are many situations in which the unknown variable is
the number of interest periods that the dollars must remain
invested or the rate of return (interest rate) that must be
earned.
For example, assume that you invest $5,000 today in a
savings and loan association that will pay interest
compounded annually.
You need to accumulate $8,857.80 for a certain project.
How many years does the investment have to remain in the
savings and loan association?
Using the general formula, we can tell that the answer is 6
years, which is calculated as follows:
Accumulated amount = Factor x Principal
Factor = Accumulated amount / Principal
= $8,857.80 / $5,000.00
= 1.77156
Looking down the 10% column in Table 1.1, the factor of
1.77156 appears at the sixth-period row. Given that interest
is compounded annually, the sixth period is interpreted as 6
years.
This example was constructed so that the factor equals a
round number of periods. If it does not, interpolation is
needed. The examples, exercises, and problems in this article
do not require interpolation.
We can use the same method to determine the required
interest rate.
---------------------------------
present value of single amount & annuity; Practical
application of time value technique.
The time value of money suggests a preference of having
money as of now than at a future point of time.
The concept of time value of money helps in arriving at the
comparable value of the different rupee amounts arising at
different points of time into equivalent values at a particular
point of time (present or future).
Learn about the techniques of time value of money: 1.
Compounding Technique 2. Discounting or Present Value
Technique
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1. The compounding technique is used to find out the future
value of different cash flows occurring at different points of
time. According to this technique, interest earned on the
initial principal or cash outflow becomes part of the principal
for calculating interest for the next period. As a result
interest is earned on interest as well as on the initial
principal. This interest earned on interest is known as
compounding effect and hence compounding technique.
2. Discounting technique is used to make cash flows
occurring over different future periods comparable at the
present time. In this technique present worth of future cash
flows are calculated.
Techniques of Time Value of Money: Compounding and
Discounting or Present Value Technique (With Formulas and
Examples)
Techniques of Time Value of Money – Compounding
Technique and Discounting Technique (With Effective Rate of
Interest)
These techniques of time value of money are now being
discussed in detail:
Technique # 1. Compounding Technique:
The compounding technique is used to find out the future
value of different cash flows occurring at different points of
time. According to this technique, interest earned on the
initial principal or cash outflow becomes part of the principal
for calculating interest for the next period.
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As a result interest is earned on interest as well as on the
initial principal. This interest earned on interest is known as
compounding effect and hence compounding technique.
This compounding technique can be explained for
calculating:
a. The future value of a single present cash flow.
b. The future value of a series of unequal cash flows over a
period of time.
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c. The future value of a series of equal cash flows over a
period of time.
d. The future value of a cash flow when compounding is
done more than once in a year.
e. The future value of an annuity due.
a. The future value of a single present cash flow:
The mathematical formula of calculating compounding
interest can be used in calculating the future value of a single
present cash flow.
b. The future value of a series of unequal cash flows over a
period of time:
When an investor has invested his money in unequal
installments over a period of time, he may want to know the
value of his investments after a certain period.
c. The future value of a series of equal cash flows over a
period of time (FV of an annuity):
Let us take an example to understand the concept of an
annuity. Mr. X has invested an equal amount say Rs. 10,000
each at the end of 1st, 2nd and 3rd year for 3 years at a
certain rate of interest. This investment of equal amount or
equal cash outflow can be termed as an annuity.
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Another feature of an annuity is that cash flows (payment or
receipt) should occur over a period of equal time intervals.
Hence, an annuity can be defined as a series of equal cash
flows (either inflows or outflows) occurring over a period of
equal time intervals.
We can find out the future value of an annuity by calculating Mathematically, effective rate of interest and normal rate of
the sum of future values of equal amount occurring over a interest (stated rate) are equal when they produce the same
period of equal time intervals as follows: future value of an investment.

Assuming annuity amount as A, invested at the end of each However, when compounding is done more than once in a
period at r (rate of interest) over n periods of time, the year, the effective rate of interest will be higher than the
formula for calculating future value of an annuity (FVAn) can stated annual rate of interest.
be derived as follows –

The relationship between the effective interest rate and the

FVIFA for different combinations of r and n can also be found stated annual interest rate is as follows:
from the future value interest factor of an annuity table.

The following table shows the relationship between normal

ADVERTISEMENTS: rate of interest of 12% per annum and effective rate of
interest under different compounding periods:

d. The future value of a cash flow when compounding is

done more than once in a year: Technique # 2. Discounting or Present Value Technique:

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However, in many cases interest is compounded more than

once in a year, say semi-annually, quarterly or even monthly.
Discounting technique is used to make cash flows occurring
Formula for calculating the compounding value or FV of a
over different future periods comparable at the present time.
cash flow when compounding is done more than once in a
In this technique present worth of future cash flows are
year will be same i.e. –
calculated.

Concept of Effective and Stated (Normal) Rate of Interest:

The present value approach works exactly in reverse of the
compounding technique. In the case of compounding
technique we ascertain the worth of all cash flows at a future
Effective Rate of Interest:
date while in case of present value technique the worth of all
future cash flows (both receipts or payments) are calculated
at the present date by adjusting for time value of money.
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We know money received in the future is less valuable than

The effective rate of interest is the rate of interest under money received at present time. Therefore, the present
annual compounding, which provides the same future value value of future cash flow is calculated by multiplying it with a
as provided by annual interest rate compounded more than discounting factor. That is why this technique is known as a
once in a year. discounting technique.

The concept of effective rate of interest is quite useful in Discounting technique can be explained for calculating:
financial decision making particularly in investment
opportunities involving different compounding periods.
Investment opportunity having the highest effective rate of
a. Present value of a future sum.
interest is to be selected.

b. Present value of a series of unequal cash flows.


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c. Present value of a series of equal cash flows.
a. Present Value of a Future Sum:
Present value of the money received in future will be less
than the value of the same money in hand today. This is
because the money in hand can be invested and its absolute
value can be increased at a future date. Whereas money
received in future has to be discounted to find its present
value. Hence, discounting is the inverse of compounding.
We can find the present value by restating the future value
equation as follows:
b. Present Value of a Series of Unequal Cash Flows:
In most of the investment proposals, it is observed that
unequal returns from these are spread over a number of
years. For the title purpose of comparison, money received
over future periods has to be discounted to present time and
compared with initial investment.
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The present value of a series of unequal cash flows can be
calculated by using the following formula:
DF1, DF2, DF3…. are the discounting factors (PVIF) for
periods 1,2,3… taken from the table of PV of one rupee.
c. Present Value of a Series of Equal Cash Flows (Annuity):
However, when a business or individual gets constant cash
inflows over a period of equal time intervals, such cash
inflows are known as an annuity. We can find the present
value of an annuity (PVA) by calculating the sum of present
values of each equal cash inflow occurring over a period of
equal time intervals.
Techniques of Time Value of Money – Compounding:
Ascertaining the Future Value and Effective Rate of Interest
The time value of money suggests a preference of having
money as of now than at a future point of time.
This implies that –
ADVERTISEMENTS:
(a) a person will have to pay in future more for a rupee
received today, implying thereby that the present value is
compounded to arrive at future value;
(b) A person may accept less today, for a rupee to be
received in the future, implying thereby that the future value
is discounted to arrive at present value. Therefore, the
inverse of the compounding process is termed as
discounting.
A series of cash flows may be compared with another series
of cash flows either with reference to a future point of time
or present date.
Accordingly, there are two valuation techniques to facilitate
such comparison:
1. Compounding; and
2. Discounting.
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Capital budgeting - Nature and significance
Capital Budgeting is a process of evaluating long-term
business decisions that need large amounts of capital. It is a
way to find a better deal for the growth of the business.
Capital budgeting is often related to important capital
decisions that impact the bottom-line of a company. It has
certain characteristic features. Here are the features one by
one.
 Difficult Decisions

Large Investments The decisions taken in capital budgeting are difficult because
they are about the future which is uncertain. Managers need
Capital budgeting is related to investments of large funds. It
to look at many factors before making capital budgeting
is often used to find projects that need large investments.
decisions. However, regardless of the amount of research,
Managers of a company identify the need for a capital
there is no guarantee that capital budgeting decisions will
budget where large sums of money are required. In capital
yield the desired results. That is why, the decisions of capital
budgeting decisions, managers analyze different
budgeting are difficult in nature.
opportunities and find the solution with optimum care.

Impact on Competitive Strength

Irreversible Decisions
The decisions taken in capital budgeting directly impact the
The decisions taken in capital budgeting are irreversible in
strengths and weaknesses of a company. While a good
nature. Therefore, making the right choices and analyzing
decision can lead to spectacular profitability, a bad decision
the basics is of optimum importance in capital budgeting.
can be fatal for the company. That is why capital budgeting
decisions are competitive in nature.
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Since the decisions cannot be taken back, managers need to
be sure which option will offer the maximum returns. Once What is Payback Period in Capital Budgeting?
applied, the decisions can either make a good profit or large
Payback is a method related to capital budgeting. The
losses. So, taking capital budgeting decisions is key to the
payback period in capital budgeting refers to the time
existence of a company.
required for the return on an investment (ROI) to "repay" or
pay back the total sum of the original investment.

High Risk

Capital budgeting decisions often carry a high amount of risk.
As large amounts of money are invested for a future
outcome that is uncertain, it is of a high-risk nature. The
large funds required in capital budgeting act like debt for the
companies and if the process goes wrong this may even lead
to bankruptcy of companies.
Long-term Impact on Profitability
Payback is a popular method of evaluation of investment
because it is easy to understand and calculate regardless of
what it actually means.
Despite being a non-DCF evaluation method, payback is used
extensively in the evaluation of investments for its simplicity
in calculation and application. It is quite useful in comparing
the calculation of similar investments.

Capital budgeting decisions are long-term in nature. They

make a long-term impact on profitability. In capital
The payback method doesn’t have any specific criteria for
budgeting, the funds are invested in projects that offer the
the evaluation of investments as a standalone tool. The only
best returns. As the process of getting returns is long, the
necessity in using the payback period method is that it
decisions usually take a long-term profitability point of view.
should be less than infinity.

Impacts on Cost Structure

Limitations of the Payback Method
The decisions of capital budgeting directly impact the cost
Despite being a simple way of evaluation of investments, the
structure of the company. As large funds are involved in the
payback method has some serious limitations because it
process, capital budgeting relies on the cost structure of the
doesn’t consider the time value of money, risks, and
company. Moreover, as decisions regarding rent, insurance,
financing issues.
and production have to be measured, capital budgeting
measures directly impact the cost structure of the company.
Although the time value of money can be measured by the time value of money to find a discounted payback
including the weighted average cost of the capital discount, period. The cash inflows of the project are discounted by a
the payback tool should not be used in isolation. given discount rate (cost of capital), and then the usual steps
are followed for calculating the payback period.

Accounting rate of return, Internal Rate of Return, DCF, Net

Economists and financial managers alternately use net
Present Value and profitability index.
present value (NPV) and internal rate of return (IRR) along
with the payback method to limit the shortcomings of the Nature of Investment
payback method in general.
Decisions

• The investment decisions of a firm are generally known

An explicit assumption in using the payback method is that
ROI continues even after the payback period. as the capital budgeting, or capital expenditure

decisions.

Calculation of Payback Period • The firm’s investment decisions would generally include

The payback period is a part of capital budgeting wherein the expansion, acquisition, modernisation and
period of time required for the return on investment to pay replacement of the long-term assets. Sale of a division or
back the sum of the original investment is calculated.
business (divestment) is also as an investment decision.

• Decisions like the change in the methods of sales

The payback period is generally expressed in years. The
process starts by calculating Net Cash Flow for each year distribution, or an advertisement campaign or a
where, research and development programme have longterm
implications for the firm’s expenditures and benefits,

Year 1 Net Cash Flow = Year 1 Cash Inflow – Year 1 Cash and therefore, they should also be evaluated as investment
Outflow decisions.

F
Then, Cumulative Cash Flow is calculated where, Importance of Investment

Decisions
Cumulative Cash Flow = Year 1 Net Cash flow + Year 2 Net • Growth
Cash Flow + Year 3 Net Cash Flow…
• Risk

• Funding
This accumulation is carried on by year until Cumulative Cash
Flow becomes a positive number. The year in which the • Irreversibility
cumulative cash inflow becomes positive that year is the
• Complexity
payback year.
Investment Evaluation

Criteria
more exact payback period is calculated using the formula −
• Three steps are involved in the

evaluation of an investment:
PaybackPeriod=AmounttobeInitiallyInvestedEstimatedAnnual
NetCashInflow 1. Estimation of cash flows

The payback method does not consider the time value of 2. Estimation of the required rate of return
money. Some economists modify this method by including
(the opportunity cost of capital)
3. Application of a decision rule for making
the choice
Investment Decision Rule
• It should maximise the shareholders’ wealth.
• It should consider all cash flows to determine the true
profitability of the project.
• It should provide for an objective and unambiguous way of
separating good projects from bad projects.
• It should help ranking of projects according to their true
profitability.
• It should recognise the fact that bigger cash flows are
preferable to smaller ones and early cash flows are
preferable
to later ones.
• It should help to choose among mutually exclusive projects
that project which maximises the shareholders’ wealth.
• It should be a criterion which is applicable to any
conceivable
investment project independent of others.
Evaluation Criteria
• 1. Discounted Cash Flow (DCF)
Criteria
– Net Present Value (NPV)
– Internal Rate of Return (IRR)
– Profitability Index (PI)
• 2. Non-discounted Cash Flow
Criteria
– Payback Period (PB)
– Discounted payback period (DPB)
– Accounting Rate of Return (ARR)
Net Present Value Method
• Cash flows of the investment project should be
forecasted based on realistic assumptions.
• Appropriate discount rate should be identified to
discount the forecasted cash flows.
• Present value of cash flows should be calculated using
the opportunity cost of capital as the discount rate.
• Net present value should be found out by subtracting
present value of cash outflows from present value of
cash inflows. The project should be accepted if NPV is
positive (i.e., NPV > 0).
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What Is Project Finance?
Project finance is the funding (financing) of long-term
infrastructure, industrial projects, and public services using a
non-recourse or limited recourse financial structure. The
debt and equity used to finance the project are paid back
from the cash flow generated by the project.
Project financing is a loan structure that relies primarily on
the project's cash flow for repayment, with the project's
assets, rights, and interests held as secondary collateral.
Project finance is especially attractive to the private sector
because companies can fund major projects off-balance
sheet (OBS).
KEY TAKEAWAYS
Project finance involves the public funding of infrastructure
and other long-term, capital-intensive projects.
This often utilizes a non-recourse or limited recourse
financial structure.
A debtor with a non-recourse loan cannot be pursued for any
additional payment beyond the seizure of the asset.
Project debt is typically held in a sufficient minority
subsidiary not consolidated on the balance sheet of the
respective shareholders (i.e., it is an off-balance sheet item).
Understanding Project Finance
The project finance structure for a build, operate, and
transfer (BOT) project includes multiple key elements.
Project finance for BOT projects generally includes a special
purpose vehicle (SPV). The company’s sole activity is carrying
out the project by subcontracting most aspects through
construction and operations contracts. Because there is no
revenue stream during the construction phase of new-build
projects, debt service only occurs during the operations
phase.
For this reason, parties take significant risks during the
construction phase. The sole revenue stream during this
phase is generally under an offtake agreement or power
purchase agreement. Because there is limited or no recourse
to the project’s sponsors, company shareholders are typically
liable up to the extent of their shareholdings. The project
remains off-balance-sheet for the sponsors and for the
government.
Not all infrastructure investments are funded with project
finance. Many companies issue traditional debt or equity in
order to undertake such projects.
Off-Balance Sheet Projects
Project debt is typically held in a sufficient minority
subsidiary not consolidated on the balance sheet of the
respective shareholders. This reduces the project’s impact on
the cost of the shareholders’ existing debt and debt capacity.
The shareholders are free to use their debt capacity for other
investments.
To some extent, the government may use project financing
to keep project debt and liabilities off-balance-sheet so they
take up less fiscal space. Fiscal space is the amount of money
the government may spend beyond what it is already
investing in public services such as health, welfare, and
education. The theory is that strong economic growth will
bring the government more money through extra tax
revenue from more people working and paying more taxes,
allowing the government to increase spending on public
services.
Non-Recourse Financing
When a company defaults on a loan, recourse financing gives
lenders full claim to shareholders’ assets or cash flow. In
contrast, project financing designates the project company as
a limited-liability SPV. The lenders’ recourse is thus limited
primarily or entirely to the project’s assets, including
completion and performance guarantees and bonds, in case
the project company defaults.
A key issue in non-recourse financing is whether
circumstances may arise in which the lenders have recourse
to some or all of the shareholders’ assets. A deliberate
breach on the part of the shareholders may give the lender
recourse to assets.
Applicable law may restrict the extent to which shareholder
liability may be limited. For example, liability for personal
injury or death is typically not subject to elimination. Non-
recourse debt is characterized by high capital expenditures
(CapEx), long loan periods, and uncertain revenue streams.
Underwriting these loans requires financial modeling skills
and sound knowledge of the underlying technical domain.
To preempt deficiency balances, loan-to-value (LTV) ratios
are usually limited to 60% in non-recourse loans. Lenders
impose higher credit standards on borrowers to minimize the
chance of default. Non-recourse loans, on account of their
greater risk, carry higher interest rates than recourse loans.
Recourse vs. Non-Recourse Loans
If two people are looking to purchase large assets, such as a
home, and one receives a recourse loan and the other a non-
recourse loan, the actions the financial institution can take
against each borrower are different.
In both cases, the homes may be used as collateral, meaning
they can be seized should either borrower default. To recoup
costs when the borrowers default, the financial institutions
can attempt to sell the homes and use the sale price to pay
down the associated debt. If the properties sell for less than
the amount owed, the financial institution can pursue only
the debtor with the recourse loan. The debtor with the non-
recourse loan cannot be pursued for any additional payment
beyond the seizure of the asset.
Loan documentation-Appraisal of terms loans by financial
institutions.
Term loan appraisal covers the appraisal of the borrower and
appraisal of the project. The characteristics of a term loan
are that term loan commitments are to be of long term. The
banks and financial institutions normally offer term loans
repayable in 10-15 years and beyond that period in
exceptional cases like housing loans. The repayment would
be made out of cash generated from business activities.
Appraisal of the borrower covers honesty and integrity of the
borrower, standing of the borrower, business capacity,
managerial competence, financial resources in relation to the
size of the project. The sources of information for the above
are the personal interview, credit investigation, trade circle
enquiries, market report, existing bank’s report, CIBIL report,
assets and liabilities statements submitted by the borrowers,
Income Tax assessment orders and wealth tax assessment
orders of promoters. Reports from credit rating companies,
assistance from ‘Venture Capitalists’ (ex: UTI ventures, ICICI
ventures etc.) may also be obtained, RBI defaulter list,
Newspapers and magazines, information from employees at
the time unit inspection etc. Appraisal of project covers
following details.
1.Commercial Viability of the project: Line of business,
demand-supply, profit margin, imports, exports, list of
important customers and suppliers, extent of competition,
costing and pricing, mechanism of the product, dependence
on single or few customers or suppliers, prevailing
Government policies, embargo etc. are to be evaluated
2. Production Arrangement: Power, water supply, transport,
infrastructure facilities like Proximity to the source of raw
materials, stores and other production facilities, workforce
etc. The Manager has to visit the place of the factory to see
that the business exists at the address furnished and also to
ascertain the infrastructure available, the level of activity
and make a preliminary report on his/her visit which includes
inspection report on prime and collateral security offered.
The Manager has to familiarise with borrower’s business,
form opinion about adequate labour strength, maintenance
of the factory, godown etc.
3. Technical feasibility (process should be contemporary):
Proper layout of the factory, quality of machinery, efficient
disposal, availability of technical staff to run the factory.
4.Market conditions & marketing arrangements: Demand,
supply, pricing etc., after the completion of project/
installation of new machinery. Names of the main buyers,
names of major competitors and their total market shares.
5. Financial appraisal: Past financial statement like profit and
loss accounts, balance sheets. The correlation between fixed
assets and under charging of depreciation, operating loss
position, contribution of other income to net profit,
valuation of closing stock, borrowings and interest cost,
extent of reserve created by revaluation of assets, unsecured
loan shown as quasi-equity, movement of unsecured loans
over the years, borrower’s stake in the business, investment
in intangible assets, other non-current assets. Acceptability
of projection and assumption considered for the assessment,
profitability estimate, solvency ratio i.e. ability to service
outside liabilities like TOL/TNW, Funded Debt/TNW etc.
Liquidity position like networking capital and current ratio.
Break Even Point and DSCR calculation. Repayment plan. The
major problems concerning term finance is maturity
mismatch, funding risk, Interest rate risk (IRR). These aspects
are to be carefully looked into while fixing loan amount and
repayment instalments.
6. Clearance from appropriate government agencies:
Consents, approvals & environment clearance aspects.
7. Non-fund based facilities: Apart from the term loan, a
project may also require non –fund based facilities like
Deferred Payment Guarantee, Co-acceptance, Buyers credit
etc. Assessment of non-fund based limits in such cases.
8. SWOT analysis (Strength, Weakness, Opportunity and
Threat)
9. Over invoicing in the case of term loan proposal to be
guarded against.
10. Enquiries about suppliers of machinery.
11. The value of primary and collateral securities in relation
to the amount of advance.
12. Balance sheets of group companies/firms to be analysed
if there is an investment of more than 10% in that company
by the borrower/loan applicant.
13. Debtors due from group companies/firms.
Financial Indicators:
Financial Indicators covers present and their projections. The
following ratios are to be examined for actual and future
projections for the period of repayment of the loan.
(i). Sales & Profitability,(ii). Tangible net worth,(iii). TOL/TNW
ratios (iv). Debt Equity Ratio.(v). Fixed asset coverage ratio
for term loan.
Calculation of DSCR (Debt Service Coverage Ratio):
Calculation of DSCR (Debt Service Coverage Ratio):While
sanctioning term loan to a borrower the banks and financial
institutions essentially calculate the DSCR.
The Debt-Service Coverage Ratio (DSCR) is a method of
calculating the repayment ability of multiple debt obligations
including proposed term loan installments. The ratio states
net operating income as a multiple of debt obligations due alternative, you should consider trade finance, contract
within one year, including interest, principal, sinking-fund finance, monetization or traditional corporate finance.
and lease payments (total debt service).

The formula for finding out debt service coverage ratio

Common Elements of Project Finance
(DSCR)
Project finance is the financing of large international projects
DSCR =(Profit after Tax+ Depreciation+ Interest on Term
like public infrastructure and public utility projects. But there
Loan)÷ (Interest on Term Loan+ Installment amount of Term
is no single definition of project finance. Despite more than
Loan).i.e. net operating income divided by total debt service.
$350 billion in project finance loans being originated
DSCR less than 1 suggests the inability of firm’s profits to
annually, the industry still doesn’t agree on a consensus
serve its debts whereas a DSCR greater than 1 means the
definition of project finance. Despite widespread
borrower is able to serve the debt obligations.The acceptable
disagreement over the definition of project finance, there is
industry norm for a debt service coverage ratio is between
widespread agreement on the elements of project finance.
1.5 to 2. To have a conclusive idea about the debt serving
The listed elements of project financings are common in
ability of the borrower, it is advisible to DSCR for the entire
every project finance transaction.
period of loan instead of only for one year.
Project Financings Are Capital-Intensive

A less visible element of project finance is that it involves

Sensitive Analysis: Sensitive analysis is to be done for term
huge amounts of financing because it is used to finance
loan assessment by slightly changing the assumption in the
major international development and infrastructure projects.
project. This is done to see the impact of adverse changes in
According to Project Finance International, the average
the assumption.
project financing in 2017 was almost $750 million. While
Global Trade Funding provides project financing of at least
$20 million, project financings typically involve amounts
Assessment of DPG/APG: Assessment of DPG is done in the
ranging $50 million to more than one billion dollars. Think
same method term loan is assessed, as it is a substitution of
infrastructure projects primarily in developing countries.
the term loan.Assessment of Advance Payment Guarantee
(APG) is done in the same way for fund based limits. Since
the borrower receives advance payment for the material to
Project Financings Have Numerous Participants
be supplied by him at future date, advance received should
be reduced from working capital gap. Another feature of project financings is that they always
involve many, many participants. Beginning with the project
Basic components of project finance.
sponsors, the vast amounts involved in project finance
usually require equity investors, project finance providers like
Global Trade Funding, project lenders which frequently
Elements of Project Finance Overview become a consortium of lenders, to share the risk, and so on.
What is project finance? It’s the most common question in Review our Project Finance Learning Center for extended
the industry yet it’s difficult to answer because there is no information about the project participants and stakeholders.
universally accepted definition of project finance. Worse still,
many widely used definitions of project financing aren’t in
agreement. Because there are numerous elements of project Project Financings Are Non-Recourse
finance common to all project financings, we look to those
Project finance is either non-recourse or very limited
elements of project finance to provide context.
recourse as to individual shareholders, including the project
sponsors. Non-recourse financing means the borrowers have
no personal liability in the event of monetary default. Project
Identifying the common elements of project finance is a companies are generally limited liability special purpose
worthy exercise to determine if project finance is really the entities, so any recourse the lender may have will be limited
best type of financing for your deal. If you cannot envision all to the project assets if the project defaults on the debt.
of these elements of project financing being part of your
deal, project finance is not the right financing. In the
The project is owned by a special purpose entity which is
formed for the express purpose of owning the project. The
project company has no credit or assets so lenders don’t
evaluate the project company when underwriting the
project. Because project loans are non-recourse and the
borrowers have no assets to satisfy deficiencies in the event
of project default, underwriting is focused entirely on the
viability of the project.
Project Financings Are Off-Balance Sheet
Project finance is off-balance-sheet financing. In project
finance transactions, the project company that owns the
project is a stand-alone company known as a special purpose
entity. Because there are numerous participants and
stakeholders in the project and ownership of the projected is
a Special Purpose Entity, the ownership interest of the
project sponsor or other project participant is a sufficiently
minority subsidiary interest. As such the balance sheet of the
project company is not consolidated onto the balance sheets
of the project sponsors or shareholders.
The off-balance-sheet element of project finance is attractive
to project sponsors because project loans do not negatively
impact the sponsor’s balance sheet, nor does it impact their
available borrowing capacity. Government entities also find
the off-balance-sheet feature of project finance attractive
because project debt and liabilities don’t impact their
balance-sheets, relieving pressure on an increasingly stressed
fiscal space.
Project Finance Documents
One of the most important features of project finance is the
extent of project documents. Project financings are so
complex, involve such vast amounts and so many
participants, projects necessarily must also involve extensive,
complex project finance documents if they are to be
successful. Well-organized, well-written project documents
are an absolute requirement of project financings. Because
project finance documents play such an important role in
project finance we have prepared a Project Finance
Document summary with a brief description of each of the
typical project documents.
Project Financings Allocate Risk
International project financing transactions tend to be riskier
than ordinary corporate finance deals. Because of the risk
exposure, allocation of the risk in the deal is often critical for
approval of the project finance loan.
Risk allocation, which is accomplished in the project
documents, attempts to match risks and corresponding
returns to the deal participants most capable of successfully
managing them. For example, EPC Contracts, which are fixed-
price, turnkey contracts for construction that include severe
penalties for delays put the construction risk on the
contractor instead on the SPE, the project sponsors or the
lenders. Risks inherent in typical project financings and
mitigating factors are covered in more detail below.
Project Financings Special Purpose Entities
Project ownership is ordinarily held in a single-asset, Special
Purpose Entity (SPE) with a limited life (sometimes referred
to as Special Purpose Vehicle or Special Purpose Company)
formed for the express purpose of owning a project pursuant
to a Project Finance transaction by the project sponsors.
They own only the underlying deal itself. In many cases, the
clearly defined conclusion of the project is the transfer of the
SPE.
Project Financing Cash Flow Waterfall
Again, due to the SPE and non-recourse financing, loan
documents will typically contain a contractual obligation to
apply excess cash flow from the project to debt service. Thus,
any excess cash flow applied in this manner will accelerate
loan amortization and reduce the lender’s risk exposure.
Cost of Project Financings
One of the most common features of project finance is it is
generally a more expensive financing structure than is typical
corporate finance options. Further, project finance involves
the use of highly-specialized financial structures which also
drives costs higher and liquidity lower. Margins for project
financings usually include premiums for emerging market risk
and political risks because so many projects are located in
high-risk countries. Emerging market political risk insurance
is commonly factored into overall costs.