UNIT 4: FINANCIAL

SERVICES
 INTRODUCTION
• Financial services are an important segment of the Indian financial system. Several types of financial services are needed for
the smooth functioning of a financial system.
• These services include merchant banking service, credit rating service and services such as factoring, venture capital
financing, lease and hire purchase financing and so on.

• Financial services are provided by various institutions like stock exchanges NBFC’s, banks, insurance companies and
merchant bankers.
• The financial services sector is regulated by SEBI, RBI and the Department of Banking & Insurance, Govt. of India, through
various legislations.
• Financial services are of two types :

i. Fund – based financial services : Institutions that provide fund or other assets to business organisations or persons.
ii. Fee-based financial services: Institutions that render consultancy services to business firms for taking various important
decisions or for solving some problems.
 FINANCIAL SERVICE AND FINANCIAL
INTERMEDIATION
• The financial services sector carry out the process of financial intermediation by acting as a channel through which the
financial surpluses of some groups in society are collected and then distributed to the other groups of society which have a
deficit.
• Eg. Insurance companies collect premiums from the policy holders and invest them in industrial/ commercial concerns.
 Fund Based and Fee Based Services
Fund Based Financial Services:
Fund-based financial services are those services where financial intermediary institutions provide funds to the business
firms for meeting their short-term and long-term requirements. Such services include — (i) Equipment leasing, (ii) Hire
purchase, (iii) Bill discounting, (iv) Venture capital, (v) Factoring, (vi) Housing finance, (vii) Insurance services, (viii)
Underwriting, etc. Various types of fund-based financial services are discussed below :

i. Equipment Leasing: There are some financial institutions which provide funds for equipment leasing. These
institutions are known as equipment leasing companies. The leasing company (i.e. a lessor) raises the required fund
for the purchase of assets which are leased out on rentals to the end-users (i.e., the lessee).
ii. Hire Purchase: There are some institutions which provide funds for financing an asset-purchase under hire
purchase system. Under this system, the customer (called as the hire purchaser) gets the possession of the goods
immediately, can use it and pay the price in instalments. However, the ownership of the goods remains with the
seller (called as hire vendor), and passes to the hire purchaser only after the payment of the last instalment.
iii. Bill Discounting : Some financial institutions including commercial banks provide funds to the business firms by
discounting the bills of exchange before the maturity date. They charge an amount for discounting the bill on the
drawer. This charge is known as discounting charge .
iv. Venture Capital : Some intermediary financial institutions provide seed capital to entrepreneur who start new
business with new concepts. These institutions provide the risk capital, commonly known as venture capital.
v. Factoring Service : Some financial institutions called as 'factors', take the responsibility of collecting the bills
receivables from the customers to whom credit sales have been made by a business firm. They buy the
customers' dues from the business firms at a discount and realise the dues from the customers.
vi. Housing Finance : Some financial institutions (including commercial banks) provide loans for constructing or
buying house properties. These institutions are known as housing finance institutions, such as HDFC, LIC
Housing Finance, etc. in India.
vii. Insurance Services : Some financial institutions take the business risks arising out of any accident or natural
calamities by taking annual premium from the business houses. They indemnify the risks arising out of any
accident or fire or any other reasons.
viii. Underwriting : When a company issues its shares and debentures, there lies a risk of undersubscription.
Underwriters provide a guarantee to sell certain number of shares or debentures and charge the underwriting
commission. When there is an under subscription, underwriters have to buy those excess shares and
debentures. They ensure the issuing companies a smooth and effective issue management.
Fee Based Financial Services:
Fee-based financial services are those specialised services which are rendered by some institutions managed by
professionals regarding technical matters. They charge fees for their services. There are various types of fee-based
financial services. These are — (i) Merchant Banking, (ii) Issue Management, (iii) Portfolio Management, (iv) Capital
Reorganisation, (v) Acquisition and Merger related services and (vi) Corporate Counselling. Various types of fee-based
financial services are discussed below:

i. Merchant banking : Merchant banks render professional services to the corporate organisations and other
organisations relating to some technical matters. They help to prepare Memorandum of Association, Articles of
Association, prospectus, etc. They also help the companies at the time of issue of shares and debentures. They
charge fees to provide such services from their clients.
ii. Issue management : Some financial institutions provide technical advice relating to new issue of shares and
debentures to the companies, such as pricing of issue, timing of issue, etc. These services are known as issue
management. They charge a certain amount of fees from the clients.
iii. Portfolio management : These services are rendered by the portfolio consultants. They are entrusted to manage the
funds of the investors. They are having specialised knowledge to manage investors' funds. They provide advisory
services regarding (i) optimum investment mix, (ii) type and quantum of securities to be selected for such
investment to maximise the return, etc.
iv. Corporate advisory services: Needed to ensure that an enterprise runs efficiently at its maximum potential through
effective management of financial and other resources. Includes services such as providing guidance in areas of
diversification, offering consultancies for rehabilitation of sick industrial units, offering advice on capital structure and re-
structuring, etc.
v. Acquisition and Merger related services : In the modern business world, a number acquisitions and mergers take place
in the corporate sector. In merger and acquisition process, lots of technical and legal matters are involved. There are some
organisations which provide specialised services to the corporate sector in this regard.

vi. Corporate counselling: In the modern business world, corporate organisations are confronted with various legal and
technical hurdles. In order to resolve these problems, expert advice is needed. There are some financial institutions which
provide technical advice to the corporate organisations. These services are known as corporate counselling.
vii. Credit rating : It refers to a fee-based financial service for evaluating the credit worthiness of the issuer of any security
and the capability to meet its credit obligations. Such financial service enables the companies with good credit rating (say,
AAA, AAA+ etc.) to raise funds at a cheaper rate.
viii. Stock broking: A stock broker is a member of a recognised stock exchange. He buys, sells, or deals in stock trading on
behalf of their clients.
ix. Depository & custodial service: A depository is an organisation which holds the securities of any individual
or organisation in electronic form and facilitates the transfer of ownership of those securities on settlement
dates. An investor who wants to avail of these services has to open an account with the depository through a
depository participant. (e.g., National Securities Depositories Ltd. (NSDL) in India, and HSBC as the
depository participant). On the other hand, a custodian is an intermediary who provides custodial services to
its clients through maintaining an account of these securities, collecting the benefits/rights accruing to the
clients in respect of those securities, etc.
Distinction between Fund-Based and Fee-Based Financial Services
Following are the main points of distinctions between fund-based financial services and fee-based financial
services: Points of Fund-Based Financial Fee-Based Financial Services
Distinctions Services

Definition Fund- based financial services are those services where
financial intermediary institutions provide funds to the
business firms for meeting short term and long term
requirements
Consideration Financial institutions provide funds to the business firms
by charging rent or interest.
Fee-based financial services are those
expert services which are rendered
by some institutions managed by
professionals regarding various
technical matters.
Financial institutions render various
technical services by charging fees.
Purposes The main purpose of these services is providing capital The main purposes of these services are-
to the business firms. i. Drafting MOA, AOA, prospectus,
etc.
ii. Preparing various projects.
iii. Issue of securities related services.
iv. Counselling the management of
companies.
v. Capital restructuring related advice.
Functions These services provide alternative capital to the These services provide technical and
business firms, such as, lease financing, hire purchase legal advice, such as corporate
financing, underwriting, etc. counselling, capital restructuring, etc.
Examples Examples of these services are- Examples of these services are:
i. Equipment Leasing, i. Merchant banking,
ii. Hire Purchase, ii. Issue management,
iii. Bill Discounting, iii. Portfolio management,
iv. Venture Capital, iv. Mutual Funds,
v. Factoring, v. Acquisition and Merger related
vi. Housing Finance, services,
vii. Insurance Services, vi. Corporate counselling
viii. Underwriting etc. vii. Credit Rating, etc.
 MERCHANT BANKING: INTRODUCTION

• Merchant banking is a combination of banking and consultancy services. It provides consultancy to its clients for
financial, marketing, managerial and legal matters.
• Consultancy means to provide advice, guidance and service. It helps a business person to start a business. It helps to
raise (collect) helps finance .It helps to expand and modernize the business .
• It help in restructuring of a business . It helps to review sick business units. It also helps companies to register, buy and
sell share at the stock exchange.
• Merchant banking can be defined as a skill-oriented professional service provided by merchant banks to their clients,
concerning their financial needs, for adequate consideration, in the form of fee.
• Merchant Bank Merchant banking activities has started in India in 1972 by the State Bank of India through separate
wing named SBI Capital Markets Ltd. (SBICAP).
• Later on, several banking and financial institutions had started merchant banking activities such as Bank of Baroda
Financial Services Ltd. (BOB Fiscal), Canara Bank Financial Services Ltd. (CANFINA), ICICI Merchant Banking
Services etc.
• Merchant bank is the intermediary that links the companies that require capital with the suppliers of capital. It
offers an array of specialised financial services as well as provides capital to the corporate sector.
• In USA, it is known as 'Investment Banks’.
• Mainly Merchant Bank renders fee. based advisory services to the corporate organisations relating to issue of
securities, broking related services, corporate counselling, various project related advice, etc.
• The Securities and Exchange Board of India (SEBI) has defined the Merchant Bank as "any person who is
engaged in the business of issue management either by making arrangement regarding selling, buying or
subscribing to securities or acting as manager, consultant, adviser or rendering corporate advisory service in
relation to such issue management.“
• Thus, merchant Bankers act as intermediaries between the issuer companies and the subscribers of securities in
the primary market. This process is known as Merchant Banking.
• No person shall carry on any activity as a merchant banker unless he holds a certificate granted by the SEBI.
 Categories of Merchant Banks operating in India
As per the SEBI (Merchant Bankers) Regulations, 1992, there are four categories of merchant bank operating in
India, these are:
a) Category I: The merchant banker which carries on any activity of the issue management, i.e., the preparation of
prospectus and other information relating to the issue, determining financial structure, tie up the financiers and
final allotment and refund of the subscription, and to act as adviser, consultant, manager, co-manager and
underwriter;
b) Category II: The merchant banker which acts as an adviser, consultant, co-manager, underwriter and portfolio
manager ;
c) Category III : The merchant banker which acts as underwriter, adviser, and consultant to a issue;
d) Category IV: The merchant banker which acts only as an adviser or consultant regarding issue.
 Functions performed by Merchant Bankers

1. Issue Management: In the past, the function of a merchant banker had been mainly confined to the
management of new public issues of corporate securities by the newly formed companies, existing companies
(further issues) and the foreign companies in dilution of equity as required under FERA In this capacity the
merchant banks usually act as sponsor of issues. The services provided by them include, the preparation of the
prospectus, underwriting arrangements, appointment of registrars, brokers and bankers to the issue, advertising
and arranging publicity and compliance of listing requirements of the stock-exchanges, etc. They act as experts
of the type, timing and terms of issues of corporate securities and make them acceptable for the investors on the
one hand and also provide flexibility and freedom to the issuing companies.
The procedure of the managing a public issue by a merchant banker is divided into two phases, viz;
a. Pre-issue management
b. Post-issue management
a. Pre-issue management-
Steps required to be taken to manage pre-issue activity is as follows:-
i. Obtaining stock exchange approvals to memorandum and articles of associations.
ii. Taking action as per SEBI guide lines
iii. Finalizing the appointments of the following agencies:
• Co-manager/Advisers to the issue
• Underwriters to the issue
• Brokers to the issue
• Bankers to the issue and refund Banker
• Advertising agency
• Printers and Registrar to the issue
iv. Advise the company to appoint auditors, legal advisers and broad base Board of Directors
v. Drafting of prospectus
vi. Obtaining approvals of draft prospectus from the company’s legal advisers, underwriting financial institutions/Banks
vii. Obtaining consent from parties and agencies acting for the issue to be enclosed with the prospectus.
viii. Approval of prospectus from Securities and Exchange Board of India.
ix. Filing of the prospectus with Registrar of Companies.
x. Making an application for enlistment with Stock Exchange along, with copy of the prospectus.
xi. Publicity of the issue with advertisement and conferences.
xii. Open subscription list.

b. Post-issue management:
Steps involved in post-issue management are:-
i. To verify and confirm that the issue is subscribed to the extent of 90% including devolvement from underwriters in
case of under subscription
ii. To supervise and co-ordinate the allotment procedure of registrar to the issue as per prescribed Stock Exchange
guidelines
iii. To ensure issue of refund order, allotment letters / certificates within the prescribed time limit of 10 weeks after the
closure of subscription list
iv. To report periodically to SEBI about the progress in the matters related to allotment and refunds
v. To ensure the listing of securities at Stock Exchanges.
vi. To attend the investors grievances regarding the public issue
2. Credit Syndication: Merchant banks provide specialised services in preparation of project, loan applications
for raising short-term as well as long- term credit from various bank and financial institutions, etc. They also
manage Euro-issues and help in raising funds abroad.
3. Portfolio Management: Merchant banks offer services not only to the companies issuing the securities but also
to the investors. They advise their clients, mostly institutional investors, regarding investment decisions.
Merchant bankers even undertake the function of purchase and sale of securities for their clients so as to
provide them portfolio management services. Some merchant bankers are operating mutual funds and off shore
funds also.
4. Promotional Activities: A merchant bank functions as a promoter of industrial enterprises in India He helps the
entrepreneur in conceiving an idea, identification of projects, preparing feasibility reports, obtaining
Government approvals and incentives, etc. Some of the merchant banks also provide assistance for technical
and financial collaborations and joint ventures.
 Role of Merchant Banks in Capital Market
Merchant banks play multifarious roles in the capital market. Such roles are discussed below:
i. Acting as lead manager : Acting as lead manager in the issue of shares of a company is the most important aspect
of merchant banking business. It is now compulsory that all public issues must be managed by one or more lead
managers. A merchant bank acts as a lead manager in the public issue and makes the issue successful.
ii. Acting as underwriters : The issuing companies appoint underwriters to make the issue successful. Merchant banks
may be appointed as underwriters. They perform underwriting activities very efficiently and successfully.
iii. Acting as bankers to the Issue : Merchant banks may be appointed as the banker to the issue by the issuing
companies. They accept applications and application money from the investors at the time of issue of shares and
refund excess application money. They perform these tasks very efficiently.
iv. Acting as portfolio managers : The main function of a portfolio manager is to manage the investment portfolio of
its clients efficiently. Merchant banks appoint professionals having sound stock market knowledge and skill. So, they
perform the functions of portfolio managers very effectively. To act as portfolio manager, the merchant banks require
a certificate from the SEBI.
v. Acting as project counsellor : The main task of a project counsellor is to appraise the technical financial and
commercial aspects of a project. After evaluating various aspects, it gives its recommendations relating to the
acceptance or rejection of the project. Merchant banks employ experts from the industries who are capable enough to
do this job efficiently. So, they act as project counsellors.
vi. Acting as registrars to an issue and share transfer agents: Merchant banks act as registrars and share transfer
agents. In that capacity, they perform the following functions:
a. Collecting applications and application money from the applicants.
b. Keeping proper records of application money received.
c. Guiding the companies in determining the basis of allotment of shares.
d. Issuing the allotment letters to the applicants.
e. Issuing the refund orders for the excess applications.
f. Keeping detail records of the holders of the securities.

vii. Acting as sponsor to the Issue : Merchant banks act as sponsor to the issue. As sponsors they play the important
role such as placement of shares, listing of shares, selection of the broker and the underwriter, etc.
viii. Acting as credit collectors : Merchant banks play active roles in arranging loans for a company and receive such
credit on behalf of its client from the financial institutions. They act as guarantors of loans raised by such companies.
 Difference between Merchant Bank and Commercial Bank
Merchant Bank
i. Merchant bank also called as
investment bank focuses on the needs of
large corporations.
ii. According to SEBI regulation act,
1992, merchant bank is a person who is
engaged in the business of issue
management or rendering corporate
advisory services in relation to issue
management.
iii. A merchant bank cannot undertake
banking business.
iv. Merchant banking serves mainly large
companies and high net worth
individuals.
v. Activities of the merchant bankers are
controlled by SEBI.
vi. Merchant banks generates most of
their profits from the fees they charge for
services provided.
Commercial Bank
Commercial banks also called retail banks
focus on the needs of individuals and
small business concerns.
The main business of commercial bank is
to accept the deposit of money from the
public for the purpose of lending or
investment.
A commercial bank can undertake
merchant banking business.
Commercial banking is accessible to
anyone for basic banking needs.
Activities of commercial banks are
controlled by the RBI.
Commercial banks earn profit by
providing various loans.
 Underwriting
• Underwriting is the process through which an individual or institution takes on financial risk for a fee. This risk
most typically involves loans, insurance, or investments. The term underwriter originated from the practice of
having each risk-taker write their name under the total amount of risk they were willing to accept for a specified
premium.
• Underwriting is one of the most important functions in the financial world wherein an individual or an institution
undertakes the risk associated with a venture, an investment, or a loan in lieu of a premium. Underwriters are
found in banking, insurance, and stock markets.
• The nomenclature ‘underwriting’ came about from the practice of having risk takers to write their name below
the total risk that s/he undertakes in return for a specified premium in the early stages of the industrial revolution.
• Today, underwriting is one of the key functions in the financial world and has become a discipline of sorts in
itself.
 Types of Underwriting
1. Underwriting in insurance: In the insurance world, underwriters determine whether an insurance agency
should undertake the risk of insuring a client. They determine the risk and exposure of clients and also how
much insurance should be granted to a client, how much they should pay for it and whether or not to offer an
insurance policy to the client in the first place.
2. Underwriting in stock market: In the securities market, underwriting involves determining the risk and price
of a particular security. It is a process seen most commonly during initial public offerings, wherein investment
banks first buy or underwrite the securities of the issuing entity and then sell them in the market. This ensures
that the issuers of the security can raise the full amount of capital while earning the underwriters a premium in
return for the service. Investors benefit a lot from the underwriting process as the information provided by an
underwriting agency can help them take a more informed buying decision. An underwriter who holds a large
chunk of the securities of a particular company or is the market maker for such a security provides the core
liquidity for the security and enhances price stability and distribution.
3. Underwriting in banking: Underwriters in the banking sector perform the critical operation of appraising the
credit worthiness of a potential customer and whether or not to offer it a loan. They appraise the credit history
of the customer through their past financial record, statements, and value of collaterals provided, among other
parameters.
 Investment Banking
• An investment bank is a financial services company or corporate division that engages in advisory-based financial
transactions on behalf of individuals, corporations, and governments.
• It assists high-net-worth individuals, companies, or government to raise or create capital. They underwrite new
securities for all types of corporations, assist in the sale of securities, and arrange for mergers and acquisitions or
reorganisations.
• An investment banker is an expert who understands and advises corporations about the feasibility of large
projects. He helps in identifying the risks associated with the projects before his client can invest time and money.
 Services provided by Investment Banks
Functions of Investment Banks (IBS) The IBs perform mainly two types of activities :
(a) They help the private and public corporate houses in issuing securities in the primary segment of the capital market, providing
underwriting commitments to the issue and acting as intermediaries in trading for clients;
(b) They give advise to their clients regarding merger and acquisitions (M & A) in both sell-side and buy-side. They also provide
financial advise to the investors and assist them in purchasing securities, managing financial assets and trading in securities.
Services provided by the IBs :
I. The fund raising service :
(a) The IB is an indispensable player in the issue management of any company. It assists the issuer of a security in different ways, e.g. it
analyses the market demand for such securities, designs the nature of this initial offer, makes the pricing of the issue, and arranges
for the marketing of these issues to the investors. Thus, the fund-raising services are provided by the IB to the issuer company. It
assists the clients to raise funds from the market through IPOs, FPOs, QIPs, Rights Issue, Preferential Allotment etc. [IPO : Initial
Public Offering ; FIP: Follow-on Public Offering;QIP : Qualified Institutional Placement].
(b) Any investment bank in India (which is regarded as Merchant Banker) should be registered with the SEBI as per SEBI regulations
(1992) to act as merchant banker or Book Running Lead Manager (BRLM). The pre-issue activities of the Lead manager include : (i)
due diligence of company's operation/management/business plans etc. (ii) drafting and designing the offer document, (iii) finalizing
the prospectus, (iv) drawing up marketing strategies for the issue, (v) ensuring compliance with stipulated requirements and other
formalities with the stock exchange and Registrar of Companies.
(c) The post-issue activities of any investment bank (viz., the merchant bank in India) includes the management of escrow account
(which is not operative until the issue starts), coordination non-institutional allocation, coordination with the Registrar for
dispatching the re dematerializing of securities, and coordinating the works of other intermediaries involved the issue process.
The investment bank also acts as the Registrar to the issue. It has to the list of eligible allottees, ensure crediting of shares to the
demat accounts of the allottees, and dispatch the refund orders. The Lead investment bank also appoints the Banker to the issue
to carry out activities relating to collection of application amount, transit amount to escrow account and dispatching refund
amounts

II. Corporate Advisory Services - The corporate advisory services are spread over a vast spectrum of corporate activity. Some
of them are very well suited for investment banks, with the rest finding place with specialist advisory firms. The essence of
corporate advisory services for investment banking relates to Business advisory, Restructuring advisory, Project advisory
and Merger & Acquisition advisory. Corporate Advisory Services is an umbrella term that encompasses specialized advice’s
rendered to corporate houses by professional advisers such as accountants, investment banks, law practitioners and host of
similar service providers.
Some of the important corporate advisory services are as follows:
a. The project advisory services: The IBs provide advisory services to different public and private sector companies for
undertaking any new project. They also arrange for the finance required for initiating and completing the project, say, by
developing relationship with many export credit agencies in different countries (for the provision of export credit, local
currency bank debt, etc.)
b. Advisory services for Merger and Acquisition : The IBs give Merger and Acquisition guidance to their clients regarding
strategic alternatives, financial restructuring and ownership transitions. They provide both buy-side and sell-side advisory
services in this regard.
• In case of buy-side advisory service, the IBs work with the clients who have identified particular acquisition targets
and assist them in negotiation, due diligence, terms and conditions of transaction, documentation and financing of
transaction etc.
• In case of sell-side advisory service, the IBs help their clients in the sale of a minority stake, a majority stake, or 100%
of the stocks/ assets of the client by identifying the qualified buyers suitable for each deal.
• The IBs also assist their clients in reverse merger. These mergers may take place between an unlisted company with
a listed company, or merger between a financially healthy company with a sick company etc.

c. Infrastructure advisory services : The IBs also provide the infrastructure project companies (in sectors like power
generation, airport construction etc.) and the developers of such projects the advisory and infrastructure capital
services for raising their required fund through private equity, external commercial borrowing, structured finance etc.
Their advisory services include pre-investment project feasibility study and appraisal, project implementation etc.
d. Strategic advisory services : The IBs help the corporate houses to frame and implement key strategies relating to
their business. These strategies relate to entry into a new market, exit from a business, off-shoring for end-customers
etc.
e. Sales and trading service : The IBs are also involved in the trading of equity, bonds, currency and derivative
instruments on behalf of their clients.
f. Equity research and broking service : The IBs generally have research and analysis wings that offer specialized
advise in terms of equities and equity prices of different industries in an economy.
 Credit Rating
Introduction:
• Credit rating is a mechanism whereby an independent third party makes an assessment, based on different sources
of information on the credit quality of the assessed debt instrument. Basically, rating which is expressed by
assigning symbols having definite meaning, is an opinion regarding the timely repayment of principal and interest
thereon. It is therefore an independent, easy-to-use measure of relative credit risk.
• Credit rating can be defined as an independent opinion expressed by the independent credit rating agencies that
states about capacity of an entity to meet its obligations and is based on various quantitative and qualitative
factors.
• Prof. L.M. Bhole has defined credit rating as “ an act of assigning values to credit instruments by estimating or
assessing the solvency, i.e., the ability of the borrower to repay debt and expressing them through pre-determined
symbols”.
 Overview of Credit Rating
• A company requiring finance in issuing debt-related instruments in capital market desires to obtain credit rating about
such instrument. The company as borrower has to seek a credit rating from an independent credit rating agency in order
to reduce the information asymmetry problem. The reason behind this is that investors like individual, banks and
institutional investors normally rely on external ratings as a measure for the borrower's credit and default risks.
• Credit rating is used broadly for evaluating debt instruments including long-term instruments, like bonds and
debentures as well as short-term obligations, like Commercial Paper. In addition, fixed deposits, certificates of deposits,
structured obligations including non-convertible portion of partly convertible debentures, etc. are also rated.
• A set of both qualitative and quantitative indicators are considered as criteria of credit rating. While the qualitative
indicators comprise a firm's growth potential, its capital requirements, the degree of competition in the market
environment, its productive diversification, ownership structure and quality of corporate governance, quantitative
indicators include debt leverage; the company's profitability and efficiency; its returns on equity/assets, etc.
• A company, desirous of rating its debt instrument, has to pay a fee to credit rating agency for this service. The different
rating agencies may give dissimilar ratings for the same security.
• A credit rating is technically an opinion on the relative degree of risk associated with timely payment of interest and
principal on a debt instrument. It is an informed indication of the likelihood of default of an issuer on a debt instrument,
relative to the respective likelihoods of default of other issuers in the market.
 Objectives of Credit Rating
Globalization of the capital market—along with diversification in the types of securities— posed a challenge to
institutional as well as individual investors as they always analyze the risks associated with investments. There are
several instances in the recent past where innocent investors were cheated by fly-by-night operators. In such a
situation, an ordinary investor would be unable to differentiate between “safe and good investment opportunities”
and “unsafe and bad investments”. Borrower's size, or reputation by name, is not is not a sufficient enough
guarantee of a timely payment of interest and principal. In this backdrop, investors rely upon the opinion of an
independent and credible agency, which judges impartially/professionally the credit quality of different companies
and assists investors in making the right decisions. The main objectives of credit rating are highlighted as under:

• To assist investors by providing a simple system of gradation of corporate debt instruments;

• To form an opinion on the relative capacities of borrowers to meet their obligations;
• To provide financial services—directly to the company called the borrower and also indirectly to the investors,
described as lenders—in the debt market;
• To offer guidance to investors in determining a credit risk associated with a debt instrument;
• To bridge the information gap significantly when market irregularities are strong and financial literacy low.
 Rating Methodology
In India, the rating exercise starts at the request of the company. The process of obtaining a rating is quite lengthy and time consuming.
The rating of a financial instrument requires a thorough analysis of relevant factors that affect the creditworthiness of the issuer. The
primary focus of the rating exercise is to assess future cash generation capability and their adequacy to meet debt obligations in adverse
conditions. The analysis attempts to determine the long-term fundamentals and the probabilities of change in these fundamentals, which
could affect the credit-worthiness of the borrower. Analysis typically involves at least five years of operating history and financial data as
well as company and rating agency forecasts of future performance. Ratings are assigned after an in-depth study of both objective and
subjective factors related to business, financial management and so on. Ratings are based on an indepth study of the industry and an
evaluation of the strengths and weakness of the company. The analytical framework for rating consists of the following five broad areas:
Economy analysis : This analysis takes into account the economy wide factors such as labour laws, industrial laws, export-import laws,
tax regulations etc. which have bearing up borrowing firm. For instance, if this legal environment is not liberal enough then it becomes
difficult for the borrowing firm to operate smoothly and get expected return from investment.
Business analysis : It relates to an analysis that covers industry risk, operating efficiency, legal position, market position or market share,
etc. of the borrowing firm. The analysis on industry risk focuses on the prospects of the industry and the competitive factors that affect
the industry. The demand-supply forces, price trends, changes in technology, investment plans of the major players in the industry, entry
barriers, number of potential entrants etc. are taken into consideration for this analysis. Similarly, the analysis regarding market position
of the industry covers the study of market shares of respective firms, marketing arrangements, type of products and the variety of
customers. The study on operating efficiency of a firm includes the analysis of production process, cost structure, locational advantage,
input availability, human resource management etc. The study on legal position of the firm covers the areas such as the prospectus of the
firm, the accuracy of information, filing of tax returns and compliance of other legal obligations with respective authorities.
Financial analysis : This analysis takes into account the financial performance of the company, say, adequacy of cash flows for
debt servicing, 'earnings protection', accounting quality, financial flexibility etc. The accounting quality, for instance, is generally
judged on the basis of the methods followed by the firm in respect of capital adequacy norms, income recognition, inventory
valuation, depreciation of fixed assets etc. The protection to earnings, on the other hand, is examined on the basis of profitability
ratio, earnings growth and projected earnings. The financial flexibility of the firm is examined in terms of the alternative sources
of liquidity available to the firm. The contingency plans of the firm under critical situations are also into account while
examining financial flexibility. A critical analysis is done regarding projected performance of the firm over the life of the debt
instrument.
Management evaluation : This evaluation process studies the track record of the regarding its managerial capability to
overcome adverse situations. It takes into vision and mission of the firm, managerial strategies, control systems, personal policies
and the managerial performance of its subsidiary firms, if any.

Fundamental analysis : It covers an analysis of asset quality, profitability, sensitivity towards tax rates/interest rates, liquidity
management etc. The analysis of liquidity management for instance, takes into account the capital structure of the firm, matching
of asset: liquid asset of the firm etc. The study on asset quality takes into consideration management policy of the firm,
composition of assets etc. On the other hand, the profitability of the firm is studied in terms of the reserves, spreads, profitability
ratio, etc.
All such information are collected and analysed by a team of professionals of credit rating agency. They submit their
recommendations to the rating committee which ultimately assigns the rating.
Credit Rating Process
These steps are discussed below:
i. Request from the issuer: At the beginning stage, the issuer requests the CRAs for rating an instrument and makes
an agreement for rating containing significant clauses like confidentiality, sharing information with the CRAs and
thereafter on an ongoing basis when the rating is under observation.
ii. Management Interaction: The CRAs start discussion with the management of the issuing entity. Such discussions
cover competitive position, strategy, financial policy, historical performance and long-term financial position. This
practically helps rating analysis to assess management capability and risk appetite. From the initial management
interaction to the assignment of the rating, the rating process normally takes three to four weeks.
iii. Rating Committee: After such discussion, rating committee of CRAs prepare a report stating the analyst team's
assessment of the business risk, financial risk, and management risk associated with the issuer. CRAs submit the
report to the rating committee who ultimately decides the rating.
iv. Advice to Issuer: On finalization of a rating, the rating committee communicates the rating decision to the issuer.
Since the issuer has discretion to accept or reject the initial rating (except, for public issues of debt in India), CRAs
following global best practice to allow the issuer to decide whether to accept the rating. If the issuer agrees with the
rating, a letter of acceptance is to be sent by the issuer to CRAs. As a result, a suitable press release along with a
rationale is released to the public domain. On the other hand, if the issuer does not agree with the rating, the issuer
may request for further review of the rating. It is the discretion of the CRAs who may or may not decide to modify
the rating, depending on the facts of the case.
v. Publication: Once the issuer has accepted the rating, it is circulated to CRAs’ subscriber base. Rating
information is also updated on line on website of CRAs. If the CRAs do not modify the rating which the issuer
continues to disagree, it can reject the rating. Finally, the outcome is that the rating does not get published.
vi. Confidentiality: Issuer provides a significant portion of the information, which is highly sensitive to the CRAs
only for the purpose of arriving at ratings. CRAs are not supposed to share such information with other
divisions or group companies of CRAS or any other person and they should maintain strict confidentiality
about such information.
vii. Surveillance and Annual Review: After assigning the rating, CRAs monitor the issuer's performance and the
economic environment in which the issuer operates. This observation is required to be aware of current
developments so that CRAs can review sensitive areas once again.
 Credit Rating Symbols
Separate sets of symbols are generally used by the credit rating agency for rating the long-term, medium-term and short-term
debt instruments. Long-term instruments consist of fixed income securities like debentures and bonds issued by different
companies. The public deposits, Certificate Deposits and other medium-term securities are included in this category, while the
short-term instruments include Commercial Papers and other short-term securities. Now, we can indicate some of the rating
symbols used by different rating agencies of India while rating the securities of different maturities.
Rating (indicating the safety of return of the principal amount along with interest) of long term securities by CRISIL (Credit
Rating Information Services of India Ltd.)
(i) AAA : Highest safety
(ii) AA : High safety
(iii) A : Adequate safety
(iv) BBB : Moderate safety
(v) BB : Inadequate safety
(vi) B : Risky
(vii)Here (+) and (-) signs are used as suffixes to these symbols to indicate competitive position of an instrument within a group,
e.g., AAA+ or AA+ would mean a comparatively better position within the group of such instruments, while AAA- would
mean comparatively lower position of the instrument in a particular group of such instruments.
Rating of medium-term securities by CRISIL and rating symbols used :
(i) FAAA : Highest safety

(ii) FAA : High safety

(iii) FA : Adequate safety
(iv) FB : Inadequate safety

(v) FC : Risk prone

(vi) FD : Default expected
Rating of short-term securities by CRISIL and the rating symbols used :

(1) P1 : Highest safety

(2) P2 : High safety
(3) P3 : Adequate safety

(4) P4 : Risk prone

(5) P5 : Default expected
 Credit Rating Agencies
1. Credit Rating Information Services of India Ltd. (CRISIL) : The CRISIL was established in January, 1988, as the pioneer credit rating
agency in India. It was promoted jointly by ICICI, UTI, GICI, LICI, United India Insurance Company and some domestic and foreign
banks. In 1996, it entered into a strategic tie up with the USA's largest credit rating agency 'Standards and Poor's (S & Ps). Later on S & Ps
acquired 67.7% stake of CRISIL. As a result, CRISIL became a subsidiary company of S & Ps. Activities of CRISIL are discussed below :
i. It rates the debt instruments, preference shares, commercial papers, etc. of Indian companies.
ii. It renders advice to the corporate organisations regarding optimum use of organizational resources, capital structure, technical matters, etc.
iii. It forays into SMEs’ (Small and Medium Scale enterprises) rating.
iv. It has started rating several products of banks, financial institutions, etc.
v. It has started to rate various hospital and healthcare institutes in India and abroad.

2. Investment Information and Credit Rating Agency(ICRA): The ICRA was incorporated in January, 1991 as an independent credit rating agency in
India by the IFCI and other leading development banks and commercial banks. The ICRA has a strategic tie up with Moody's Investors services.
Moody’s Investors service is the major shareholder of ICRA which has four main business segments. These are : (a) rating, (b) consulting services,
(c) outsourced services and (d) IT-related services. Recently, the company has also been exploring opportunities in the ratings of SMEs. It has also
started corporate governance rating services in India.
3. Credit Analysis and Research Ltd. (CARE) : The CARE was set up in India by the IDBI and other development banks in November, 1993. It is
purely an Indian rating agency which has started recently to expand internationally. It has also started expanding into research, but it is still in its
nascent stage. Recently it promoted a rating agency called ARC Ratings, in which it has 20% stake. This will help to strengthen its overseas footings.
Recently it has started 'IPO grading'.
 Venture Capital Finance
• Start up companies with a potential to grow need a certain amount of investment. Wealthy investors like to invest
their capital in such businesses with a long-term growth perspective. This capital is known as venture capital and
the investors are called venture capitalists.
• It is the money provided by an outside investor to finance a new, growing, or troubled business. The venture
capitalist provides the funding knowing that there’s a significant risk associated with the company’s future profits
and cash flow. Capital is invested in exchange for an equity stake in the business rather than given as a loan.
• Such investments are risky as they are illiquid, but are capable of giving impressive returns if invested in the right
venture. The returns to the venture capitalists depend upon the growth of the company. Venture capitalists have
the power to influence major decisions of the companies they are investing in as it is their money at stake.
• These venture capital companies provide the necessary risk capital to the entrepreneurs so as to meet the
promoters’ contribution as required by the financial institutions. In addition to providing capital, these VCFs
(venture capital firms) take an active interest in guiding the assisted firms.
• Formerly, banks and other related sources were the only forms of funding available for small businesses and
startups. Thanks to the evolvement of angel investors and top venture capital firms in India startups have access
to more reliable forms of funding.
 Features of Venture Capital Financing
The main features of venture capital can be summarized as follows:
a. High Degrees of Risk: Venture capital represents financial investment in a highly risk project with the
objective of earning a high rate of return.
b. Equity Participation: Venture capital financing is, invariably, an actual or potential equity
c. participation wherein the objective of venture capitalist is to make capital gain by selling the shares once the
firm becomes profitable.
d. Long Term Investment: Venture capital financing is a long term investment. It generally takes a long period to
encash the investment in securities made by the venture capitalists.
e. Participation in Management: In addition to providing capital, venture capital funds take an active interest in
the management of the assisted firms. Thus, the approach of venture capital firms is different from that of a
traditional lender of banker. It is also different from that of a ordinary stock market investor who merely trades
in the shares of a company without participating in their management. It has been rightly said, “venture capital
combines the qualities of banker, stock market investor and entrepreneur in one.”
 Advantages of Venture Capital
i. They bring wealth and expertise to the company
ii. Large sum of equity finance can be provided
iii. The business does not stand the obligation to repay the money
iv. In addition to capital, it provides valuable information, resources, technical assistance to make a business
successful

Disadvantages of Venture Capital

i. As the investors become part owners, the autonomy and control of the founder is reduced
ii. It is a lengthy and complex process
iii. Funding is relatively scarce and difficult to obtain
iv. Extensive due diligence is required
 THE FUNDING PROCESS: APPROACHING A
VENTURE CAPITAL FOR FUNDING AS A COMPANY
• Step 1: Idea generation and submission of the Business Plan
• The initial step in approaching a Venture Capital is to submit a business plan. The plan should include the below points:

a. There should be an executive summary of the business proposal

b. Description of the opportunity and the market potential and size

c. Review on the existing and expected competitive scenario

d. Detailed financial projections
e. Details of the management of the company
There is detailed analysis done of the submitted plan, by the Venture Capital to decide whether to take up the project or no.
Step 2: Introductory Meeting
Once the preliminary study is done by the VC and they find the project as per their preferences, there is a one-to-
one meeting that is called for discussing the project in detail. After the meeting the VC finally decides whether or
not to move forward to the due diligence stage of the process.

Step 3: Due Diligence

The due diligence phase varies depending upon the nature of the business proposal. This process involves solving of
queries related to customer references, product and business strategy evaluations, management interviews, and
other such exchanges of information during this time period.
Step 4: Term Sheets and Funding
If the due diligence phase is satisfactory, the VC offers a term sheet, which is a non-binding document explaining the
basic terms and conditions of the investment agreement. The term sheet is generally negotiable and must be agreed
upon by all parties, after which on completion of legal documents and legal due diligence, funds are made available.
TYPES OF FUNDING BY A VENTURE CAPITAL
Exit Route for a VC Firm
Exit routes refer to an event that would wrap a VC deal. At the end of a successful VC deal, the exit
route would lead venture capitalists to close their investment and reap profits from it. Usually, an exit
route for a venture capital firm is the startup getting any of the following-

• Initial Public Offering (IPO)

• Promoters buying back the equity
• Mergers & Acquisitions
• Selling the stake to other strategic investors
 PRIVATE EQUITY

Private equity is an alternate mode of private financing, which is composed of funds and investors that directly
invest in private companies, or that engage in buyouts of public companies, resulting in the delisting of public equity.
These companies are not listed or traded on any stock exchanges.
Private equity investors generally work towards funding new technology, making new acquisitions, expanding
working capital and bolstering balance sheets of companies. Private Equity firms also work in the same manner like
Venture Capitalists -- invest in the long term in startups to help them grow and then reap benefits after the
companies go public or merge with other firms.

However, PEs are different as unlike Venture Capitalists who only invest in startups they invest in mature
companies also that seek funds to improve their performance. Private Equities make money from management fees
and also charge performance fees for sale or turnaround growth of the company.
Difference between Private Equity and Venture Capital
 Loan Syndication
• Loan syndication is the process of involving a group of lenders in funding various portions of a loan for a single
borrower.
• Loan syndication most often occurs when a borrower requires an amount too large for a single lender to provide
or when the loan is outside the scope of a lender's risk exposure levels. Thus, multiple lenders form a syndicate to
provide the borrower with the requested capital.
• The borrower can be a corporation, an individual project, or a government. Each lender in the syndicate
contributes part of the loan amount, and they all share in the lending risk.
• One of the lenders act as the manager (arranging bank), which administers the loan on behalf of the other lenders
in the syndicate. The syndicate may be a combination of various types of loans, each with different repayment
terms that are agreed upon during negotiations between the lenders and the borrower.
 Participants in a syndicated loan
Arranging bank: Also known as the lead manager and is mandated by the borrower to organize the funding based on
specific agreed terms of the loan. The bank must acquire other lending parties who are willing to participate in the lending
syndicate and share the lending risks involved. The financial terms negotiated between the arranging bank and the
borrower are contained in the term sheet. (The term sheet details the amount of the loan, repayment schedule, interest rate,
duration of the loan and any other fees related to the loan.) The arranging bank holds a large proportion of the loan and
will be responsible for distributing cash flows among the other participating lenders.

Agent: The agent in a syndicated loan serves as a link between the borrower and the lenders and owes a contractual
obligation to both the borrower and the lenders. The role of the agent to the lenders is to provide them with information
that allows them to exercise their rights under the syndicated loan agreement. However, the agent has no fiduciary duty
and is not required to advise the borrower or the lenders. The agent’s duty is mainly administrative.

Trustee: The trustee is responsible for holding the security of the assets of the borrower on behalf of the lenders.
Syndicated loan structures avoid granting the security to the individual lenders separately since the practice would be
costly to the syndicate. In the event of default, the trustee is responsible for enforcing the security under instructions by
the lenders. Therefore, the trustee only has a fiduciary duty to the lenders in the syndicate.
 Types of Syndicated Loans
1. Underwritten deal: With the underwritten deal, the lead underwriter both guarantees and syndicates the entire loan,
and if the loan isn't fully subscribed the arranging bank has the option of absorbing its remaining portions.
From there, if the markets are bullish, the lead agent has the option of selling these remaining portions to other investors
at a profit. However, in a bear market, the lead agent may be forced to sell the undersubscribed portions at a loss or write
them off altogether.
The advantages of any bank taking on the role of lead agent in an underwritten deal are threefold. For one, syndicated
loans can be hugely profitable because the risks involved with such large amounts of capital typically results in higher-
than-average service fees. Secondly, this kind of loan makes the arranging bank appear to be more competitive. Thirdly,
underwritten deals offer floating interest rates, and as such are exposed to less risk than debts that have fixed rates.

2. Best-efforts syndication deal: Best-efforts syndication is more common to North America than Europe. The lead
agent doesn’t commit or guarantee the full amount of the loan; rather, any undersubscribed portions are ideally filled
by taking advantage of changes in market conditions.
For borrowers, however, should the remaining portions remain undersubscribed, they may have little choice but to accept
a smaller loan amount or move to have the agreement cancelled in its entirety.
3. Club deal: This type of syndicated loan typically represents smaller amounts of money -- less than $150 million on
average. The primary difference between the club deal and other syndicated loans is that with the club deal, the lead
underwriter shares the fees earned from the loan facility equally, or close to equally, with the other partners in the
consortium.

Advantages of Loan Syndication

a. Less time and effort involved- The borrower is not required to meet all the lenders in the syndicate to negotiate the
terms of the loan. Rather, the borrower only needs to meet with the arranging bank to negotiate and agree on the
terms of the loan. The arranger then does the bigger work of establishing the syndicate, bringing other lenders on
board, and discussing the loan terms with them to determine how much credit each lender will contribute.
b. Diversification of loan terms- Since a syndicated loan is contributed to by multiple lenders, the loan can be
structured in different types of loans and securities. The varying loan types offer different types of interest, such as
fixed or floating interest rates, which makes it more flexible for the borrower. Also, borrowing in different currencies
protects the borrower from currency risks resulting from external factors such as inflation and government laws and
policies.
c. Large amount- Loan syndication allows borrowers to borrow large amounts to finance capital-intensive projects. A
large corporation or government can borrow a huge loan to finance large equipment leasing, mergers, and financing
transactions in telecommunications, petrochemical, mining, energy, transportation, etc. A single lender would be
unable to raise funds to finance such projects, and therefore, bringing several lenders to provide the financing makes
it easy to carry out such projects.
d. Positive reputation- The participation of multiple lenders to finance a borrower’s project is a reinforcement of
the borrower’s good market image. Borrowers that have successfully paid syndicated loans in the past elicit a
positive reputation among lenders, which makes it easier for them to access credit facilities from financial
institutions in the future.

Disadvantages of Loan Syndication

a. Negotiations take time- Even with a lender intermediary, the formation of a syndicate takes time since the
lenders require extensive documentation to become familiar with the borrower. Loan term negotiations
between the borrower and the syndicate are also clocked in weeks, if not months. As a result, the entire process
ends up consuming more time than necessary.

b. Difficulty in relationship management- Management of multiple lenders at once can quickly become a
mammoth task unless the borrower knows how to take the bull by the horns. Because any delay in
communication, even between the syndicated lenders, can complicate the credit lines unfavorably. And
inevitably require additional effort from the borrower’s end.
 Lease Financing
• Lease financing is one of the important sources of medium- and long-term financing where the owner of an asset
gives another person, the right to use that asset against periodical payments.
• The owner of the asset is known as lessor and the user is called lessee.
• The periodical payment made by the lessee to the lessor is known as lease rental.
• Under lease financing, lessee is given the right to use the asset but the ownership lies with the lessor and at the
end of the lease contract, the asset is returned to the lessor or an option is given to the lessee either to purchase the
asset or to renew the lease agreement.
 Types of Lease
a. Capital Lease: This is also called ‘financial lease’. A capital lease is a long-term arrangement which is non-
cancellable. The lessee is obligated to pay lease rent till the expiry of lease period. The period of lease agreement
generally corresponds to the useful life of the asset concern. A long-term lease in which the lessee must record the
leased item as an asset on his/her balance sheet and record the present value of the lease payments as debt.
Additionally, the lessor must record the lease as a sale on his/her own balance sheet. A capital lease may last for
several years and is not cancellable. It is treated as a sale for tax purposes.
b. Operating Lease: Contrary to capital lease, the period of operating lease is shorter and it is often cancellable at the
option of lessee with prior notice. Hence, operating lease is also called as an ‘Open end Lease Arrangement.’ The
lease term is shorter than the economic life of the asset. Thus, the lessor does not recover its investment during the
first lease period. Some of the examples of operating lease are leasing of copying machines, certain computer
hardware, world processors, automobiles, etc. Operating lease is short-term and cancellable by the lessee. It is also
called as an ‘Open end Lease Agreement’. In case of a financial lease, the risk of equipment obsolescence is shifted to
the lessee rather than on the lessor.
c. Sale and Leaseback: It is a sub-part of finance lease. Under a sale and leaseback arrangement, a firm sells an asset to
another party who in turn leases it back to the firm. The asset is usually sold at the market value on the day. The firm,
thus, receives the sales price in cash, on the one hand, and economic use of the asset sold, on the other. This is
nothing but a paper transaction. Sale and lease back transaction is suitable for those assets, which are not subjected to
depreciation but appreciation, say for example, land.
d. Leveraged Leasing: A special form of leasing has become very popular in recent years. This is known as
Leveraged Leasing. This is popular in the financing of “big-tickets” assets such as aircraft, oil rigs and railway
equipment. In contrast to earlier mentioned three types of leasing, three parties are involved in case of
leveraged lease arrangement – Lessee, Lessor and the lender.

Differences between Operating lease and Financial lease

 Advantages of Leasing
i. Balanced Cash Outflow- The biggest advantage of leasing is that cash outflow or payments related to leasing are
spread out over several years, hence saving the burden of one-time significant cash payment. This helps a business
to maintain a steady cash-flow profile.
ii. Quality Assets-While leasing an asset, the ownership of the asset still lies with the lessor whereas the lessee just
pays the rental expense. Given this agreement, it becomes plausible for a business to invest in good quality assets
which might look unaffordable or expensive otherwise.
iii. Better Usage of Capital- Given that a company chooses to lease over investing in an asset by purchasing, it releases
capital for the business to fund its other capital needs or to save money for a better capital investment decision.
iv. Tax Benefit- Leasing expense or lease payments are considered as operating expenses, and hence, of interest, are tax
deductible.
v. Off-Balance Sheet Debt- Although lease expenses get the same treatment as that of interest expense, the lease itself
is treated differently from debt. Leasing is classified as an off-balance sheet debt and doesn’t appear on the
company’s balance sheet.
vi. No Risk of Obsolescence- For businesses operating in the sector, where there is a high risk of technology becoming
obsolete, leasing yields great returns and saves the business from the risk of investing in a technology that might
soon become outdated. For example, it is ideal for the technology business.
vii. Termination Rights- At the end of the leasing period, the lessee holds the right to buy the property and terminate the
leasing contract, thus providing flexibility to business.
 Disadvantages of Leasing
i. Lease Expenses- Lease payments are treated as expenses rather than as equity payments towards an asset.
ii. Limited Financial Benefits- If paying lease payments towards a land, the business cannot benefit from any
appreciation in the value of the land. The long-term lease agreement also remains a burden on the business as the
agreement is locked and the expenses for several years are fixed. In a case when the use of asset does not serve the
requirement after some years, lease payments become a burden.
iii. Reduced Return for Equity Holders- Given that lease expenses reduce the net income without any appreciation in
value, it means limited returns or reduced returns for an equity shareholder. In such a case, the objective of wealth
maximization for shareholders is not achieved
iv. Processing and Documentation- Overall, to enter into a lease agreement is a complex process and requires
thorough documentation and proper examination of an asset being leased.
v. No Ownership- At the end of the leasing period, the lessee doesn’t end up becoming the owner of the asset though
quite a good sum of payment is being done over the years towards the asset.
vi. Maintenance of the Asset- The lessee remains responsible for the maintenance and proper operation of the asset
being leased.
vii. Limited Tax Benefit- For a new start-up, the tax expense is likely to be minimal. In these circumstances, there is no
added tax advantage that can be derived from leasing expenses.
 Factoring Services
• Factoring is a financial service in which the business entity sells its bill receivables to a third party at a discount in order
to raise funds.
• It differs from invoice discounting. The concept of invoice discounting involves, getting the invoice discounted at a
certain rate to get the funds, whereas the concept of factoring is broader.
• Factoring involves the selling of all the accounts receivable to an outside agency. Such an agency is called a factor.
• The seller makes the sale of goods or services and generates invoices for the same. The business then sells all its
invoices to a third party called the factor.
• The factor pays the seller, after deducting some discount on the invoice value. The rate of discount in factoring ranges
from 2 to 6 percent. However, the factor does not make the payment of all invoices immediately to the seller.
• Rather, it pays only up to 75 to 80 percent of the invoice value after deducting the discount. The remaining 20 to 25
percent of the invoice value is paid after the factor receives the payments from the seller’s customers. It is called factor
reserve.
• The factoring agreement usually assumes that the whole credit risks as well as the collection of the accounts are taken
by the factor. Factoring offers enterprises, particularly small and medium ones, a means of financing their need for
working capital, but also an instrument of collection of receivables and default risk hedging.
 Types of Factoring
i. Recourse Factoring - In recourse factoring, the factor does not assume the credit risk (risk of non-payment by the
debtors). In other words, if the receivables become bad, i.e. if the customer does not pay on maturity, risk of bad
receivables remains with the seller, and the factor does not assume any risk associated with the receivables. The
factor provides the service of receivables collection, but does not cover the risk of the buyer failing to pay the debt.
The factor can recover the funds from the seller (client) in the case of such default. The seller assumes the risks
associated with the credit and the buyer’s creditworthiness.
The factor charges the seller for the management of receivables and debt collection services, while also charging interest
on the amount advanced to the client (seller).

ii. Non-recourse Factoring - In non-recourse factoring, the factor assumes the risk of non-payment by the client’s
customers. The factor cannot demand any outstanding amount from the client (seller).
The commission or fees charged for non-recourse factoring services are higher than for recourse factoring. The factor
assumes the risk of non-payment on maturity and consequently takes an additional fee called a del credere commission.

iii. Domestic Factoring - In domestic factoring three parties are involved (the seller, the buyer, and the factor), while in
export factoring there are four (the seller, the buyer, the domestic factor, and the factor abroad). In domestic
factoring, the factor mediates between the seller and the buyer. All three parties are located in the same country.
iv. Export Factoring - Export factoring is similar to domestic factoring, except there are four parties involved.
There are consequently two factors involved in the transaction, and it is referred to as the two-factor system of
factoring.

v. Conventional or Full Factoring - In full factoring, the factor performs almost all services of collection of
receivables, maintenance of sales ledger, credit collection, credit control and credit insurance.
The factor also fixes up a draw limit based on the bills outstanding maturity-wise and takes the corresponding risk
of default or credit risk and the factor will have claims on the debtor as also the client creditor.
Full factoring is also known as Old Line Factoring. In India, factoring agencies like SBI Factors are doing full
factoring for good companies with recourse.