Where let out property is vacant for part of the year [Section 23(1)(c)]:
Where let out property is vacant for part of the year, loss due to vacancy is deductible from the higher of Expected Rent and actual rent received or receivable and remaining amount will be the GAV of the property.
The former costs are known as a sunk cost.
'Non-resident Indian' is an individual who is a citizen of India or a person of Indian origin and who is not a resident of India. Thus, in order to determine whether an Individual is a non-resident Indian or not, his residential status is required to be determined under Section 6. As per section 6 of the Income-tax Act, an individual is said to be non-resident in India if he is not a resident in India and an individual is deemed to be resident in India in any previous year if he satisfies any of the following conditions:
1. If he is in India for a period of 182 days or more during the previous year; or
2. If he is in India for a period of 60 days or more during the previous year and 365 days or more during 4 years immediately preceding the previous year.
However, in respect of an Indian citizen and a person of Indian origin who visits India during the year, the period of 60 days as mentioned in (2) above shall be substituted with 182 days. The similar concession is provided to the Indian citizen who leaves India in any previous year as a crew member or for the purpose of employment outside India.
The Finance Act, 2020, w.e.f., Assessment Year 2021-22 has amended the above exception to provide that the period of 60 days as mentioned in (2) above shall be substituted with 120 days, if an Indian citizen or a person of Indian origin whose total income, other than income from foreign sources, exceeds Rs. 15 lakhs during the previous year. Income from foreign sources means income which accrues or arises outside India (except income derived from a business controlled in or a profession set up in India).
Note: The Finance Act, 2020 has introduced new section 6(1A) to the Income-tax Act, 1961. The new provision provides that an Indian citizen shall be deemed to be resident in India only if his total income, other than income from foreign sources, exceeds Rs. 15 lakhs during the previous year. For this provision, income from foreign sources means income which accrues or arises outside India (except income derived from a business controlled in or a profession set up in India).
However, such individual shall be deemed to be Indian resident only when he is not liable to tax in any country or jurisdiction by reason of his domicile or residence or any other criteria of similar nature.
Thus, from Assessment Year 2021-22, an Indian Citizen earning total income in excess of Rs. 15 lakhs (other than from foreign sources) shall be deemed to be resident in India if he is not liable to pay tax in any country.
A person shall be deemed to be of Indian origin if he, or either of his parents or any of his grand-parents, was born in undivided India.
Budgeting is the process of creating a plan to spend your money. This spending plan is called a budget. Creating this spending plan allows you to determine in advance whether you will have enough money to do the things you need to do or would like to do.
Effective Budgeting: Essentials # 1.
Sound Forecasting:
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Business forecasts are the foundation of budgets. The forecasts are discussed by the executives and when most profitable combinations of forecasts are selected, they become budgets. The more sound are the forecasts better results would come out of the budgeting.
Effective Budgeting: Essentials # 2.
An Adequate, Planned and Reliable Accounting System:
There should be a proper flow of accurate and timely information in the business which is ‘must’ for the preparation of budgets. The finance department should continuously supply financial data on the basis of which budget estimates and forecasts are to be made. If the data are wrong all the estimates will be wrong and the very objectives of budget will be misguiding.
Effective Budgeting: Essentials # 3.
Efficient Organisation:
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Preparation of Budget and its operation requires efficient, adequate and best organisation. Therefore, a budgeting system should always be supported by a sound organisational structure demarcating clearly the lines of authority and responsibility.
Moreover, there should be true delegation of authority from top to lower levels of management so that executives at all levels may get the opportunity to make best decisions and get themselves involved in budget making exercise.
Effective Budgeting: Essentials # 4.
Formation of Budget Committee:
It is the Budget Committee that receives the forecasts and targets of each department as well as periodic reports and finalizes the final acceptable targets in form of Mater Budget. The Budget Committee also approves the departmental budgets. It is imperative that opportunities must be provided to the executives of all the departments for their participation in the process of budget making.
Effective Budgeting: Essentials # 5.
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Cleanly defined Business Policies:
Budgets for each department should be prepared taking into account the policies set for particular department. Policies should be precise and clearly defined as well as free from any ambiguity.
Effective Budgeting: Essentials # 6.
Availability of Standard Information:
It is very essential that sufficient and accurate relevant data should be made available to each department. Take for example, sales forecasts, production targets, price data may not flow from normal accounting system alone and these data should be collected and processed by using advanced statistical techniques and methods.
Effective Budgeting: Essentials # 7.
Support of Top Management:
In order to make budgets effective, each member of top management should cooperate and should involve themselves enthusiastically in the process of budget making. The whole system of budget making should enjoy the active and spontaneous support of the top management.
Effective Budgeting: Essentials # 8.
Good Reporting System:
An effective budgeting system also requires the presence of a proper feed back system. As work proceeds in the budget period, actual performance should not only be recorded but it should also be repaired with the budgeted performance. The variations should be reported promptly and clearly to the appropriate levels of management.
The reporting system should be designed in such a way that along with variations, the causes of such variations and persons responsible for such variations are also reported so that management may decide about suitable remedial or corrective actions.
Effective Budgeting: Essentials # 9.
Motivation:
All the employees or staff other than executives should be strongly and properly motivated towards budgeting system. There is need to make each member of the staff feel too much involved in the budget making system.
Limitations of Budgeting
Inaccuracy
Budgeting is based on a lot of assumptions in estimating the expenses and revenues. These are generally based on trends and the market scenario prevailing at the time of making the budget. Budgets can also be based on the predictions made for the coming year considering the data available at the time of budgeting.
Any shift in the macroeconomic conditions, like an economic downturn or changes in currency exchange rates, changes in interest rates etc., can lead the actual costs that vary significantly from the budgeted expenses.
Time-Consuming & Costly
Budgeting exercise can be at times a very time-consuming exercise. It involves extra manpower to get the estimates as accurate as possible. Especially for a big company with various departments, budgeting exercise takes a huge effort. The time consumed may be low in cases where the company uses budgeting software and the employees are well-trained. If the company uses zero-based budgeting technique, the time, cost and effort involved can be considerably large.
Rigidity
Budgeted numbers are considered sacrosanct by all the departments and there is usually very less flexibility after budgeting exercise finishes. The entire focus of senior management is on the budget and all the strategies revolve around the budgeted numbers. Any change in the market situations does not generally evoke the attention of the management to make any drastic change in the strategy due to budget constraint. The company should rather shift as per the market and book more profit rather than stick to the budget.
Excessive Spending
Some managers believe that all the funds that are allocated to their department need to be spent. It is believed that if they do not use as much as they are authorized to in the current budget, the funds budgeted for them in the next budget would be reduced. This leads to unnecessary wastage of funds and proves harmful to the company as a whole affecting its profits.
Scope for Manipulation
At times, an experienced manager may deliberately inflate his expenses and try to reduce the revenue targets to be set in the budget. This way he can easily get an opportunity to get the favorable variances against the budgeted numbers, that is, by incurring lower costs than budgeted cost and achieving higher revenue than the budgeted revenue. This misleads the stakeholders and demotivates the employees.
Activity-based costing (ABC) is a costing method that identifies activities in an organization and assigns the cost of each activity to all products and services according to the actual consumption by each. This model assigns more indirect costs (overhead) into direct costs compared to conventional costing.
A fundamental difference between traditional costing and ABC costing is that ABC methods expand the number of indirect cost pools that can be allocated to specific products. The traditional method takes one pool of a company's total overhead costs to allocate universally to all products.
Implementation Steps
Step #1: Activity Identification
First, activities must be identified and grouped together in activity pools. Activity pools are the supporting activities that tie in to a product line or service These pools or buckets may include fractionally assigned costs of supporting activities to individual products as appropriate during the second step.
Step #2: Activity Analysis
ABC continues with activity analysis, clearly identifying the processes which support a product and avoiding some of the systemic inaccuracies of traditional costing. ABC costing requires activity analysis, similar to the process mapping found in lean manufacturing.
This activity analysis identifies indirect cost relationships and allows assignment of some percentage of that activity to an end product directly.
Step #3: Assignment of Costs
Based on the findings of step #1 and #2, costs are assigned to an activity pool. For example, human resources costs would be assigned to indirect administrative or indirect management costs. These pools will each have some contribution to object cost.
Step #4: Calculate Activity Rates
Initial analysis may include direct labor hours, or indirect support labor. These activities must be assigned a value in real currency. All weightings must be added at this step. For instance, production labor hours should be in terms of a weighted labor rate including benefit costs.
Step #5: Assign Costs to Cost Objects
Once activity costs, pools and rates are identified and clearly defined, the next step is to assign them to cost objects. Objects are generally defined as the results offered to a customer. In both manufacturing and non-manufacturing environments, this product should have some saleable value to compare to the assigned costs.
Step #6: Prepare and Distribute Management Reports
Once ABC costing analysis is complete, that cost data should be placed in a concise and coherent manner for cost object and process owners. This communication of the costing analysis is critical to justify the cost of the analysis, as often this is not an inconsequential cost.
Need to Provide Depreciation
Depreciation needs to be provided because an asset is bound to undergo wear and tear over a period of time. This reduces the working capacity and effectiveness of the asset. Hence, this should reflect the value of the asset, at which it is carried in the books of accounts.
Also, every asset becomes obsolete over a period of time, as new technology and innovation take over. The value of the asset will hence decrease over time and this must be accounted for.
| STRAIGHT LINE METHOD | DIMINISHING BALANCE METHOD |
|---|---|
| The depreciation amount provided on the asset using Straight Line Method is constant every year throughout the lifetime of the asset. | The depreciation amount provided on the asset is not constant every year but the percent of depreciation is constant. |
| Value of Asset | |
| The value of the asset becomes zero or nill at the end of the lifetime of the asset. | The value of the asset never become zero at the end of the lifetime of the asset. |
| Depreciation Amount | |
| The depreciation amount of the asset stays same for all the years of lifetime of an asset. | The depreciation amount of the asset is higher in the earlier years and become lesser in the later years. |
| Profits Earned | |
| Under Straight Line Method, the profits earned on the asset during the earlier years of the asset is higher because of the less maintenance and repair costs. | Under Diminishing Balance Method, the profits earned on the asset during the earlier is less when compared to later years. |
| Overall Charge | |
| In Straight Line Method, the overall charge on the assets go on increasing year by year because of the increasing maintenance and repair costs of the asset as the time passes. | In Diminishing Balance Method, the overall charge remains more or less same because of the decreasing depreciation in the later years and increasing repair costs as years pass. |
Responsibility accounting is a system that involves identifying responsibility centers and their objectives, developing performance measurement schemes, and preparing and analyzing performance reports of the responsibility centers. Responsibility accounting involves gathering and reporting revenues and costs by areas of responsibility.
Prerequisites of responsibility accounting: Personal Factors in Responsibility Accounting says a program to develop for management accounting controls which must be considered as a prime responsibility of top management with the accounting department in providing the technical assistance. To assure the follow-through and therewith the ultimate success of the program, management must provide a complete clarification of the objectives and responsibilities of all levels of the organization.
Like other management tools, responsibility accounting suffers from some limitations. Some of the limitations are stated below:
(i) It is practically difficult to design an organisation chart which might delineates lines of responsibility and grant authority required for responsibility assigned.
(ii) There is likely to be a conflict between individual interest and organisation interest leading to serious problems for implementation of policies.
(iii) A lot of passive resistance may be faced as a result of which basic objectives of the organisation may be lost.
(iv) This system ignores the personal reactions of the personnel involved in the process of implementation.
(v) There must exist a good reporting system without which the tool becomes useless and meaningless.
An audit is the examination, inspection and verification of any organization, system, process or product. An investigation is an in-depth and detailed examination. An audit is performed to catch hold of any deviations in the accounts. The purpose of an investigation depends upon the nature of the business.
Indifference points refer to the EBIT level at which the EPS is same for two alternative financial plans. According to J. C. Van Home, 'Indifference point refers to that EBIT level at which EPS remains the same irrespective of debt equity mix'.
EBIT refers to a company's earnings before interest and taxes. EBIT will be the same either way. EPS stands for earnings per share, which is the profit the company generates including the impact of interest and tax obligations. EPS is particularly helpful to investors because it measures profits on a per share basis.
The indifference point is the level of volume at which total costs, and hence profits, are the same under both cost structures. At the cost indifference point, total costs (fixed cost and variable cost) associated with the two alternatives are equal.
S1 = Number of equity shares or amount of equity share capital under alternative 1. S2 = Number of equity shares or amount of equity share capital under alternative 2. The point of indifference can also be determined by preparing the EBIT chart or range of earnings chart.
Primary market | Secondary market | |
Also called as | New Issue Market (NIM) | After Issue Market (AIM) |
Role of the market | Market where stocks are issued for the first time | Market where stocks are traded once issued |
Intermediaries | Investment banks | Brokers |
Sale of securities | Directly by companies to investors | Sold and purchased amongst investors and traders |
Price of shares | Fixed at par value | Changes depending on the supply and demand of shares |
Mutual Funds vs Direct Stocks
1.Returns
Perhaps the dilemma for a novice investor starts here.
Practically speaking, as compared to equity, mutual fund returns are regular, carry lower risk and offer benefits of compounding.
Which means the longer you stay invested in the fund, the more you earn. Also in the case of a diversified portfolio, the returns don’t fluctuate as much.
In comparison, since direct equity is invested in individual stocks, your returns can see a lot of surges and declines within short spans.
2.Risks
In mutual funds, the fund manager ensures investment in different sectors and is tracking the market all the time.
Whereas, direct stocks come with higher risks.
To diversify here would mean to invest in many different industries with a considerable amount of invested capital.
Yes, for investors who have the appetite and know the market, the high returns are definitely a reward. However, they come with a considerable amount of risk.
3.Performance
Both direct equity and mutual funds are based on the same company stocks being traded in the stock market. But the effects of the market flip-flops, are different on both.
In mutual funds, an under-performing stock gets balanced by another well-performing stock.
Hence, the gains are not affected to a huge degree.
But, in direct stocks, if that one under-performing stock is where most of your money is invested, that would mean your returns will become very low.
Unless of course, you check your stocks very efficiently and such situations are foreseen, which is rare.
4.Tax Benefits
Mutual Funds can provide tax benefits to an investor under Section 80 C if invested in equity- linked saving schemes (ELSS). This is not something direct equity investment can boast of.
Also, the latter comes with a short-term capital tax; that has to be paid if the stocks are sold within 1 year.
But, there is no such liability with mutual funds.
5.Control on Investment
Aggregation makes control and monitoring much simpler. That is the advantage of mutual funds. You are monitoring the fund and not the individual companies in the portfolio.
But, this would mean that you do not have a direct control over which stocks your money is invested in.
Which is a fair assumption, but that is the price you pay for convenience.
In stark contrast, stocks demand your attention day in and day out. That implies, if you have invested in 20 companies, you control and watch all the 20 companies every single day.
Net Income Approach was presented by Durand. The theory suggests increasing value of the firm by decreasing the overall cost of capital which is measured in terms of Weighted Average Cost of Capital. This can be done by having a higher proportion of debt, which is a cheaper source of finance compared to equity finance.
Weighted Average Cost of Capital (WACC) is the weighted average costs of equity and debts where the weights are the amount of capital raised from each source.
WACC
=
Required Rate of Return x Amount of Equity + Cost of debt x Amount of Debt
Total Amount of Capital (Debt + Equity)
According to Net Income Approach, change in the financial leverage of a firm will lead to a corresponding change in the Weighted Average Cost of Capital (WACC) and also the value of the company. The Net Income Approach suggests that with the increase in leverage (proportion of debt), the WACC decreases and the value of firm increases. On the other hand, if there is a decrease in the leverage, the WACC increases and thereby the value of the firm decreases.
For example, vis-à-vis equity-debt mix of 50:50, if the equity-debt mix changes to 20: 80, it would have a positive impact on the value of the business and thereby increase the value per share.
Consider a fictitious company with below figures. All figures in INR.
Earnings before Interest Tax (EBIT) = 100,000
Bonds (Debt part) = 300,000
Cost of Bonds issued (Debt) = 10%
Cost of Equity = 14%
Calculating the value of a company
EBIT = 100,000
Less: Interest cost (10% of 300,000) = 30,000
Earnings (since tax is assumed to be absent) = 70,000
Shareholders’ Earnings = 70,000
Market value of Equity (70,000/14%) = 500,000
Market value of Debt = 300,000
Total Market value = 800,000
Overall cost of capital = EBIT/(Total value of firm)
= 100,000/800,000
= 12.5%
Now, assume that the proportion of debt increases from 300,000 to 400,000 and everything else remains same.
(EBIT) = 100,000
Less: Interest cost (10% of 400,000) = 40,000
Earnings (since tax is assumed to be absent) = 60,000
Shareholders’ Earnings = 60,000
Market value of Equity (60,000/14%) = 428,570 (approx)
Market value of Debt = 400,000
Total Market value = 828,570
The Capital Asset Pricing Model (CAPM) is a model that
describes the relationship between the expected return and risk of investing in
a security. It shows that the expected return on a security is equal to the
risk-free return plus a risk premium, which is based on the beta of that
security. Below is an illustration of the CAPM concept.
APM Formula and Calculation
CAPM is calculated according to the following formula:
Expected return on a security = Risk-free rate + (Beta of
the security X Risk Premium)
Ra = Rrf + [BaX(Rm – Rrf)]
Note: “Risk Premium” = Expected return of the market - Risk-free
rate
The CAPM formula is used for calculating the expected
returns of an asset. It is based on the
idea of systematic risk (otherwise known as non-diversifiable risk) that
investors need to be compensated for in the form of a risk premium. A risk
premium is a rate of return greater than the risk-free rate. When investing,
investors desire a higher risk premium when taking on more risky investments.
Expected Return CAPM - Expected Return
The “Ra” notation above represents the expected return of a
capital asset over time, given all of the other variables in the equation. “Expected return” is a long-term assumption
about how an investment will play out over its entire life.
Risk-Free Rate CAPM - Risk-free Rate
The “Rrf” notation is for the risk-free rate, which is
typically equal to the yield on a 10-year US government bond. The risk-free rate should correspond to the
country where the investment is being made, and the maturity of the bond should
match the time horizon of the investment. Professional convention, however, is
to typically use the 10-year rate no matter what, because it’s the most heavily
quoted and most liquid bond.
Beta CAPM - Beta
The beta (denoted as “Ba” in the CAPM formula) is a measure
of a stock’s risk (volatility of returns) reflected by measuring the
fluctuation of its price changes relative to the overall market. In other
words, it is the stock’s sensitivity to market risk. For instance, if a
company’s beta is equal to 1.5 the security has 150% of the volatility of the
market average. However, if the beta is equal to 1, the expected return on a
security is equal to the average market return.
A beta of -1 means security has a perfect negative correlation with the
market.
Market Risk Premium
From the above components of CAPM, we can simplify the
formula to reduce “expected return of the market minus the risk-free rate” to
be simply the “market risk premium”. The
market risk premium represents the additional return over and above the
risk-free rate, which is required to compensate investors for investing in a
riskier asset class. Put another way, the more volatile a market or an asset
class is, the higher the market risk premium will be.
Corporate restructuring is an action taken by the corporate entity to modify its capital structure or its operations significantly. Generally, corporate restructuring happens when a corporate entity is experiencing significant problems and is in financial jeopardy. The process of corporate restructuring is considered very important to eliminate all the financial crisis and enhance the company’s performance. The management of concerned corporate entity facing the financial crunches hires a financial and legal expert for advisory and assistance in the negotiation and the transaction deals. Usually, the concerned entity may look at debt financing, operations reduction, any portion of the company to interested investors.
In addition to this, the need for a corporate restructuring arises due to the change in the ownership structure of a company. Such change in the ownership structure of the company might be due to the takeover, merger, adverse economic conditions, adverse changes in business such as buyouts, bankruptcy, lack of integration between the divisions, over employed personnel, etc.
Objective of Corporate Restructuring
Corporate restructuring is implemented in the following
situations:
Increase Profits: The undertaking may not be enough profit making to cover the cost of capital of the company and may cause economic losses. The poor performance of the undertaking may be the result of a wrong decision taken by the management to start the division or the decline in the profitability of the undertaking due to the change in customer needs or increasing costs.
Gain Reverse Synergy: This concept is in contrast to the
principles of synergy, where the value of a merged unit is more than the value
of individual units collectively. According to reverse synergy, the value of an
individual unit may be more than the merged unit. This is one of the common
reasons for divesting the assets of the company. The concerned entity may
decide that by divesting a division to a third party can fetch more value
rather than owning it.
Gain Cash Flow Requirement: Disposing of an unproductive
undertaking can provide a considerable cash inflow to the company. If the
concerned corporate entity is facing some complexity in obtaining finance,
disposing of an asset is an approach in order to raise money and to reduce
debt.
Various techniques of Corporate Restructuring Strategies
Merger:
This is the concept where two or more business entities are
merged together either by way of absorption or amalgamation or by forming of a
new company. The merger of two or more business entities is generally done by
exchange of securities between the acquiring and the target company.
Demerger:
Under this corporate restructuring strategy, two or more
companies are combined into a single company to get the benefit of synergy
arising out of such a merger.
Reverse Merger:
In this strategy, the unlisted public companies have the
opportunity to convert into a listed public company, without opting for IPO
(Initial Public offer). In this strategy, the private company acquires a
majority shareholding in the public company with its own name.
Disinvestment:
When a corporate entity sells out or liquidates an asset or
subsidiary, it is known as “divestiture”.
Takeover/Acquisition:
Under this strategy, the acquiring company takes overall
control of the target company. It is also known as the Acquisition.
Joint Venture (JV):
Under this strategy, an entity is formed by two or more
companies to undertake financial act together. The entity created is called the
Joint Venture. Both the parties agree to contribute in proportion as agreed to
form a new entity and also share the expenses, revenues and control of the
company.
Strategic Alliance:
Under this strategy, two or more entities enter into an
agreement to collaborate with each other, in order to achieve certain
objectives while still acting as independent organisations.
Slump Sale:
Under this strategy, an entity transfers its one or more
undertaking for lump sum consideration. Under Slump Sale, an undertaking is
sold for a consideration irrespective of the individual values of the assets or
liabilities of the undertaking.
Features of Money Market Funds
Given below are a few points that you should know before you think of investing in money market instruments-
High Liquidity
The maturity period of one year offered by these funds makes
them highly liquid. Additionally, these funds tend to generate fixed income for
the investors in such a short period; owing to which they are taken for close
substitutes of money. Moreover, it is easy to trade money market instruments
across currencies, maturities, debt structure as well as credit risk, which
makes it ideal for institutions seeking to borrow or invest for the short term.
Secure Investment
These financial instruments are considered one of the most
secure investment avenues available in the market. Since issuers of money
market instruments have a high credit rating and the returns are fixed
beforehand, the risk of losing the invested capital is minuscule.
Fixed returns
Since money market instruments are offered at a discount to
the face value, the amount that the investor gets on maturity is decided in
advance. This effectively helps individuals in choosing the instrument that
would suit their financial needs and investment horizon.
Physical trading
Money markets across the world essentially operate over the
counter, which implies that the trading of these funds cannot be made online.
Hence, investments in the money market are made physically by authorized
representatives or in person. Later, a physical certificate is issued to the
buyer of the money market instrument.
Wholesale Market
Money markets are designed to provide and accept bulk
orders. Thus, retail investors who have enough capital can directly participate
in money markets, while individual investors must invest in debt mutual funds
that invest in money markets in order to benefit from this market.
Multiple Instruments
Unlike capital markets which usually trade in one single
type of instrument, money markets trade is multiple instruments. These
instruments differ in terms of maturity periods, debt structure, credit risk,
currency, among others. Money market instruments are therefore considered ideal
for diversification through exposure.
Key Money Market Participants
Since money markets deal with only bulk orders, they are not
open to individual investors. As a result of which, multiple institutional
investors such as financial institutions and dealers looking to borrow or lend
money for a short term participate in the trading of these instruments.
Regulated by RBI
The Indian money market is controlled and regulated by the
Reserve Bank of India. RBI is the only institution that can influence the
organised sector, while the smaller unorganised sector is largely beyond its
control. However, due to the considerably larger size of this organised sector,
regulatory actions taken by the RBI can produce a substantial impact on the way
in which this entire market operates.
Functions of Money Market
Money Markets have continued to exist in modern economies
due to their unique features along with their ability to carry out certain key
functions that other financial markets cannot. The five leading functions that
a money market carries out in the modern economic system include-
Providing Trade Financing
Modern day money markets play a vital role in ensuring that
there is adequate capital available to institutions engaged in domestic as well
as international trade. Internationally, short term funding for ventures may be
available to traders through ‘bills of exchange’ apart from other routes. These
are instruments that are discounted by the bill market. In common practice,
discount markets and acceptance houses are engaged in financing overseas
trading ventures using these ‘bills of exchange’.
Ensuring Industrial Financing
Many industries and industrial houses issue bonds on the
bond market or shares on the stock market in order to receive long term
financing of their operations. There are two ways in which money markets help
with industrial financing- providing short term funding and producing an impact
on capital markets. Short term funding from money markets can help industries
finance their day to day operations and meet working capital requirements. The
long term capital is obtained by industries through the issue of bonds or
shares on applicable capital markets. However, since the rate applicable to
short term lending determines the applicable yield of long term capital market
instruments, the market is clearly impacted by money market movements.
High Liquidity Investment Solution
The money market offers a lucrative, low risk route to
institutions such as commercial banks in using their excess funds to earn
additional income. Commercial banks need to generate this additional income in
order to ensure that they have sufficient liquidity so as to meet uncertain
demands such as withdrawal of consumer deposits. Usually, commercial banks
invest their funds in near money assets that have a short maturity period. This
way, the banking sector is able to generate additional income while maintaining
sufficient liquidity.
Ensuring Self Sufficiency of Banks
Commercial banks operating in developed money markets have
ample opportunities to invest and generate further income such that their self
sufficiency improves in the long term. In case of dire cash crunch, banks can
borrow funds from the RBI. Thus, money market instruments can help banks
achieve their needs through the availability of funds at rates that are lower
than those charged by the central bank. Additionally, money markets provide twin
benefits of helping banks earn additional income and also acting as a source of
funds to banks when required.
Maintaining Money Supply for Central Banks
Central Banks are responsible for maintaining and
controlling both the money market and capital market. As these markets operate
using short term interest rates, they serve as an indicator of the country’s
overall economic health. Such information provides accurate guidance to the
central bank regarding how it should rectify any problems that might occur in
the current situation. Thus, in the presence of a developed money market, the
central bank has access to a secure, quick as well as effective way to
influence various submarkets without having to overextend itself.
The most significant and traditional function of commercial
bank is accepting deposits from the public. The deposits may be of three types:
Saving deposits, Current deposits and fixed deposits. In case of current
account, people can withdraw deposits in part or in full at any time he likes
without notice.
Usually no interest is paid on them, because the bank cannot utilise these short-term deposits. Savings deposits are payable on demand and money can be withdrawn by cheques. But there are certain restrictions imposed on the depositors of this account. Deposits in this account earn interest at nominal rates. Fixed deposits are made for a fixed period of time. A higher rate of interests is paid on the fixed deposits.
The second important function of the commercial bank is to
provide loans against suitable mortgages to the public to fulfill their needs
of money. Loans can be granted in the form of cash credit, demand loans, short-
term loan, overdraft, discounting of bills etc. Under cash credit system,
borrower is sanctioned a credit limit up to which he can borrow from the bank.
The interest payable by the borrower is calculated on the amount of credit
limit actually drawn. Demand loans granted by a bank are those loans which can
be recalled on demand by the bank any time.
Here, the interest is payable on the entire sum of demand loans granted. Short-term loans (like car loans, housing loans etc.) are given as personal loans against some security. The interest is payable on the entire sum of loan granted. In case of overdraft facility, an account holder is allowed to withdraw a sum of money in excess of the amount deposited with the bank.
Here, the borrower who has received this facility, has to pay interest on the amount overdrawn. Another important form of bank lending is through discounting or purchasing the bills of exchange. A bill of exchange is drawn by a creditor on the debtor specifying the amount of debt and also the date when it becomes payable. Such bills of exchange are normally issued for a period of 90 months.
3. Credit Creation:
This is an unique function performed by the commercial banks. A bank has sometimes been called a factory for the manufacture of credit. In the process of acceptance of deposits and granting of loans, commercial banks are able to create credit.
4. Transfer of funds:
Commercial banks are able to transfer funds of a customer to
other customer’s account through the cheques, draft, mail transfers,
telegraphic transfers etc.
5. Agency functions:
In modern time, commercial banks also act as an agent of the
customer. However, banks charge fee or commission for these functions.
Agency functions include:
(a) Collection of cheques, bills and drafts,
(b) Collection of interest, dividend etc.
(c) Payment of interest, installments of loans, insurance premium etc.
(d) Purchase and sale of securities
(e) Transfer of funds through demand drafts, mail transfer etc.
6. Other functions:
Apart from the above important and most popular functions,
commercial banks also perform the following other functions:
(a) Payment of credit letters and travellers cheques, gift cheques, bank draft etc.
(b) Dealing in foreign exchange.
(c) Locker services.
(d) Provision of tax assistance and investment advice etc.
From the above analysis, it is clear that in a modern economy the commercial banks play an important role in various economic activities of the country.
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