Investing & Financing

Areas to be covered:
➢ CASH SURPLUS

➢ CASH DEFECIT

➢ BANK DEPOSITS

➢ MONEY MARKET DEPOSITS

➢ CERTIFICATE OF DEPOSITS

➢ GOVERNMENT STOCKS

➢ RISK ASSOCIATED WITH ABOVE FINANCING OPTION

➢ ARRANGING FINANCE FROM BANK

MEANING OF SURPLUS FUNDS: The funds available with an organisation
after it pays-off all its liabilities and expenses are known as surplus
funds. An organisation has surplus funds when one or more of the
following conditions are fulfilled:

• Assets exceed its liabilities.

• Revenues exceed its expenditures.
• Receipts exceed its payments.
• The working capital needs of the organisation reduce.
• The organisation has sold a non-current asset.

There are two types of surplus:

a) Permanent surpluses: these are funds that the organisation does not
need in the near future. The organisation has these funds in surplus
for a long time. Such permanent surpluses must always be invested.
They must never be sitting idle in the organisation’s bank account.

b) Temporary surpluses: these surpluses are available for a short

period. They must be invested until they are required to finance the
existing operations or new investments.
Use of surplus funds: An organisation must invest its surplus funds (i.e.
funds that are more than the immediate needs of the organisation)
into various securities to earn income. An organisation must ensure
that the security chosen for investment is safe i.e. there is no risk of
capital loss and can be liquidated easily. Any loss of capital will
negatively affect the working capital management of the
organisation.
• Transaction motive: An organisation needs money to finance its
various transactions in the ordinary course of business such as
paying money towards its trade payables, paying salaries to its
employees, etc.

• Precautionary motive: Due to the uncertainty involved in business

transactions, the cash inflows forecasted by an organisation may
significantly differ from the actual cash inflows. An organisation
should keep aside some money to meet expenses that may arise
unexpectedly.

• Speculative motive: Speculation means investing in order to earn

profits by accepting risk. Although speculative investments carry
high risk, they are capable of yielding high returns. An organisation
may get an opportunity to earn profits by doing activities that are
outside its normal course of business.
BANK DEPOSITS: It allows the account holder to deposit and withdraw
money from the account. The bank maintains a record of the
transactions between the bank and the customer. The balance in the
bank account is the amount owed by the bank to the customer.

Types of bank deposits:

1. High street bank deposits: These are interest-earning accounts

offered by all high street banks.

2. Sight deposits: The investor can instantly withdraw cash from a sight
account. He does not have to give any notice to the bank for
withdrawing cash from his account. It offers low interest rate.

3. Time deposits: Unlike sight deposits, the investor needs to provide a

notice to the bank before withdrawing money from his bank
account. Due to this restriction, the rate of interest offered by a
bank on time deposits is higher than that offered for sight deposits.

4. High interest accounts: Investors with huge amounts of money have

the facility of depositing their funds in high interest accounts.
Usually, these accounts provide immediate access to funds.
 5. Option deposits: Option deposits are arrangements between an
investor and his banker for a specific period. The interest rate
offered by the banks for option deposits is linked to base rate and
the investor earns a guaranteed return in real terms. However, the
investor has restricted access to his funds deposited in the option
deposits.

Purpose of bank deposits:

• To store surplus cash at a safe place.
• To earn interest on idle (surplus) funds without taking any risk.
• To obtain guaranteed return on surplus funds.
• To have quick (either immediate or at a short notice) access to the
cash deposited in the bank.

Features of bank deposits

• Bank deposits are a highly safe form of investment.
• They are a highly liquid form of investment.
• An investor can choose a bank deposit that matches his needs.
• The rate of return offered by various kinds of bank deposits is not the
same.
MONEY-MARKET DEPOSITS: Money market deposits are fixed interest
termed deposits with banks and security houses. They are very short
term deposits of up to one year (overnight, 7days ’notice, 1month,
3months, 6months, etc). As they are non negotiable, they can not be
liquidated before the date of maturity. Such deposits are suitable when
cash flow requirements are predictable. These deposits can either be:
• “Fixed” - the interest rate and maturity dates are agreed at the time
of the transaction.
• “Call” - the interest is variable and the deposit can be terminated if
the required notice is given.

CERTIFICATE OF DEPOSIT: Certificate of deposit is a time deposit with

a bank or a building society. It bears a specified maturity date and
interest rate. The rate of return is slightly higher than government
securities.
The title of the certificate of deposit belongs to its holder. Hence,
the holder can transfer the certificate of deposit by delivering it to
the buyer. This makes it more liquid than a money-market time
deposit. A money-market time deposit with a bank cannot be
terminated until it matures.
Features of certificate of deposit (COD):
• COD is similar to fixed deposits offered by banks. However, the fixed
deposits are nonnegotiable whereas CODs are negotiable. Hence, a
holder of COD can freely trade them in the secondary market.

• A COD can be liquidated prematurely by paying penalty charges.

• The discount rates for COD are market-determined.

• The rate of return offered by COD is marginally higher than that on

government securities.

• The maturity period of a COD ranges from 91 days (if issued by a

bank) to 1-3 years (if the certificate of deposit is issued by a
financial institution).

Purpose of certificate of deposit (COD):

• To obtain an attractive rate of interest with low credit risk.

• To invest surplus funds for a short term in a highly liquid security.

• To quickly liquidate an investment (at the prevailing market rate).

Government inventory / Gilt-edged securities (Gilts): Gilts are
marketable securities issued by the British Government to finance its
spending and to control the money supply. Their prices are sensitive
to interest rate changes and can cause capital loss. The prices of
gilts are inversely linked with the interest rate. If a rise in the interest
rates is expected, it will result in a fall in the prices of gilts and vice-
versa. An investor needs to invest at least £1,000 for buying new gilts.
However, there is no limit on the maximum amount.

Features of Gilts:
• Usually gilts have a face value of £ 100.
• The government promises to redeem the gilts on a specific date.
• The title of the gilts can be passed on electronically.

Purpose of issuing Gilts: Investment in gilts is made by buyers seeking

investments with low risk. Gilts are considered as low risk investments
due to the following reasons:
• The government cannot default on its own gilts.
• A buyer of gilts knows the time and the amount of interest to be
received by him in advance.
• An investor buying a gilt and holding it until its redemption knows
his that his return is fixed.
Local authority short term loans: The time of payment for expenses
and the receipt of local taxes and government grants may not be
synchronised in the case of some local authorities i.e. they may not
happen at the same time. Hence, to finance their expenses the local
authorities issue short term loans. Bank overdrafts, bonds, bills of
exchange, local authority deposits, etc are the instruments used by
local authorities to borrow funds.

Features of local authority short term loans

• The securities issued by local authorities are held by a few entities.
Unlike gilts, they do not enjoy wide spread holding.
• The security issued by a local authority is not as good as the
security issued by the central government.
• The rate of return offered by the local authorities on their loans is
higher than that offered by gilts.

Purpose of local authority short term loans

• To finance the expenses of a local authority.
• To raise finance for other ‘public bodies’ from Britain and outside
Britain such as the Port authorities.
• To allow various entities to invest their funds in the local authority.
A bank can finance a project through the following ways:

1. Overdraft facility: allowing customers to borrow funds through their

current accounts.

2. Term loan: fixed amount given as loan for a specific period.

3. Bankers’ acceptance facility: the bankers accept bills of exchange

of his customers.

4. Committed facility: bank agrees to make a specific amount of funds

available to the borrower on demand.

5. Uncommitted facility: the bank does not have an obligation but it

can, at its discretion lends funds to the borrower up to a certain
specified sum.

6. Revolving facility: it is a credit facility that is renewed after regular

periods. If the borrower has repaid the loan, then the borrower can
borrow again.
TYPES OF BANK LOANS ON THE BASIS OF PAYMENT TERMS

• Installment Loans: It is a loan that is repaid through small equal

periodic payments that are spread over a period of time. The
borrower makes regular and fixed payment to the lender until the
loan is completely repaid. The legal contract between the lender
and the borrower states the amount and period of payment. Hence,
the borrower knows the amount and due date of his liability.

• Bullet Loans: The repayment of principal of a bullet loan is done at

the end of the loan term. The borrower only makes interest payment
during the tenure of the loan. The borrower needs to keep aside
amount funds to make huge payment at the end of the term of the
loan. It requires a high level of self- discipline and professional
integrity from the management. It is also known as lump sum or
single payment loan. Usually, bullet loans are given for period of less
than a year.
On the basis of period-of-payment-terms:

• Short Term Loans: Short term loans normally have durations of less
than one year. These loans are taken for specific purposes e.g.
purchasing raw materials, paying to temporary labourers, to make
major repairs in machinery etc. and are repaid after the purposes
are fulfilled.

• Long Term Loans: The loans with duration of more than five years are
considered long term loans. These loans are given to purchase
assets with long term cash flows such as to purchase heavy
machinery, land, building etc. Project with long term cash flows
should be financed with long term loans.

• Intermediate Term Loans: The durations of these loans ranges

between one and five years. These loans are used to acquire assets
that require more than one year to generate sufficient cash inflows
to repay the loan.
On the basis of security:

• Secured Loans: The borrower provides a collateral to the lender for

obtaining a secured loan. The secured loan has a charge on the
certain assets of the borrower e.g. a ‘fixed charge’ on one asset or
a ‘floating charge’ over several assets. In the case of default, the
lender can sell the assets that were given as collateral to realise his
debts.

• Unsecured Loans: Unsecured loans are available only to borrowers

with excellent credit reputation because the borrower does not
have to provide any collateral while accepting these loans. The risk
of losing the principal is higher in the case of an unsecured loan.
Hence, it is more expensive than secured loans.

• Personal Guarantees: The borrower obtains the loan by providing a

guarantee of repayment from a third person. The third person is
known as guarantor and agrees that in the case of default, he will
be repaying the loan. The guarantee put all the personal belongings
of the guarantors at risk. The guarantor’s liability extinguishes when
the debt is paid off.
• Add-On Interest: It is also known as ‘flat rate’ loan. Interest is
calculated on the entire original principal. Then the interest is
added to the original principal. The installments are made by
dividing the principal plus interest by the number of installments.

• Discount or Front-End Loans: The lender gives the loan to the

borrower after deducting the interest from the principal. The
deduction of interest by the lender at the time of making the loan
makes the effective interest rate on the discount or front end loans
more than the specified interest rates.

• Balloon Loans: It is a long term loan with very low interest payments.
It is attractive to borrowers who wish to have minimum cash outflow
during the duration of the loan. This loan allows the borrower to
defer most of the repayment until the end of the payment period.

• Amortised Loans: An amortised loan is long term loan and is repaid

by the borrower slowly, over several years. The borrower makes small
equal sized payment over a long period of time to the lender to pay
off the loan. Initially the interest part of the payment is more than
the principal part. In the subsequent years, the proportion of
interest payment falls and proportion of principal repayment rises.
The interest is paid only on the principal that is not yet repaid.
TERMS AND CONDITIONS OF BANK LOANS

Terms affecting bank loans: The following factors are considered while
determining the terms of the bank loan:

1. Cost of the loan: the term will clearly state the interest rate
charged on the loan e.g. LIBOR plus 2%.

2. Duration of loan: the term of the loan must not extend beyond the
useful life of the asset. The bank expects the borrowers to repay
whilst they are enjoying the benefits of the asset.

3. Internal procedures of bank: the guidelines used by the bank while

assessing and approving the loan.

4. Regulations: the regulations enacted by the government. The

government can cap the interest rate at which loans can be given
to a specific sector.

5. Negotiations: the negotiations between the bank and customer on

the interest rate, the term and the security to be offered.
LOAN COVENANTS: Loan covenants are the conditions that the
borrowers must comply in order to adhere to the terms in the loan
agreement. Loan covenants ask the borrowers to either fulfill certain
conditions or forbid them from taking certain actions. The bank may
consider violation of loan covenant as a default from the borrower.
In such a case, the bank can levy penalties or call back the loan. A
bank can waive the loan covenants on a temporary or permanent
basis.

Types Of Loan Covenants:

1. Quantitative covenants: These covenants place restrictions on the

borrower’s financial position of the borrower e.g, the total debts of
the borrower will not exceed 200% of the shareholder’s funds.

2. Positive covenants: These covenants require the borrower to do

something e.g, submit a copy of financial statements of the
borrower.

3. Negative covenants: These covenants restrict the borrower from

doing something e.g, the borrower will not take a new loan until the
current loan is repaid.
Overdrafts: Overdraft from a bank is a one of the most popular
methods of obtaining short term funds. Usually, it is used for general
business purposes e.g. purchasing raw materials, paying salaries to
staff, payment to trade payables etc. The interest rate on overdraft
is normally linked to the base rate and is revised when the bank
changes its base rate. Arrangement fees refer to the fees that are
levied by the bank for setting up the overdraft ability. An
organisation needs to pay an arrangement fees to bank for obtaining
the overdraft facility.

Types Of Overdrafts:

1. Committed facility: The customer can overdraw his account up to

a certain level during a specified period of time e.g. the bank
allows the customer to overdraw up to $35,000 until 31 June20X9.

2. Uncommitted facility: The customer is allowed to overdraw his

account up to a certain limit. However, the bank retains the right
to reduce or cancel the overdraft facility at any time and without
giving a notice. Hence, the overdraft facility is dependent upon
the goodwill and support of the bank.
Comparison Between Bank Loan And Overdraft:

Overdraft Bank Loan

• The borrower can change the • The amount of loan is fixed.
amount borrowed within the
assigned limit.
• Interest is paid only on the • Large amounts can be borrowed.
amount overdrawn.
• The bank can increase the • No such flexibility is available.
amount of overdraft by doing a
review of the borrowers’ needs.
• Can be used as medium term • Borrower knows the time of
loan, the borrower needs to installments. Allows the borrower
renew the overdraft facility after to plan his cash flows in a better
periodic intervals. manner.
• Interest cost is comparatively • Interest cost is comparatively
higher. lower
• Bank can ask the borrower to • The borrower has to adhere to
repay the overdraft on demand. the safeguards mentioned the
loan covenants.
Trade Credit: Credit available from suppliers is one of the easiest and
cheapest sources of short-term finance. If credit is obtained, it
reduces the need for finance from other sources e.g. banks. The
advantage of trade credit is that interest is not usually charged
unless the firm defaults on payment.

Benefits of trade credit:

• The seller can purchase the raw materials and pay later when it has
sold the inventory.

• It eases the pressure on cash flows because the buyer is required to

pay after the end of the credit period.

• It allows the purchaser of raw materials to offer a longer credit

period to its customers thereby helping to increase its sales.

• Factoring is an arrangement where receivables are sold by an

organisation to a factor. The factor provides funds as well as
collection services.
Letter Of Credit: It is a promise to pay. It assures the seller that they will
be paid as long as they fulfill the terms of the contract of sale. It is
used primarily when the buyer and seller belong to different
countries and facilitates international trade. It is a document issued
by a financial institution and usually provides an irrevocable
payment undertaking. The letter of credit can also be used as a
source of payment for a transaction i.e. an exporter can obtain funds
by redeeming the letter of credit.

Buyer’s Credit: It is a form of credit available to the buyer (importer)

from the foreign lenders such as banks and financial institutions, for
payment of their imports on the due date. If local funds are more
expensive than the LIBOR then an importer can access funds costing
around LIBOR by using buyer’s credit. Foreign banks usually lend to
the buyer based upon the letter of credit issued by the buyer's bank.
The foreign bank considers the letter of credit as a bank guarantee.

Export Credit Insurance: It offers insurance protection to the seller

(exporter) against non-receipt of foreign receivables. There are a
number of reasons due to which the buyer (importer) may default
such as outbreak of war, depreciation of buyer’s currency or
bankruptcy of the buyer.