Complete Financial Landscape

I felt the need to put down the entire scope of Financial Sketch and so here I am.

Let’s first ask ourselves - The main objective of Finance!!

• Profit maximization to prove Business efficiency 
• Wealth Maximization to improve the Value of Shareholders 

In order to make things fall in perspective, let me touch upon the key elements of Financial Landscape.

Let’s now delve into each element so as to understand the scope in a better way.

Financial System:

It is the system that covers financial transactions & exchange of Money between Investors, Lenders and Borrowers (also called as Financial Participants) with a primary aim to accelerate growth in the Economy by facilitating flow of funds, monitoring and regulating the participants.

Structure of Financial System is as follows:

1. Financial Market: It is a Marketplace where Buyers and Sellers participate in the trade of assets such as Equity, Bonds, Currencies and derivatives. Financial Market is further categorized into four major categories:

2. Financial Instruments: The buyers and sellers trade in specific instruments in an environment of transparent pricing, trading regulations with Costs & fees applied.

3. Financial Participants: All entities which are involved in financial transactions and exchange of Money are the Financial participants.

4. Financial Regulator: These are government entities which help in monitoring all the financial transactions as well as financial participants in case of any misdoings.

5. Financial Services: Many experts provide services for carrying out financial transactions in the system and enabling free flow of funds.

Transaction in a Financial Environment

Let’s try and understand how transactions happen in a Financial Environment.

The Flow chart explains it all i.e. There must be various sources of capital which create pool of Money and finally it is invested in the destination of capital.

A.) Source of Capital: It is the origin from where Money flows into the Financial System. Such generators of Money are Individuals, Government and Companies.

• Individuals earn money through Time, Labor, Expertise and Effort. 

Retail Category Clients: Such Individuals have Capital less than INR 25 lac available for the investment in Systematic investment Plan (SIP) which is a way to invest in Mutual Funds. Such investment is driven by Savings which calls for a specific amount to be set aside on monthly or yearly basis so as to negate volatility. The Money from Retail Clients is generally invested in Blue chip companies assuring high rate of return.

High Net-worth Individuals: Such Individuals have Capital as high as INR 25 lac available for investment in Portfolio management services schemes. A Financial Analyst (Buy-side) in form of a Portfolio Manager is assigned who then owns this pool of Capital to invest it in Destination of Capital such as Real Estate, Commodities (Gold, Crude etc.), Debt, and Equity etc. which are also called as Asset classes. The target optimal Return on Investment (ROI) is around 15-17%.

Ultra high Net-worth Individuals: Such Individuals have Capital as high as INR 1 CR available for investment in Scheme such as Alternative investment Fund. Such money can then be invested in small and mid-cap companies considering the high risk factor which is taken into account.

• Government has huge tax income which is available for investment and expenditure. The funds from government are invested generally in huge infrastructure projects such as Highway; Airport projects etc. spread over 10-15 years and targeting Return on investment (ROI) around 6-7 %.
• Similarly a profit generating entity i.e. Company also has funds available for further investment. Companies as a Source of Capital are a detailed structure. As we all know that companies are of various types such as Partnerships, Start-ups, Private ltd, Public etc. The Financial participants and Analysts differ based on the type, stage and phase at which the Company is in operation.

Let’s first discuss various stages in a Company’s Life-cycle from its commencement:

B.) Pool of Capital: All the above transactions are facilitated by Asset Management Companies (AMC) such as Angel Investors, Venture Capitalists, Private Equity Firms etc. and a team of Buy-side Analysts, who pool the money from Sources of Capital, owns that money to make wise investment decisions.

They are also the buyers of various asset classes and owners of Fund capital. AMC with help of its Buy-side analysts invests in subset of companies, checks the movement of stock prices, runs various risks on the portfolios, come up with risk mitigation plans, monitor the performance of various portfolios and make commission on deals.

The entities investing in Private Equity funds are Pension Funds, Endowments, Foundations, Bank-holding companies, High net-worth individuals, Insurance companies, Investment banks, Corporations etc. A Fund of Funds is created which is called Private Equity fund which is then invested in Companies at various stages of its development such as Seed stage, Start-up stage, Expansion stage, Replacement Capital etc. who becomes the issuers of PE Fund. People managing PE funds are called General Partners and people investing in PE Funds are called Limited Partners. Private Equity firms majorly focus on pre-IPO funding.

PE Investors tend to derive value out of the investment by making the operations very robust, improving profitability, quality of product & sales growth of the company. Thus they prominently look into the Business of the company, Financial track record, Management quality, the operating environment including the industry, and the growth strategy.

Now once the Business expands, the companies start growing at a stable growth rate. This calls for an exit of PE firm by selling its shares and asking the company to go public leading to an initial public offering (IPO) wherein the shares of an unlisted company are sold to the general public for the first time to raise capital. The functions of an IPO include Expansion, Capitalization and Diversification.

Since the process is very complex, it involves the selection of an Underwriting firm also known as Book running Legal managers or BRLMS which is basically an investment firm that acts as an intermediary (Principal Player) between a company selling securities and the investing public. Its task is to sell as much of the issue as possible, but can return any unsold shares to the issuer company without financial responsibility.

Appointing an Underwriter ensures adequate finance and dispersion of securities, increases goodwill of the company who also benefits from the expert advice and the company is in better position to service the prospective investors. Various examples of Underwriters include Goldman Sachs, Credit Suisse, and Morgan Stanley etc.

The Equity route of raising capital requires Company to be listed on Stock exchanges such as National stock exchange (NSE) or Bombay Stock Exchange (BSE). A Financial Analyst in form of Equity research Sell-side Analyst helps Company in issuing shares to Minority investors. One has to be a member of BSE / NSE in order to buy or sell shares listed on these Stock exchanges. Brokerage companies like Motilal Oswal, Morgan Stanley etc. who have membership of the exchanges then facilitate AMC activities like portfolio management, mutual funds, alternative investment funds etc.

Equity research primarily involves analyzing company’s financials, perform ratio analysis, forecast the financials i.e. financial modelling and explore scenarios with an objective of making BUY/ SELL stock investment recommendation. The Equity-research Analysts discuss their research and analysis in their equity research report which is generated after wide interaction with the clients, visiting the plants & doing the complete due-diligence of the company.

Once the report is created, it is sold to Buy-side team who puts money in Equity research report. The Money that is generated by the Sell side team through recommendation by Equity Research analyst is shared among three people that constitute the sell side team i.e. Analyst, Sales Desk and Trade desk.

An equity research analyst releases sell-side research reports to Asset management companies (AMC) or Retail investors. The Buy-side Financial Analysts use the work of sell-side researchers to make a decision on which company to invest in. 

A Credit research analyst is a financial professional who possesses expertise in assessing the creditworthiness of individuals and companies i.e. determining the credibility of the borrower by analyzing Borrower’s financial history, his/ her credit history and also the economic condition of the borrower for favorable repayment. Credit Analysts have much interaction with Buy side Client’s team. They also play a major role at rating agencies. Also they have huge opportunity in Asset Management industry.

Investment Banking Firm also plays a major role in the financial space. Although it does not hold source of capital, it acts as a mediator who provides financial advisory and research services to the Client. They also go in and look for sources of capital for the companies to raise funds. Its Capital-raising arm or Equity market arm will help company to do an IPO and raise money from minority investors. It connects destination of capital with source of capital. Investment Banking Firms also play a role in Mergers and Acquisition if the Company wants to grow inorganically. Their main purpose is to advise Clients and do not have decision making power. They earn commission on a deal made. Examples of such Investment Banks are Deutsche bank, Barclays, Goldman Sachs, Credit Suisse etc. who have internal research team, M&A Team, Equity capital markets, Sales and trading desks etc.

An M&A Analyst evaluates financial reports of the company, study company operations and decide how the company will fit in. An M&A benefits the companies through Staff reductions, Competition elimination, Economies of Scale, acquiring new technology, improved market reach & industry visibility.

In a nutshell, Sell-side firms are those firms which do Sell-research, advice, and also create Reports for investors so as to advise them to buy, sell or hold the stocks coming from sell side. E.g.: Investment Banks.

C.) Destination of Capital: The Asset Management companies (AMC) who own the pool of capital help in creation of an Asset class in form of Mutual Funds, Real estate, Gold, Equity, Debt instruments, Commodities, Bonds, Derivatives, Treasury Bills etc. for the Individuals, Companies and Government to invest in.

Role of Bank:

One also has to understand that the all the financial transactions in the entire financial landscape are carried out through one of the most important mediums called Banks.

The Banks are mainly of three types:

• Retail Banks: Retail Banks generally operate for general public which have facilities like Current and Savings Accounts (CASA), Fixed Deposits, Personal Loans, Car Loans, Mortgage, Debit and Credit Cards etc. Retail banks are the banking institutions that execute transactions directly with consumers, rather than corporations or other banks. Examples of Retail Banks are HDFC, Kotak Mahindra etc. The main purpose includes Private banking, Retail lending & services. Individual customers use local branches of larger commercial banks to avail these services.
• Corporate Banks: Corporate banks cater to Companies, Institutions, Government organizations, and MNCs. They focus on products and services for corporate and institutional customers which are very different from traditional services provided to retail customers. They are also known as Wholesale or Business Banking. They are usually referred to as the custom-tailored financing & banking services. Corporate Banks generally operate for Companies who need Working capital to be able to fund or carry on to its day-to-day activities. Punjab National Bank (PNB) is a Corporate Bank. The money is given to the corporate clients to fund their Debt as part of credit financing or to buy the inventory so as to meet the business requirements. The major role includes Treasury, Trade finance, corporate loans & SME lending along with financing activities.
• Investment Banks: Investment Bank works for profit-making Business units by helping them through financial advisory in terms of good time to acquire, merge or raise capital. They play a major role in valuation & research, fund raising strategies, Sales & trading, Equity markets, restructuring and M&A. The Sell-side analysts understand the Client’s requirements, access the markets, define good time to do the equity market application, suggest what valuation to go in for, and research continuously to come up with ideas. The main activities include Sales & trading, M&A, Investment Banking, Research, Equity Markets.

The evolution journey of a Bank is such that every bank starts of as a Retail Bank, graduates to a Corporate Bank and moves on to become an Investment Bank.

Valuation and Modelling:

Valuation is a process or procedure used to determine the worth of the business. It is important for better decision making and future planning.

The Value of the Business is the most important decisive factor & essential prerequisite for price negotiations and also while transferring the ownership in both cases of buying or selling but determining the value with absolute certainty (due to variety of calculation methods) is virtually impossible.

Valuation could be done for tax purposes, Transaction, Financial reporting, Regulatory & compliance, Dispute resolution or Portfolio valuation. Users of Valuation are existing owners, Prospective Investors, Lenders or other stakeholders and valuation is generally used in Sales process, Shareholders disputes, Tax and legal obligations or Sources of funding.

Modelling services could be provided through Business plan assistance, Strategic options & scenario planning, Business & KPI reporting, Restructuring modelling, Budgeting & forecasting, Tax modelling etc. It helps companies take key decisions and improve on strategic outcomes whether it is to evaluate a transaction, a new market opportunity or for other strategic purposes.

Financial Statements Analysis:

It is generally intrinsic to the Organization i.e. Analysis of Balance sheet, Profit & Loss statements, Cash flow statements etc. to assess the profitability, liquidity and management efficiency of the firm by working on various ratios such as:

• Operating Profit Margin (%) = Operating income ÷ Total revenue OR EBIT ÷ Total revenue
• Profit Before Interest And Tax Margin(%) = ((Earnings Before Interests and Taxes (EBIT)) ÷ (Net Revenue - Earned)) * 100%
• Gross Profit Margin(%) = (Revenue - Cost of Goods Sold) ÷ Revenue
• Adjusted Gross profit Margin(%) = (n Period Gross Profit – n Period Inventory Carrying Cost) ÷ n Period Sales
• Net Profit Margin(%) = (Net profits ÷ Net sales) x 100
• Return On Net Worth(%) OR RoE = Net Income ÷ Shareholders' Equity
• Return On Capital Employed (%) =  EBIT ÷ Capital Employed
• Return on Total Assets = EBIT ÷ Total Net Assets
• Current Ratio = Current Assets ÷ Current Liabilities
• Quick ratio = (current assets – inventories) ÷ current liabilities, OR (cash and equivalents + marketable securities + accounts receivable) ÷ current liabilities
• Debt/Equity Ratio = Total Liabilities ÷ Shareholders' Equity
• Interest Coverage Ratio = (EBIT) ÷ Interest Expense
• Debt-To-Capital Ratio = Debt ÷ (Shareholder's Equity + Debt)
• Inventory Turnover Ratio = Sales ÷ Average Inventory
• Debtors / Receivables Turnover Ratio = (Net receivable Sales) ÷ Average Net Receivables
• Investments Turnover Ratio = Net sales ÷ (Shareholders' equity + Debt outstanding)
• Fixed Assets Turnover Ratio = Net sales ÷ (Net Property, Plan and Equipment)
• Total Assets Turnover Ratio = Net sales ÷ Total Average Assets
• Number of Days In Working Capital OR Days working capital = (Average Working capital * 365) ÷ Annual Sales revenue
• Dupont Analysis (ROE) = Profit Margin x Asset Turnover Ratio x Equity Multiplier. i.e. ROE = (net income ÷ sales) x (revenue ÷ total assets) x (total assets ÷ shareholder equity)

Finally I would like to conclude saying that

The entire financial space including M&A and stock markets is driven by liquidity. If the Indian government decides to increase the interest rates on bonds, the money moves from riskier (emerging markets) to safer asset classes. Thus the amount of money available with a company to acquire new company becomes less i.e. low liquidity. The prices go down causing less volume transactions which eventually leads to downside to market.

As we all know that the Company finances its operations either via Debt or Equity routes. The companies prefer the debt route because it helps in saving taxes paid to the government as the interest income is reduced from the Net income which is taxable.

A Company goes bankrupt if it's unable to pay its debt. The interest coverage ratio helps in determining the ability to pay off its outstanding debt and the interest expenses incurred on the same. The ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by the company's interest expenses for the same period. Lower the ratio, More the company is burdened by debt expense and its ability to meet the interest expenses may be questionable.

Similarly, many other ratios help in determining the performance of a company as mentioned above.

I believe that every individual must be aware of the basic concepts in Financial domain to understand how his / her investments move in a Financial environment powered by various transactions using various financial instruments by important entities who manage and own these funds for better Returns on investment.

The article covers all aspects of Financial Landscape in a nutshell.

Happy reading and learning.