Finance and ESI

Question 1

What are Convertible notes?

Answer 1

Ans:
Convertible Notes are the short-term debt that converts into equity shares for example when an investor invests in a startup, The startup instead of returning premium+interest provides equity share to the investor. The investor has some percentage of ownership in the company and also receives profit percentage according to the company’s growth

Question 2

What are Capital Goods?

Answer 2

Ans: Capital Goods are those goods that are used in the production process to manufacture final goods & services but are not incorporated in the finished good or service. Examples of Capital Goods are Machinery, Equipment, tools, buildings, vehicles etc.

Question 3

What is Supply Chain Financing?

Answer 3

Supply Chain Financing- a type of Financial transaction in which an intermediary connects a supplier like banks or other financial institutes with buyers and facilitate suppliers and buyers in a financial transaction. In the whole transaction process, the buyer approves the invoice provided by the intermediary and gives the payment to the intermediary while the intermediary provides payment to the supplier.

If the suppliers need payment early, then the intermediary gives payment to the suppliers at a discount while it takes payment from the buyer later. This is beneficial for both suppliers and buyers as buyers get an immediate payment and suppliers get more time to give the payment.

Question 4

What is the name of the Regulatory Body for Mutual Funds?

Answer 4

AMFI (Association of Mutual Funds of India), is the subsidiary of SEBI, headquartered in Mumbai

Question 5

What are Exchange Traded Funds (ETF)?

Answer 5

ETFs (Exchange Traded Funds) are a basket of securities bought and sold in the stock market.

ETFs track a specific market index by holding a portfolio of stocks in same proportion as in the index

Question 6

What is Bancassurance?

Answer 6

Bancassurance is a partnership between a bank and a financial company under which a financial company sells its financial services to the bank’s customers and the bank takes a commission from the financial company. Both bank and a financial company share profits and losses from the sales of insurance products respectively

Question 7

What are Bonds?

Answer 7

A Bond is a type of financial instrument issued by companies, states, municipalities or a country directly to the investors to finance projects and manage operations. The Bond purchasers or investors can be an individual, company or government. The bonds issued by an issuer usually provide a fixed rate of interest to the investors.
Types of Bonds are-
* Corporate Bonds- Issued by companies
* Municipal Bonds- Issued by cities, states, governments, countries or a municipalities

Question 8

What are Trade Receivables?

What is a TReDS Platform?

Answer 8

• Trade Receivables also called Accounts Receivables are the amount owed to a business by its customers following the sale of goods or services on credit. Trade Receivables are made of all the invoices of goods or services delivered to customers but are not paid by the customers. Trade Receivables are reflected as assets on the Balance Sheet of the businesses.
• TReDS platform facilitates discounting of Trade Receivables of the MSMEs, Corporates, PSUs or other entities. The TReDS platform has three participants Seller (MSME), Buyer (Corporates, Government Departments,PSUs) and Financier (Banks, NBFCs and Other financial institutions). Invoices of trade receivables are uploaded by the buyer or seller on the TReDS platform for bidding. Once the invoices are approved, the financiers start bidding and the supplier or buyer accepts the bid accordingly. Then the discounted amount is credited to the supplier’s or buyer’s account.

Question 9

What are Nostro and Vostro accounts?

Answer 9

Nostro and Vostro accounts- Nostro and Vostro are Latin words wherein Nostro means ‘Ours’ as in our money deposited at your bank and Vostro means ‘Yours’ as in your money deposited at out bank. Nostro and Vostro are banking terms that are used when two banks or entities deposit money in each other’s deposit or vice versa.

Question 10

What are annuities?

Answer 10

Annuities are a type of Investment option, It is a contract between a person and an insurance company under which, the person buys an annuity by making a series of payments or lump-sum payments and similarly receives the payout in lump-sum or series of payments over time.

Type of Annuities-
Fixed Annuity– In a fixed annuity, a fixed payout is received

Variable Annuity- In a variable annuity, payout is variable and not fixed. Insurance companies invest the annuity in the stock market and payout is subjected to the performance of the annuity in the stock market

Index Annuity- In an index annuity, the payout depends on the performance of the stock market index like BSE’s Sensex and NSE’s NIFTY 50

Question 11

What is the structure of the Indian Financial System?

Answer 11

The Indian Financial System is broadly divided into two categories which are Banks and Non-Banking Financial Institutions (NBFI). The basic difference between them is:
* Banks accept demand deposits while NBFIs do not accept demand deposits.
* Banks are authorized to issue cheques but NBFIs are not authorized to issue cheques.

Banks-
a) are divided into Commercial Banks and Cooperative banks
b) Commercial banks are divided into Scheduled banks and Non-scheduled banks
c) Cooperative banks are divided into Urban cooperative banks and Rural cooperative banks
d) Urban cooperative banks are further divided into Scheduled and Non-Scheduled
e) Rural Cooperative banks are divided into Short Term credit institutions and Long Term credit institutions

NBFIs (Non-Banking Financial Institutions)-

NBFIs are divided into All India Financial Institutions (AIFI), NBFC, Primary Dealers and Credit Information Companies

AIFIs include NABARD, EXIM, NHB and SIDBI

Question 12

What is the difference between Commercial Bank and Cooperative bank?

Answer 12

Banks are classified into two categories which are Commercial Banks and Cooperative banks. The difference between them is:
* Commercial Banks are registered under the Banking Regulations Act, 1949 while Cooperative banks are registered under both the Banking Regulations Act,1949 and the Cooperative Societies Act, 1965.
* A Commercial bank’s main purpose is profit-making while a Cooperative bank’s purpose is providing services to its members and non-members.
* Commercial banks are regulated by the RBI while Cooperative banks are regulated by both RBI and NABARD.
* Commercial banks provide low-interest rates on deposits as compared to Cooperative banks.

Question 13

What is the difference between Scheduled banks and Cooperative banks?

Answer 13

• Scheduled banks are registered under the Second Scheduled of the RBI Act, 1934 while Non-Sheduled banks are not registered under the act. Thus, Scheduled banks are regulated as per the Second Schedule of the RBI Act, 1934 and Non-scheduled banks are not regulated by the second schedule of the RBI Act, 1934.
• Scheduled banks are required to maintain a paid-up capital of ₹5 lakhs while Non-scheduled banks have no such requirements.
• Scheduled banks are eligible for availing loans from the RBI at the bank rate or repo rate but Non-scheduled banks are not eligible to take loans from the RBI except, in an emergency.
• Scheduled banks have to maintain a CRR (Cash Reserve Ratio) with the RBI while Non-scheduled banks have to maintain CRR with themselves.
• Scheduled banks are eligible to become a member of the clearing house while Non-scheduled banks are not eligible to become a member of the clearing house. The clearing house is an intermediary that facilitates transactions between two banks. The Clearing House is managed by the RBI wherever it has its office. In the absence of the RBI office, the Clearing House is maintained by the SBI, its associates and in a few cases by public sector banks. Therefore, membership in the Clearing House enables interbank transactions
• Scheduled banks include Public banks, Private banks, Regional Rural Banks, Foreign banks and Differentiated banks (Small finance banks and Payment banks) while Non-scheduled banks include State cooperative banks and local area banks.

Question 14

What are Public sector banks, Private sector banks and Foreign banks?

Answer 14

Public sector banks- Are those banks whose majority of the ownership is more than 51% with the government. Examples are SBI and its associates, Punjab National Bank, Bank of India etc.

Private sector banks- Are those banks whose majority of the ownership is more than 51% with the private owners. Examples are Axis Bank, HDFC bank, ICICI bank etc.

Foreign banks- Are those banks which are owned by foreign entities and have established their branch in India. Examples are CITI bank, HSCB bank, Standard Chartered etc.

Question 15

What are Regional Rural Banks?

Answer 15

The Regional Rural Banks (RRB) are scheduled commercial banks that operate at a regional level in different states. Regional Rural Bank (RRB) was established in 1975 on the recommendation of the Narasimham Committee and following that RRB Act, 1976 was enacted. The first RRB, Prathama Bank was established in Moradabad, UP and it was sponsored by the Syndicate Bank. The ownership of RRBs is in a 50:15:35 ratio by the Central government, State government and Sponsored bank respectively. The Priority sector lending target of the RRBs is 75% of its total credit.

Question 16

What are Local Area Banks?

Answer 16

The Local Area Banks (LAB) are non-scheduled private banks that were established in 1996. They have a geographical limit to operate in two or three adjacent districts. Currently, there are only three operational Local Area Banks which are Coastal Area Bank (Andhra Pradesh), Krishna Bima Samruddhi LAB (Hyderabad) and Subhadra Local Bank (Maharashtra).

Question 17

What are Cooperative Banks and what is the structure of Cooperative banks?

Answer 17

Cooperative banks are formed by a group of members and provide financial services to their members and non-members. They are regulated by the RBI under the Banking Regulations Act, 1949 and Banking Laws (Cooperative Societies) Act, 1955. Examples of cooperative banks in India are Bharat Cooperative Bank, Janata Cooperative Banks and Ahmedabad Mercantile Cooperative Bank.

Structure
Cooperative banks are divided into categories which are Urban Cooperative banks and Rural Cooperative banks. Urban Cooperative banks are further classified into Scheduled banks and Non-scheduled banks. Rural Cooperative banks are classified into Short-term Cooperative Credit Institutions and Long-term Cooperative Credit Institutions.

Urban Cooperative Banks (UCBs)- They are also called Primary Cooperative Banks and are located in urban and semi-urban areas. They are registered as a Cooperative Society. State-level Urban cooperative banks are registered under the State Cooperative Society Act while Multi-state cooperative banks with more than one branch in different states are registered under the “Multi-State Cooperative Society Act, 2002”. They have the provision to provide 40% of the credit to the Priority sector.

Rural Cooperative Banks- Rural Cooperative banks are divided into two categories of Lending institutions
- Small-term Lending Institutions: They provide small-term credit in a three-tier structure which includes Primary Agricultural Credit Society (PACS) at the village level, District Central Cooperative Banks (DCCB) at the District level and State Cooperative Banks (StCB) at the state level.
- Long-term Lending Institutions: They provide long-term credit in a two-tier structure which includes Primary Cooperative Agricultural and Rural Development Banks (PCARDB) at the village level and State Cooperative Agricultural and Rural Development Bank (SCARDB) at the state level.

Other Points
* RBI regulates the State Cooperative Banks (StCB), District Central Cooperative Bank (DCCB) and Urban Cooperative Banks (UCBs) under the Banking Regulations Act, 1949. Thus, Village-level banks are not regulated by the RBI under this act.
* The first Cooperative Credit Society in India started in 1904 in the Thiruvallur district of Tamil Nadu.

Question 18

What is a NBFI?

Answer 18

Non-Banking Financial Institutions (NBFI) are those financial institutions that provide financial services without holding the status of a “Bank”. In India, NBFIs are divided into four categories which are All India Financial Institutions (AIFI), Non-Banking Financial Companies (NBFC), Primary Dealers and Credit Information Companies (CIC). RBI regulates all these four categories of NBFIs.

Question 19

What AIFIs? Write a descriptive answer on NABARD?

Answer 19

All India Financial Institutions (AIFI) also known as the Development Financial Institutions provide sector-specific long-term and short-term financial services. There are four All India Financial Institutions (AIFI) which are NABARD, EXIM bank, SIDBI and NHB.

NABARD (National Bank for Agriculture and Rural Development)
The National Bank for Agriculture and Rural Development (NABARD) was formed on 14 July 1982 on the recommendation of the B.Sivaramman Committee. It works as a regulatory body for the Regional Rural Banks (RRBs) and Apex Cooperative Banks and provides finances for Agriculture and Rural Development. It has an authorised share capital of ₹30000 crores and is under the jurisdiction of the Ministry of Finance, Government of India.

Roles of NABARD
- It serves as a financing agency and provides financing for institutions that are engaged in rural development activities.
- It provides training to institutions that are engaged in the rural development sector.
- It provides refinancing to financial institutions that provide financing to the rural sector.
- It regulates financial institutions that provide financing to the rural sector.
- It coordinates policy formulation with the Central government, State government and the RBI.
- It coordinates with the financial activities of the institutions that provide financing to the rural sector.

Rural and Agriculture Development Initiatives
- NABARD provides loans from the Rural Infrastructure Development Fund (RIDF) to state governments, state government corporations, Self Help Groups (SHG), NGOs and Panchayati Raj Institutions for 39 rural development activities under three sectors which are Agriculture and Related sector, Social Sector and Rural Connectivity.
- With the assistance of the Swiss Agency for Development and Corporation, NABARD has set up a Rural Infrastructure Fund (RIF) that provides financing for unconventional and innovative experiments in the above three sectors.
- Low-interest crop loans and investment credit loans for agriculture and allied activities are provided to farmers through the Kisan Credit Card (KCC) scheme.
- NABARD launched the E-Shakti project for the digitization of Self Help Groups (SHG) which provides financial data of the SHG’s members and enables banks to take an informed decision in giving credit to the SHGs.
- NABARD improves the sustainable livelihoods of the SHG (Self Help Groups) by providing major livelihood skill training for making jute bags and other handicrafts through its Livelihood Enterprise Development Programme (LEDP). It also provides financing for training units that provides skill development programme.
- NABARD provides consultancy services related to agriculture and allied activities through its subsidiary NABARD Consultancy Services (NABCONS).

NABARD is one of the most important organizations in India that is responsible for rural development. SHG-Bank linkage programme of NABARD aims to improve rural development by leveraging SHGs. Although NABARD has a great contribution to rural development, the rural and agriculture sectors of India are still facing development issues. Therefore, NABARD needs to bring innovative and sustainable solutions for the development of the agriculture and rural sectors.

Question 20

What are AIFIs? Write a descriptive answer on SIDBI?

Answer 20

The Small Industries Development Bank of India (SIDBI) was established in 1990 under the provision of the SIDBI Act, 1989. It is the primary institution for promoting, funding and developing the Micro, Small and Medium Enterprise (MSME) sector and coordinating functions of institutions engaged in similar activities. It is the apex regulatory body for providing overall licensing and regulation to the MSME sector. It is headquartered in Lucknow, UP and Sivasubramanian Ramann is the current chairman & Managing Director. ₹1000 crore is the paid-up capital of SIDBI.

SIDBI provides direct and indirect financing to the MSME sector in the following ways:
- Indirect financing is provided by refinancing banks for providing credit to the MSMEs
- Direct financing is provided in some areas like sustainable development, guarantee scheme, service sector financing etc.
Apart from providing financial assistance, SIDBI focuses on cluster development, enterprise development, technology modernization and upgrading skills and supporting marketing activities.

Interventions for MSME growth
- To increase the credit accessibility for the MSMEs, SIDBI launched the “Udyami Mitra” portal which provides the facility to avail loans from over 1 lakh banks without physically visiting banks. The portal also provides handholding support to MSMEs for getting finance.
- MUDRA (Micro Unit Development and Refinance Agency) bank has been set up as a subsidiary of SIDBI that provides low-interest rate loans to micro-finance institutions and NBFCs (Non-Banking Finance Institutions). These micro-finance institutions like SHGs (Self Help Groups), JLPs (Joint Liability Groups), Small banks etc provide loans to small manufacturing units, shopkeepers, fruits & vegetable vendors and Artisans up to ₹10 lakhs.
- SIDBI organises Swalamban Bazaar events in various states to provide a platform for entrepreneurs and local artisans to showcase their products or services and provide them with credit, financial literacy, market connectivity and product design.
- SIDBI launches a quarterly credit report on the MSME sector “MSME Pulse” in association with TransUnion CIBIL for close tracking and monitoring of the MSME sector in the country.
- India’s first Sentiment Index “CriSiEx” was launched by SIDBI in collaboration with CRISIL which provides business sentiment on a scale of 0 to 200 where 0 represents extremely negative and 200 represents extremely positive.

The MSME sector is a major pillar of the Indian Economy as it contributes one-third of India’s GDP and is responsible for providing employment to a large population. However, there is a lack of financial access in the MSME sector due to which it is unable to access newer technology and transformation. Therefore, it is imperative for the SIDBI to increase financial access to the MSME sector for the overall socio-economic development of India.

Question 21

What are AIFIs? Write a descriptive answer on NBFC?

Answer 21

Non-Banking Financial Companies (NBFCs) are financial institutions that provide banking-related financial services but do not have a complete banking license. They are registered under the Companies Act, 1956 or Companies Act, 2013 and regulated and supervised by the Department of Non-Banking Supervision (DNBS) of the Reserve Bank of India (RBI).

The NBFCs registered under Section 45-IA of the RBI Act, 1934 cannot commence a business of a Non-Banking Financial Institute without obtaining a certificate of registration from the bank and having a net owned fund of ₹10 crores. However, certain NBFCs are registered under other regulators and are exempted under Section 45-IA of the RBI Act, 1934 which includes:
- Housing Finance Companies
- Merchant Banking companies
- Stock Exchanges
- Stock-broking companies
- Venture Capital Fund Companies
- Nidhi companies
- Insurance companies
- Chit Fund companies

NBFCs are engaged in the following principal businesses:
- Lending or Financing
- Accepting deposits for securitization
- Acquisition of stocks, shares, debentures, bonds or securities issued by the government or local authority
- Insurance business
- Chit business
- Collection of money
- Leasing and hire-purchase

NBFCs are not permitted to engage in the following businesses:
- Purchase or sale of any goods except securities
- Sale, purchase or construction of an immovable property
- Providing any service
- Agriculture operations
- Industrial activity

Question 22

What are Primary Dealers?

Answer 22

Primary Dealers are those financial institutes that buy securities directly from the government which government sells with the assistance of the RBI (Reserve Bank of India). Then they sell these securities in the secondary market. Primary dealers provide assistance to the government in selling securities. The RBI introduced the system of Primary Dealers in 1995. Some Primary Dealers in India are STCI Primary Dealer Limited, PNB Gilts Ltd and ICICI securities Primary Dealer Ltd.

Question 23

What are the Credit Information Companies (CICs)?

Answer 23

Credit Information Companies (CICs) are third-party agencies that collect financial data of an individual pertaining to a loan like credit transactions and payment history. Then formulate a credit report and provide it to their members which are usually banks or NBFCs (Non-Banking Financial Institutions). The Credit report provided by CICs helps banks and NBFCs to measure the creditworthiness of a borrower and take the decision to give credit.

• CICs are regulated and licensed by the RBI under the Credit Information Companies Act, 2005 and CICs are also registered under the Companies Act, 1956
• There are four CICs operating in India which are TransUnion CIBIL, Equifax, Experian and CRIF High Mark.

Question 24

What are the Concerns or Challenges in the Indian Banking System?

Answer 24

1- NPAs (Non Performing Assets)- Non-performing assets are one of the major concerns in the Indian banking system. As banks do not get the repayment on loans given by them, it affects the ability of the bank to generate profit and operate smoothly. The recent economic slowdown due to covid-19 pandemic and the Russia-Ukraine war has increased the NPAs of banks.
2- Capital Adequacy- The requirement for banks to maintain their total capital in contrast to risk-weighted assets is also a challenge for banks. A low Capital Risk-weighted Asset Ratio (CRAR) indicates that the bank does not have enough capital to absorb potential losses in case of a financial crisis. Capital Adequacy reflects the financial stability of banks.
3- Cybersecurity- The increasing development and use of technology in the banking sector, has brought several cybersecurity threats to the Indian Banking system. Cyber attacks pose a great threat to customers’ data such as credit card information, personal identification number and other details. Banks are also vulnerable to their Core Banking System and Point-of-sale terminals from cyberattacks.
4- Financial Inclusion- Financial inclusion is a major challenge for banks because a large section of the population still does not have adequate banking services. It is difficult for banks to set up branches in rural areas to commence banking services because of low financial literacy, resistance to change and poor banking infrastructure.
5- Digital Literacy- The increase in the digitization of banking services is a challenge for banks to provide banking services to people with low digital literacy. It is difficult for customers with low digital literacy to understand the basic terminologies. Despite various methods to digitally check account balances, people are still coming to update their passbooks.
6- Compliance- Multiple compliance requirements for banks from different areas like Basel norms, Banking Regulations Act, 1949, Companies Act, 1956/2013 and other compliance requirements from the Finance ministry affects banks to operate smoothly. Banks face the risk of reputation if they do not comply with the regulations thus, can lead to a loss of customer trust.
7- Competition from Fintechs- Banks face high competition from fintechs. Fintechs bring innovative and convenient ways to provide financial services to customers. Therefore, customers are approaching more fintechs than banks to avail of financial services.

Question 25

What is Inflation, what are causes and measures to control inflation?

Answer 25

Inflation is the rise in the general price of goods and services in an economy. Inflation leads to a decrease in the purchasing power of individuals. It causes each unit of currency to buy fewer goods and services, thus resulting in a decrease in purchasing power of the money. If a person buys a certain number of goods with a ₹100 note, he may not be able to buy the exact goods with a ₹100 note after 10 years due to inflation.

Negative Impacts of Inflation
- Inflation discourages investment and savings due to expectations of the rise in prices.
- It causes a shortage of goods because people start hoarding essential goods due to the expectations of the rise in prices.
- It impacts lower-income consumers as they are unable to buy goods and services and take prudent actions while spending their money.

Positive Impacts of Inflation
- It increases the profit for producers as they increase the price of goods produced.
- It increases the asset price of real estate, securities or other commodities.
- It increases employment if the inflation is caused by the high demand for goods and services.

Causes of Inflation
There are several causes of inflation however, the two main causes of inflation are:
1- Demand-Pull Inflation: This is caused when the aggregate demand for goods and services increases and exceeds the aggregate supply of goods and services. The aggregate demand might increase due to an increase in spending of consumers, businesses or governments. Therefore, inflation is caused because the supply of goods and services cannot meet the demand.

High demand for goods and services leads to high demand for labour or workforce in firms. To fulfil this high demand for the workforce, firms will hire more people and increase wages to retain the existing workforce. The increase in employment and wages will lead to two consequences:
- Firms will increase the prices of their goods and services to cover the cost of hiring. Higher prices of goods & services will again lead to inflation.
- Increase in employment and wages will lead to more money in the hands of consumers. Thus, consumers will spend more which will increase the aggregate demand leading to inflation.

2- Cost Push Inflation- This is caused when the increase in the cost of important goods or services such as crude oil, natural gas, food products and healthcare products causes inflation. It results in a decrease in the aggregate supply of goods and services. Therefore, aggregate supply cannot meet the aggregate demand for goods and services.

The increase in the cost of important goods or services increases the cost of production and to cover the cost of production, firms decrease the production and increase the price of their finished goods or services. Thus, resulting in inflation.

For example, an increase in the cost of crude oil will increase the cost of producing petrol and an increase in the cost of petrol will increase the price of petrol. Therefore, transportation costs will be increased resulting in an increase in the price of groceries and causing inflation.

Measures to Control Inflation
Monetary Measures
In monetary measures, The Reserve Bank of India (RBI) controls inflation by reducing the money in the economy. RBI takes the following measures for reducing the money supply and control inflation:

• RBI increases the bank rate and repo rate which compels commercial banks to borrow less from the RBI and banks also increase their interest rates for consumers which causes people to borrow less. Thus, reducing the money supply.
• RBI increases the Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR), due to which banks have less money to lend and thus reducing the money supply.
• RBI increases the Margin requirement of banks which hesitates consumers to borrow loans from banks since they have to pay more collateral for the same amount of loan. Thus reducing the money supply and controlling inflation.
• RBI will decrease the liquidity in the market by issuing government securities and reducing the money supply
• RBI’s recently introduced Standing Deposit Facility (SDF) can be used to squeeze excess liquidity from the banks and control inflation.
• RBI can direct banks to increase or decrease lending in one sector which is causing inflation. If there is food inflation, RBI will direct banks to increase agricultural loans which will help farmers to borrow loans to produce more and meet the demand for food.
  Note!- Only Monetary policy alone cannot help to control Demand-pull inflation.

Fiscal Measures
Monetary policy is supplemented with Fiscal policy to control inflation. Government can take the following fiscal measures to control inflation:
- Government can increase income tax or Goods & Services Tax (GST) to reduce the money supply in the economy. An increase in income tax and GST will discourage households to spend and reduce the demand in the economy. Thus, reducing inflation.
- Government can reduce public expenditure on government projects and subsidies to control inflation. For example, the reduction in government projects will reduce the demand for labour and materials. This will reduce the spending of firms leading to a reduction in aggregate demand and therefore, reducing inflation.

Other Measures
- Government can increase the production of goods and services that are the cause of inflation. This can be done by implementing policies that are friendly for production like Procution Linked Incentive (PLI) and ease of doing business policies. Investment in new technologies by the government can also increase production.
- Government can use price control for controlling inflation. Government can do this by setting price limits on essential goods and services.
- Government can ban export or impose export restrictions on some goods. This will lead to a reduction in the money supply of firms and individuals who export their goods and thus, reduce inflation.

Question 26

What is Stagflation?

Answer 26

Stagflation is a situation when there is stagnation in the growth of the economy and the general price of goods and services is also high. Therefore, it is a combination of slow economic growth and inflation.

Stagflation is a challenging economic condition because if the government decreases taxes or interest rates to boost the economy, it may lead to more inflation and if taxes or interest rates are increased to decrease inflation, it may lead to more decline in the economic growth. Hence, the government has to strike a perfect balance to control inflation.

Question 27

What are WPI and CPI and what are their uses?

Answer 27

The Wholesale Price Index (WPI) is used to measure the average prices of commodities which are traded between producers and wholesalers. Prices are measured based on 697 commodities under three groups which are Primary articles, Fuel & Power and Manufactured Products.

Uses of WPI:
- It is used to measure inflation at a wholesale transaction level
- It is used to measure other macroeconomic indicators like GDP (Gross Domestic Product) and IIP (Index of Industrial Production)
- It is used by the RBI to take monetary policy decisions
- It is used by businesses to formulate policies related to the cost of production and revise their own prices
- It is used by investors to take investment decisions

WPI’s base year is set at 2011-12 and the score is set at 100. Its base year and score have been revised 6 times and currently, it is the seventh revision. WPI does not include services and taxes. It is released on the 14th of every month by the Office of Economic Advisor, Ministry of Commerce & Industry.

Consumer Price Index (CPI)
The Consumer Price Index (CPI) is used to measure the average change in prices of commodities at a retail level. It measures the change in the consumption price of households. CPI is measured using four types of indices with reference to their base year and score. The four indices are:
- CPI for Industrial Workers (CPI-IW)
- CPI for Agricultural Labourers (CPI-AR)
- CPI for Rural Labourers (CPI-RL)
- CPI for Urban and Rural combined
CPI Urban and CPI Rural are new indices and are likely to replace all other indices to measure the Consumer Price Index.

The price data is collected from towns by the NSSO (National Sample Survey Organization) and the Department of Posts (DOP) collects data from selected villages.

The CPI for Industrial Workers (CPI-IW) is published by the National Statistical Office (NSO), Ministry of Statistics & Programme Implementation while the other three are compiled by the Labour Bureau, Ministry of Labour & Employment.

Uses of CPI
- It is used to estimate inflation at a retail level
- It is used to measure other macroeconomic indicators like GDP (Gross Domestic Product) and IIP (Index of Industrial Production)
- It is used by the RBI to take monetary policy decisions
- It is used by businesses to formulate policies related to the cost of production and revise their own prices
- It is used by investors to take investment decisions

Question 28

Write a note on the RBI and its key functions?

Answer 28

The Reserve Bank of India (RBI) is the central bank of India formed on April 1, 1935. It is the regulator of the Indian Banking system and works to ensure stability in the Indian financial system. RBI plays a key role in promoting financial inclusion and supporting the growth of the economy.

According to the Preamble, the basic functions of the RBI are:
- Printing and issuing banknotes in India
- Keeping reserve assets such as gold, foreign currencies, securities and other assets
- To implement the Monetary Policy framework to meet the challenges of the increasingly complex economy
- To maintain price stability while keeping in mind the economic growth of India

The Key functions of RBI are:
1- Issuer of Currency- The RBI is responsible for issuing banknotes and coins. The currency is printed and minted in various cities of India by the Bhartiya Reserve Bank Note Mudran (BRBNM) and The Security Printing and Minting Corporation of India (SPMCIL). The currency is supplied by the RBI to currency chests of selected scheduled banks, which then distribute to other branches and commercial banks.

2- Regulator of Banks and NBFIs- RBI is responsible for protecting the interest of depositors with an effective regulatory framework. The banks and Non-Banking Financial Institutions are regulated and supervised by the RBI under the provisions of the RBI Act, 1934 and the Banking Regulations Act, 1949. RBI sets standards and procedures for banking practices to ensure stability in the banking sector.

3- Monetary Policy Management- RBI is responsible for formulating and executing a monetary policy in India to maintain financial stability. It is a key tool to control inflation and the money supply in the market. RBI uses monetary policy tools such as the Repo rate, CRR, SLR, MSF, SDF and Bank rate to control the money supply in the market.

4- Regulating Forex Market- RBI is responsible for keeping foreign exchange reserves like foreign currency, bonds, gold, treasury bills, Special Drawing Rights (SDR) and other securities. This foreign exchange reserve is used to maintain the foreign exchange rate.

5- Banker’s Bank- RBI acts as a banker for commercial banks in the country. It acts as a Lender of the Last Resort and provides emergency funds to banks facing a shortage of funds. It acts as a Clearing House and facilitates interbank transaction services. It also provides the facility to deposit funds with the RBI through Reverse Repo and Standing Deposit Facility (SDF) and earn interest.

6- Banker to the Government- RBI acts as a banker to the government in the following ways:
- It receives and makes payments on behalf of the government
- It provides a temporary loan facility to the state and central governments through the “Ways and Means Advance (WMA)”
- It manages contingency funds, consolidated funds and public accounts of state and central governments
- It acts as an advisor to the government in formulating monetary and fiscal policies
- It facilitates issuing of government securities like bonds and treasury bills
- It issues public debt and new loans on behalf of the central and state governments
7- Payment and Settlement System- RBI regulates and supervises the payment and settlement system in India under the Payment and Settlement System Act, 2007. It uses the NPCI (National Payment Corporation of India) to regulate and supervise Bharat Bill Payment System (BBPS), Unified Payment Interface (UPI), RUPAY and other payment systems.

RBI also formulates guidelines and provisions for the RTGS (Real-Time Gross Settlement) and NEFT (National Electronic Fund Transfer). RBI has also recently launched a pilot project for implementing the Central Bank Digital Currency (CBDC).

8- Insurance on Deposit and Credit Guarantee- RBI provides insurance and credit guarantee services through Deposit Insurance and Credit Guarantee Corporation (DICGC). It provides insurance up to ₹5 lakhs for depositors in times when banks default or go bankrupt and provides a credit guarantee of up to ₹2 crores to depositors if depositors are unable to make the repayment of loans up to ₹2 crores.

History of RBI
The Reserve Bank of India (RBI) was formed on April 1, 1935, following the provision of the RBI Act, 1934. It was formed based on the recommendation of the Hilton Young Commission. RBI was nationalized in 1949 and since then it is fully owned by the Ministry of Finance, Government of India.

The first governor of RBI was Osborne Smith while the first Indian governor of the RBI was Chintaman.D.Deshmukh.

Question 29

Explain Monetary Policy?

Answer 29

Monetary Policy is formulated and executed by the Reserve Bank of India (RBI). It is used by the RBI to control the money supply in the economy and boost economic growth. The first Monetary Policy Committee (MPC) was formed in 2016 to form a monetary policy framework. RBI uses the following monetary policy tools:

1- Open Market Operations (OMO)- Open Market Operations (OMO) is the buying and selling of government securities like bonds, treasury bills etc by the RBI. The RBI sells government securities to decrease the money supply in the economy and purchases government securities to increase the money supply in the economy.

2- Liquidity Adjustment Facility (LAF)-Liquidity Adjustment Facility includes the Repo agreement and Reverse Repo agreement. Under the Repo agreement, RBI increases the Repo rate for banks to decrease the money supply as borrowers will buy less due to the increased Repo rate. Similarly, RBI decreases the Repo rate which leads to more borrowing and increases the money supply.

Under a Reverse Repo operation, RBI borrows money from the banks to squeeze liquidity and decrease the money supply. RBI increases the reverse repo rate which encourages banks to deposit money with the RBI, resulting in a decrease in the money supply. RBI decreases the Reverse Repo rate which discourages banks to deposit money with the RBI, thus, increasing the money supply.

Note- It is called the Repo or Repurchase agreement because securities are sold against credit with an agreement to repurchase those securities at a predetermined rate and date.

3- Bank Rate- It is the rate at which the RBI provides credit to banks for the long term. RBI increases the bank rate which increases the cost of borrowing from RBI, thus, decreasing the money supply. RBI decreases the bank rate which decreases the cost of borrowing, thus increasing the money supply.

The key difference between the Bank rate and the Repo rate is that banks are required to pledge securities as collateral in the Repo rate but Banks are not required to pledge collateral to avail of loans at the Bank rate.

The bank rate is aligned with the MSF rate which means that the Bank rate is equal to the MSF rate. Thus the connection between the Repo rate, Bank rate and MSF rate is:
MSF Rate = Repo Rate + 0.25% Bank Rate and Bank rate = MSF Rate

4- Marginal Standing Facility (MSF)- It is another short-term credit facility provided to banks only in times of emergency. The credit is provided against the SLR (Statutory Liquidity Ratio) of the bank and up to 3% of their NDTL (Net Demand and Time Liability). The minimum amount of ₹1 crore is provided and afterwards, a multiple of ₹1 crore.

RBI increases and decreases the MSF rate similarly to the Repo rate to control the money supply in the economy.

5- Reserve Requirement- Banks are required to maintain the Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) as a percentage of their NDTL specified by the RBI. CRR is the cash reserve that banks have to keep with the RBI. It is mainly used by the RBI to control the money supply.

SLR is the percentage of deposits of banks’ liquid assets such as bonds, gold, cash and other government securities that they have to keep with themselves. It is used to control the money supply. However, it is also used to ensure the bank is solvent. The maximum limit of SLR is 10%.

6- Long-Term Repo Operation (LTRO)- The Long-Term Tepo Operation (LTRO) is another monetary policy tool used by RBI to provide liquidity to banks at a “Repurchase Agreement (REPO)”. Liquidity is provided to banks at a repo rate or more than the repo rate for a tenure of 1 to 3 years. Thus it fulfils the long-term financing needs of banks.

The LTRO reduced the cost of borrowing for banks which is an important component of the MCLR (Marginal Cost of Lending Rate). Thus, banks also have their MCRL rate which leads to more borrowing by people. Therefore, It is used as a tool by the RBI to increase the money supply in the economy.

LTRO is provided through auction with a minimum bid of ₹1 crore and multiple of ₹1 crore.

Question 30

Explain Fiscal Policy?

Answer 30

Fiscal Policy is the use of government revenue collections (Taxes and Non-tax) and expenditure to influence a country’s economy. The objectives of fiscal policy are to boost economic growth, reduce unemployment and control inflation.

Changes in the level of taxes and government expenditure affect the following macroeconomic indicators:
- Aggregate demand
- Savings and Investments
- Income distribution
- Allocation of resources

Expansionary Fiscal Policy
In an Expansionary fiscal policy, the government reduces taxes and increases expenditures that increase the aggregate demand of the country. Expansionary fiscal policy leads to an increase in the money supply in the economy which leads to an increase in aggregate demand for goods and services.

Expansionary Fiscal policy is used:
- To boost economic growth in the country
- To prevent or fight recession
- To increase lending and borrowing activity in the country
- To reduce unemployment

Contractionary Fiscal Policy
In Contractionary fiscal policy, the government increases taxes and reduces government expenditures that decrease the aggregate demand in the country. Contractionary fiscal policy leads to a decrease in the money supply which leads to a decrease in aggregate demand for goods and services. This leads to a decrease in the economic growth of the country.

Contractionary Fiscal policy is used:
- To curb or reduce inflation
- To reduce the budget deficit
- To control the balance of payment

Question 31

What is Fiscal Deficit?

Answer 31

A fiscal deficit is a situation when the government’s Total expenditure exceeds the Total Revenue, excluding money borrowed by the government. This means that the government is spending more than it earns. It is expressed as the percentage of GDP (Gross Domestic Product). An Increase in fiscal deficit can lead to inflation.

The Formula of Fiscal deficit is “Total Expenditure – Total Revenue (Excluding Borrowings)”.

Question 32

What are Derivatives and what are its types?

Answer 32

A derivative is a contract between two or more parties whose value is derived from an underlying asset, index or interest rate. Derivatives are used for hedging against risk, speculation of future prices and gaining exposure to markets.

Types of Derivatives
1- Futures – It is a standardized contract between two parties traded on an exchange. In a future contract, the underlying asset, price, settlement date, margin requirement and contract size are predetermined and cannot be changed after the contract is made.

For example, Party A wants to sell its stocks worth ₹500 believing that prices might fall in the future while Party B wants to purchase those stocks believing that prices will rise in the future. They both sign a future contract for the transaction of stocks.

If the price of the stocks on the settlement date is lower than ₹500, then Party A will get a benefit against the risk of loss and if the price is higher than ₹500 then Party B will gain profit.

2- Forward- It is a non-standardized contract similar to Futures and is traded over the counter. Thus, it is not traded on an exchange. In a Forward contract, the underlying asset, price, settlement date and margin requirement are predetermined but it is can be changed or tailored even after the contract is made.

For example, A farmer signs a forward contract with the baker at ₹50 per kg believing the prices might decrease in the future.

If the price of wheat on the settlement date is higher than the predetermined price, the farmer loses the potential gains but if the price is lower than ₹50 per kg then the farmer would have saved himself from the potential loss.

Differences between Future and Forward contracts are:
- Future Contract is traded on an exchange but Forward contract is traded directly, not on the exchange
- Forward Contract has more counterparty risk than the Future Contract as it is not traded on a third-party platform. Thus, there is a risk of default by one of the parties. Whereas, In a Futures Contract, there is a guarantee of settlement by both parties as it is managed by the Exchange.
- Forward Contract is customizable even after the contract has been made but Futures Contract is not customizable after the contract is made.
- Future Contract has a margin requirement and has to deposit margin with the stock exchange to cover potential losses. Whereas, there is typically no Margin requirement in a Forward Contract
- Futures Contracts are more liquid than Forward Contracts as the transaction of the underlying assets is automatically processed by the exchange with no delay.

3- Options- An Option is a contract under which the owner of the underlying asset has the right but not an obligation to buy or sell underlying assets at a predetermined price on or before a specified date. There are two types of Options contracts:

Put Option- It gives the owner the right but not the obligation to sell the underlying asset at a predetermined price and on or before a specified date.

For example, an Owner owns a stock worth ₹100 and believes that the price of the stock will fall. He buys the Put options with the strike price of ₹90.

If the stock price falls to ₹80, he will exercise his Put Option and save an additional loss of ₹10. However, if the price remains above ₹90, he will not exercise the Put Option and the Put Option will expire worthless and only the cost of purchasing the Put option has to be paid.

Call Option- It gives the right but not the obligation to the buyer to buy the underlying asset at a predetermined price and on or before a specific date.

For example, A buyer does not own a stock worth ₹100 and believes that the price of the stock will rise. He buys the stocks through the Call option with the strike price of ₹130.

If the price of stock rise above ₹130, he can buy the stock on or before the expiry date and gain profit. However, if the price of the stock does not rise above ₹130 by the expiry date, his strike price will expire and he will not exercise the Call option but still, he will pay the cost of the Call option.

4- Swaps- A swap is an over-the-counter contract between two parties to exchange financial instruments such as interest rates, currency, commodities etc. A swap agreement is decided based on prevailing interest rates, agreed notional amount and other relevant market factors.

Swaps can also be seen as a series of forward contracts through which two parties exchange financial instruments.

Interest rates Swaps- In this type of swap, two parties sign a contract to exchange their fixed or variable interest rates. For example, Party A with a fixed interest rate from a mortgage comes into a Swap agreement with Party B with a variable interest rate from a mortgage.

Party A will pay the fixed interest rate to Party B and Party B will pay variable interest rates to Party A.

Currency Swap- In a currency swap, two financial institutions or companies from different countries exchange the principal amount and interest of their respective currency. It is used to hedge against fluctuations in exchange rates or raise funds in a different currency.

Question 33

What is Risk Management in Banking Sector and what are the measures to control risk?

Answer 33

Banks are vulnerable to several financial risks that can affect their ability to perform or sustain. Thus, Risk Management in banking is very essential to prevent any financial constraints on banks.

The types of risks faced by banks are:
Credit Risk
Credit risk faced by banks is related to the default on credit lent by banks. A Default can be done by borrowers or counterparty. Banks also face credit risk if the borrowers fail to meet the terms & conditions of the loan borrowed by them.

Default on a loan can lead to an increase in Non-Performing Assets (NPAs) which can affect the financial stability of banks.
Measures
- Reduce NPAs by forming an action plan to prevent generating new NPAs
- Form an action plan to recover the bank’s assets
- Risk pricing strategy wherein, a high-interest rate is charged to borrowers with a low credit history or creditworthiness
- Increase collateral requirement
- Reduce loans concentration in specific sectors, industries or borrowers
- Strengthening loan review mechanism

Liquidity Risk
Liquidity risk is a risk when banks are unable to meet their short-term debt obligations. They fail to meet the compliance of depositors which could be due to low cash or equity flow.

Measures
- Diversify funding sources and reduce dependence on a single source of funding. This will improve the cash supply to banks and meet their debt obligations
- Maintain more liquid assets such as cash, bonds, gold and government securities to use them when the need arises
- Banks should Stress test liquidity position by evaluating the position of their assets in adverse scenarios. This will help to identify the liquidity position of banks’ assets in difficult situations and take preventive measures.
- Implement good Asset-liability management practices to ensure that their assets and liabilities are appropriately matched
- Maintain goods relationships with stakeholders such as depositors, investors, financial institutions, regulatory bodies and government

Market Risk or Systematic Risk
Market risks or systematic risks are the risks that are associated with an increase in variation of market prices such as interest rate prices, commodity prices, equity prices and exchange rates. Systematic risks pose a threat to the whole economy and disruption of the entire financial system.

Measures
- Portfolio diversification which involves investing in different assets to reduce exposure to a single asset
- Implementing stress testing on the portfolio by stimulating the market risk and evaluating the adverse impact on the portfolio.
- Implementing Hedging strategies such as futures, forwards, options and swaps
- Training and Development programmes for employees such as risk management, financial training and regulatory requirements training

Interest Rate Risks
Interest rate risks arise due to high variations in interest rate changes which may be due to inflation or economic performance. It affects the earnings of banks and the economic value of banks’ assets and liabilities.

Measures
- Robust interest rates policy should be implemented by banks. There should be strategic changes in the MCLR (Marginal Cost of Fund-based Lending Rate) or any other reference rate according to changes in the interest rate of the market
- Stress testing should be done by simulating the effects of high-interest rate changes and the impact of stress testing should be evaluated on the finances of banks
- Robust Asset liability management should be done by banks which should involve regular monitoring of banks’ assets and liabilities and changing investment and lending decisions based on the interest rate risks

Operational Risks
Operational risks are the risks that result from the failure of internal procedures, employees or systems such as employee fraud, technical issues and compliance issues.

Measures
- Internal audits should be conducted by banks regularly to detect internal fraud and measure potential risks in daily operation
- Banks should have a robust IT (Information Technology) system that can perform banking functions and reduce manual work
- Outsourcing should be done for process improvement, better technology and cost reduction. Outsourcing should also be regularly monitored to prevent any non-compliance or problem from the third party.
- Regular staff training and development should be done to prevent any non-compliance or poor performance from the employees

Question 34

Write a note on Primary Market in India?

Answer 34

A primary Market is a place where buying and selling of securities take place for the first time such as bonds and stocks. It is also called Initial Public Offering (IPO) as shares are issued for the first time by the company. National Stock Exchange (NSO) and Bombay Stock Exchange (BSE) facilitate the buying and selling of securities.

Buying and selling of securities in India are regulated by the SEBI (Securities Exchange Board of India) through the Securities Contract Regulations Act, 1956.

The functions of the Primary Market are:
- It facilitates companies to raise capital by issuing securities
- It provides a platform for establishing the initial price of securities

Types of issues in the Primary Market are:

1- Initial Public Offering (IPO)- An IPO is when a company issues its share for the first time to the general public following the listing on the stock exchange.
2- Follow-on Public Offering (FPO)- An FPO is when an already listed company issues its shares to the public for the first time to raise additional funds. The differences between an IPO and FPO are:
- IPO is used by the company when the company is listed on the stock exchange and immediately starts offering shares but in FPO the company is already listed and issues new shares
- IPO is primarily used to raise capital or pay off debt while the FPO is primarily used to meet additional funding needs of the company
3- Right Issue- A Right issue is when the company issues additional shares to the existing shareholders of the company for raising additional capital
4- Bonus Issue- In a Bonus issue, the company issues additional shares to its existing shareholders free of cost or without charging any fees. They are issued to encourage market participation and increase the number of outstanding shares of the company
5- Private Allotment- In a private allotment, shares and convertible securities are issued to a selected group of investors. Private allotment of shares can be provided to up to 200 investors in a financial year.

Types of Private Allotment are-
a) Preferential Allotment- In Preference allotment, preference is provided to a selected group of investors as they receive dividends before equity shareholders. Preference shareholders do not get the right to vote in the company.
b) Qualified Institutional Placement (QIP)- Under QIP, shares are provided to Qualified Institutional Buyers (QIB) who are registered with the Securities Exchange Board of India (SEBI). QIBs include banks & financial institutions, mutual funds, venture capital funds, insurance companies etc.
c) Institutional Placement Programme (IPP)- IPP is another method of raising capital by allotting shares to Qualified Institutional Buyers (QIB). IPP is used only to raise the minimum public shareholding requirement to 25%.
Differences between QIA and IPP are:
- Companies issuing shared through IPP have not complied with the minimum public shareholding requirement of 25% but Companies issuing through QIP have already complied with the minimum public shareholding requirement
- There is no pricing restriction for issuing shares on IPP but there are restrictions on pricing in QIP

Question 35

Write a note on Secondary Market of India?

Answer 35

A Secondary market is a place where securities are traded between investors once, they are issued in the primary market. It is also called the stock market as it involves the trading of shares between investors.

The main difference between the Primary and Secondary markets is that in the primary market, securities are issued directly by the companies while in the secondary market, securities are not issued directly by companies and are traded between different investors.

Types of Secondary Market
There are two types of Secondary markets:
1- Stock Market- It facilitates buying and selling of securities such as equity shares, bonds, mutual funds, Exchange Traded Funds (ETFs), derivatives etc. Trading of securities in a stock market is facilitated by the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE).
2- Over-the-Counter Market (OTC)- In an OTC market, securities are traded directly between two parties without the involvement of a stock exchange. It involves trading corporate bonds, commodities, foreign exchange and derivates like interest rate swaps, currency swaps and credit default swaps.

OTC is less regulated and less transparent than the Stock market and thus poses a higher risk to investors.

The Functions of the Secondary Market are:
- It provides liquidity to the market by facilitating buying and selling of securities among different investors
- It helps in identifying the fair market price of securities through the forces of Deman and Supply
- It facilitates investors to manage risk by diversifying their portfolio by buying and selling different securities
- It facilitates the transfer of ownership from one investor to another
- It improves market efficiency because the best trading companies raise capital to fund the development of the economy

Question 36

Write a note on Money Market in India?

Answer 36

The Money market in India refers to a place where highly liquid short-term financial instruments are traded from one day to one year. The key participants in the money market are RBI, Commercial banks, Public-sector banks, NBFCs, LIC etc. In India, the money market is regulated by the RBI (Reserve Bank of India) and SEBI (Securities and Exchange Board of India).

Money Market Instruments in India
1- Call Money, Notice Money and Term Money markets- Under call money and Notice money and term money markets, buying and selling of funds take place between banks and other financial institutions.
- Under the Call money market, transactions take place within 1 day
- Under the Notice money market, transactions take place from a tenor of 2 days to 14 days
- Under the Term money market, transactions take place from a tenor of 15 days to 365 days

Term Money transactions are facilitated on the NDS (Negotiated Dealing System) platform while the Call money and Notice Money transactions take place on the NDS-Call. The NDS platform is operated by the RBI.

2- Treasury Bills- Treasury bills are short-term debt instruments issued by the RBI on behalf of the central government through auction. They are issued at a discount and redeemed at the face value. They are issued in three tenors of 91 days, 182 days and 364 days.

For example, A treasury bill of ₹100 face value is issued by the government at a discount of ₹95 for a 91-day tenor. The investor will redeem a profit of ₹5 at maturity. Thus, the gain on a treasury bill is the difference between the face value and discount value of the bill.

3- Commerical Paper- Commercial Papers are short-term debt instruments that are issued as promissory notes by corporates, primary dealers and All India Financial Institutions (AIFI) to meet their short-term liquidity requirement. It serves as an alternative for corporates to borrow from a bank.

Commercial Papers are issued at a discount by the issuer and redeemed at face value by the investor.

Features
- They are issued from a tenor of 15 days to 1 year
- They are issued at a denomination of ₹5 lakhs and multiple
- Only a scheduled bank can act as an Issuing and Paying (IPA) or intermediary to facilitate transactions between issuer and investor
- Every issue of commercial, including renewal should be treated as a fresh issue

4- Certificate of Deposit (CD)- CDs are negotiable short-term debt instruments issued by banks as promissory notes from a maturity period of 3 months to 1 year. They are used by banks to meet their short-term liquidity requirements.

Features
- They are issued by Scheduled commercial banks, Regional Rural banks and Small finance banks
- Issued to individuals, corporates, trusts, funds and associations
- Issue at either Over-The-Counter (OTC) markets or recognized stock exchanges in India
- Issued at either fixed or floating rate of interest

5- Commercial Bills- Commercial bills are short-term debt instruments which are used to provide liquidity between three participants which are seller (issuer), buyer and bank.

For example, A seller of goods wants to sell his goods to a company (buyer). The buyer agrees to purchase goods worth ₹10000 on credit and pay the amount at a future date but the seller needs immediate money.

Therefore, for this seller will issue a commercial bill to the buyer that serves as a written promise that the buyer has to pay the amount for the goods purchased.
The seller will sell the commercial bill to a bank or financial institute and the bank will provide ₹9000 to the seller at a discount rate of 10%. The banks will thereafter, take the principal amount ₹10000 from the company at maturity.

Thus, in a commercial bill transaction
- seller receives immediate liquidity
- Buyer receives goods and services if they are unable to pay the amount immediately
- Banks earn profit by buying the commercial bill at a discount

Question 37

What is the difference between Growth and Development?

Answer 37

Economic growth is the increase in the real value of goods and services produced in an economy. It is quantitative and is typically measured by an increase or decrease in the percentage of the GDP (Gross Domestic Product). Other quantitative factors include National Income and Per Capita income.
Economic development is a broader term and it includes both quantitative and qualitative factors. Along with quantitative factors, it includes factors that improve the Quality of life or standard of living which are:
- Human Development Index
- Human Poverty Index
- Literacy rate
- Healthcare improvement
- Life expectancy

Question 38

Explain Factor cost and Market Price?

Answer 38

Factor Cost
Factor Cost is the final cost of the product after producing the goods or services. It includes the cost paid to the factors of production plus the price of the product decided by the producer to sell in the market. Factor cost includes rent for Land, wages for Labor, interest for Capital and profit shared with Entrepreneur.
For example, If a shoe manufacturer purchases raw materials for ₹1000 and pays ₹500 salaries to labour and decides to earn a profit on the manufactured shoe of ₹300 then, the Factor cost will be ₹1000+₹500+₹300 = ₹1800.

Market Price
Market Price is the final price of goods or services that are sold in a market to consumers. It includes indirect taxes and subsidies imposed on the product. The formula for calculating the market price is Factor Cost + Indirect tax - Subsidies. (Indirect tax – Subsidies) is also called Net Indirect Tax (NIT).
Therefore, Market Price = Factor Cost + Net Indirect Tax (NIT)
So for finding Factor Cost after the market price of goods or services, the formula will be Factor Cost = Market Price – Net Indirect Tax (NIT)

Question 39

What is GDP, what are the ways to measure it?

Answer 39

Gross Domestic Product (GDP) is the final value of all the goods and services produced within a boundary of a country in a specified time period. It is one of the main tools to measure the growth or development of a country.

There are three ways to measure the GDP of a country:
1- Production Approach- In this method, the Gross Value Added (GVA) is calculated at each stage of the production process in the country. GVA is calculated by deducting the Value of Intermediate Consumption from The Gross Value of Output. Thus, the formula for Production Approach is GVA = Gross Value of Output – Value of Intermediate Consumption.

• Gross Value of Output is the total value of final goods and services produced in a country
• The value of Intermediate Consumption is the total cost of goods and services used in the production process. It includes the cost of raw materials, components, services, energy etc.
  For example, If a manufacturer produces 100 products worth ₹10000 in a Financial Year and the Value of Intermediate Consumption of producing 100 products is ₹3000. Then the Gross Value Added by the manufacturer will be ₹10000 - ₹3000 = ₹7000.
  Similarly, the GVA by all the industries can be summed to find the GDP of a country.

2- Expenditure Approach- In this method, GDP is calculated by the summation of the expenditure on final goods and services of all the sectors in a country and deducting the import expenditures of all the sectors.

The formula for calculating GDP using this approach is C + I + G + Net Export (Export-Import).
- “C” is the expenditure by the Household sector. It only spends on consumption goods
- “I” is the expenditure by the Private sector. It only spends on capital goods
- “G” is the expenditure by the Government sector. It spends on both consumption goods and capital goods
Note!- Import expenditure of all the sectors is not included and Intermediate goods and services are not included in the C, I and G.
3- Income Approach- It is the method GDP is calculated by measuring the total income earned by all the factors of production which are land, labour, capital and entrepreneurship.

The formula for calculating GDP using the Income method is Compensation of Employees (COE) + Operating Surplus (OS) + Mixed Income (MI) + Rental Income + (Taxes on Production and Imports – Subsidies)

• COE includes salary and other benefits given to employees by businesses and the government
• Operating Surplus (OS) is the rent, interest and profit made by incorporated businesses by selling goods and services
• Mixed-Income (MI) is the profit made by unincorporated businesses or self-employed workers like restaurant owners, plumbers, barbers etc.
• Taxes on Production and imports are income earned by the government

In India, the National Statistical Office (NSO) measures GDP by both the Production approach and the Expenditure approach.

Question 40

What is GNP?

Answer 40

The Gross National Product (GNP), also known as the Gross National Income (GNI) is the total value of goods and services generated by the residents of a country regardless of their location. It includes income generated by Indian residents living in India and abroad.

The formula for calculating the GNP is GDP + Net Factor Income From Abroad (NFIA) = GNP. Wherein, NFIA = Income from abroad to India – Income from India to abroad
- GDP is the final value of goods and services produced within a country’s border
- NFIA is the final net income generated by Indian residents by working or having businesses in foreign countries

The two main differences between GDP and GNP are:
- GDP does not measure the final value of income generated from outside the country while GNP measures that
- GDP includes the final value of goods and services generated by foreign nationals working in India but GNP excludes that

Question 41

What is Nominal GDP and Real GDP, what is the difference between them?

Answer 41

Nominal GDP or GDP at Current Market Price

Nominal GDP is calculated by calculating the value of final goods and services at the current market price. For example, if in 2023 a total of 500 units of goods and services were produced at ₹20 then the Nominal GDP will be 500 * 20 = 10000₹.

Real GDP or GDP at Constant Price

Real GDP is calculated by taking the price of the base year for calculating the final value of goods and services. The base year for calculating Real GDP in India is 2011-12. It is set by the Central Statistical Office (CSO), MoSPI. It is the more accurate way to measure the GDP.

For example, if the total goods and services produced in 2023 are 500 units and the base price of goods and services in 2011-12 was ₹10 then the Real GDP in 2023 will be ₹5000.

Difference between Nominal GDP and Real GDP

• Nominal GDP includes both changes in price and production but Real GDP only includes the change in Production or quantity.
• Nominal GDP reflects the change in both the price and production of goods and services while Real GDP reflects only the change in the production of goods and services

Real GDP is a more accurate way of measuring GDP than Nominal GDP because it shows the change in the production of goods and services from the base year. The change in both price and quantity of goods and services in Nominal GDP makes it difficult to measure economic growth.

Question 42

What is GDP deflator?

Answer 42

GDP Deflator shows the percentage change in the current price of goods and services compared to the price of the same goods and services in the base year. The formula for calculating GDP Deflator is Nominal GDP/Real GDP * 100.

If the GDP Deflator is increased by 20%, then it shows that the current prices of goods and services are 20% higher than it was in the base year.

The GDP deflator is used as an alternative to the CPI (Consumer Price Index) for measuring inflation. The difference between both is that CPI includes imported goods and services but the GDP deflator does not include imported goods and services.

Note- GDP – Depreciation = Net Domestic Product (NDP)
GNP – Depreciation = Net National Product (NNP)
Depreciation is the decrease in assets over time.

Question 43

What is National Income and Per Capita Income?

Answer 43

National Income is the sum total of all the income generated by the factors of production within India and abroad within a financial year. It includes Net Factor Income From Abroad (NFIA) thus, it does not include income going from India to abroad.

National Income is equal to the Net National Product (NNP) at factor cost as it involves the factor income generated by Indian residents. Thus, the formula for calculating national income from NNP will be GDP at factor cost + NFIA - Depreciation = NNP at factor cost. Therefore NNP at factor cost is equal to the National Income.

Thus, the difference between GNP at factor cost and National Income is that National Income does not include depreciation.

Per Capita Income
Per Capita Income is the average income of a people in a country in a specified year. It is often used as an indicator to measure the standard of living in a country. The formula for measuring per capita income is National Income/Total Population of the country.

Question 44

What is Micro and Macro economics?

Answer 44

Ans:
Microeconomics studies the decisions taken by individuals, firms or a sector while Macroeconomics studies the decision taken by a region, nation or government as a whole. Microeconomics uses a bottom-up approach and studies the economy in detail while Macroeconomics takes a top-down approach and studies the economy as a whole. Both Macro and Microeconomics are interrelated to some extent for example- the rise in Inflation is a “Macro effect” but due to the rise in inflation it increases the price of raw materials and affects individuals’ decision making which is a “Micro effect”.

Microeconomics studies the Demand and Supply equation in the individual markets while Macroeconomics studies GDP, Inflation, National income, unemployment, price indices, output, consumption, International trade etc.

Question 45

What is an Economy?

Answer 45

Ans:
An economy is an area where the production, distribution and consumption of goods and services take place. It can be a firm, state, region, country or a particular area of a country. So basically “Economics” is the study of an Economy

Question 46

Which Sector of the Economy is also called Knowledge Sector?

Answer 46

Ans:
Quaternary Sector

Quaternary Sector: It is a sub-sector of the Tertiary sector. It is also called the ‘Knowledge’ sector because knowledge or information-based services are provided in this sector like education, consultation, legal services, research & development, media, IT(Information Technology) etc. It plays the most important role in determining the quality of human resources an economy has

Question 47

Which sector of the economy has top level decision makers that ultimately affects the growth of the economy?

Answer 47

Ans:
Quinary Sector

Quaternary Sector: It is a sub-sector of the Tertiary sector. It is also called the ‘Knowledge’ sector because knowledge or information-based services are provided in this sector like education, consultation, legal services, research & development, media, IT(Information Technology) etc. It plays the most important role in determining the quality of human resources an economy has

Question 48

Describe Primary, Secondary and Tertiary Sectors of the economy?

Answer 48

Ans:

1. Primary Sector: Primary sector is that sector that involves the extraction of Natural resources directly from the earth for the end use of exploitation. It includes Mining, Agriculture, Fishing, Forestry, Hunting etc. When the agriculture sector contributes to a minimum of half of the National Income then it is called an “Agrarian economy”
2. Secondary Sector: Secondary sector is that sector in which the extracted raw materials from the primary sector are processed into finished goods. It is also called the industry sector. When the secondary sector contributes to a minimum of half of the National Income then it is called an “Industrial Economy”
3. Tertiary Sector: Tertiary sector is also called the service sector where the provision of services takes place like Healthcare, Tourism, Education, Information Technology (IT), Real-estate, Banking, Transportation, Telecommunication, Franchising, Legal services, Consultation etc. When the service sector contributes to a minimum of half of the National income it is called a Service economy.

Question 49

What are the key differences between a Market Economy and a Non -Market or Planned economy?

Answer 49

Ans:
1) Ownership:
Market Economy- The factors of production in a Market economy is owned by private individuals, firms and corporations
Non-Market Economy- In a Non-market Economy factors of production is majorly owned by the government

2) Competition:
Market Economy- The market economy has competition because of a large number of private individuals and firms operating in the market
Non-Market Economy- Due to the absence of a Market in a Non-Market economy, there is no competition

3) Production & Distribution:
Market Economy- In a market economy, production and distribution is controlled by the demand and supply factors of the market
Non-Market Economy- In a Non-Market or planned economy, the Production and Distribution of goods and services are decided by the government

4) Property Rights:
Market Economy- There are property rights given to individuals
Non-Market Economy- No property rights are given to the individuals in a planned economy because of the belief that it causes exploitation of labours

5) Wealth & Capital:
Market Economy- Market Economy focuses on the creation of wealth & Capital
Non-Market Economy- There is no idea of creating capital or wealth in a planned economy

Question 50

What are the Factors of Production?

Answer 50

Ans:
Factors of production are the resources or inputs that are used in the production process to produce goods and services. The 4 primary factors of production are Land, Labour, Capital and Entrepreneur.

The primary factors of production are those factors that do not transform by the production process like land, labour, capital while secondary factors of production are transformed into finished goods like raw materials and energy.

Question 51

What is a Financial Crisis and what were the Causes of the 2007-08 Global Financial Crisis?

What was the impact of Global Financial Crisis on India and What was India’s response?

Answer 51

Financial Crisis is a situation where there is a decrease in the value of financial assets due to a disruption in the financial market such as a currency crisis, stock exchange crisis and banking crisis. Financial Crisis leads to:

• Decline in the Economic growth of a country
• Loss of confidence in the financial system
• Unemployment
• Poverty and Hunger
• Inequality

Causes of Global Financial Crisis

Sub-Prime Lending
Sub-prime lending by financial institutes in the USA was the main cause of the 2007-08 Global financial crisis. Sub-prime mortgages were provided to low-income homebuyers. They were unable to lend back to banks and financial institutes when the interest rates of houses rose. Sub-prime mortgage buyers had poor creditworthiness which led to the collapse of the financial sector

Securitization
Another cause of the financial crisis was the securitization of Sub-prime mortgages. Homebuyers were provided mortgages in the form of securities by lenders which also led to default of credit by investors due to poor creditworthiness. Complex financial instruments were also used such as Credit Default Swaps (CDS) and other derivatives which further increased the risk of default.

Regulatory Failures
The government and the Financial regulatory authorities implemented poor regulations on lending and there was inadequate supervision of banks and financial institutions. This encouraged more sub-prime lending for homebuyers and resulted in more mortgage defaults.

Excessive Leverage Excessive Leverage
Banks and financial institutes were highly leveraged due to high Sub-prime lending. This increased the risk exposure of banks and financial institutes which led to the financial crisis after the loans were defaulted.

Credit Rating Agencies
Poor judgement by the Credit Rating Agencies (CRA) also led to the financial crisis. CRAs gave high credit ratings to investors and some complex financial instruments which led to high exposure of banks.

Impact of the Global financial crisis on the Indian Economy
1- Capital Outflow- There was a great decrease in capital outflow in India due to the financial crisis. The increase in capital outflow was a result of the withdrawal of Foreign Institutional Investors (FII) from the Indian market and the withdrawal of foreign currency deposits which depreciated the value of Indian currency

2- Stock Market Crash- Following the withdrawal of Foreign Institutional Investors (FII), there was a great decline in the stock market of India. This was caused due to the reduction in the Foreign Portfolio Investments (FPI) from other countries which affected the prices of the stock market heavily

3- Money Market- The Financial Crisis prompted the Indian banks and financial institutes to tighten their liquidity position and increase short-term interest rates. Banks were hesitant to lend resulting in a slowdown in credit growth and a decline in investment.

4- Decline in GDP- Key sectors such as manufacturing, real estate and services were affected by the financial crisis. Due to the global financial crisis, there was an increase in global prices of commodities and a reduction in global demand. This resulted in the decline of the manufacturing sector in India and Real estate investors were finding it difficult to raise funds due to high-interest rates.

The Services sector which included IT, BPO and Tourism services was also impacted by the global financial crisis due to less demand in the global market. All this culminated to decline of India’s GDP (Gross Domestic Product) growth.

India’s Response to the Financial Crisis
The Indian Economy was not directly impacted by the Global Financial Crisis as the Indian Economy was not much exposed to the Sub-Prime mortgage market like other countries and India was not deeply integrated with the Global Financial system.

However, the Indian Economy was indirectly affected and India used a combination of Monetary and Fiscal policy measures to control the economic crisis and improve India’s GDP growth which was

Monetary Policy Measures
- RBI reduced the CRR (Cash Reserve Ratio) to 5% and Statutory Liquidity Ratio (SLR) to 24%. This resulted in more liquidity for banks to lend and further increased the money supply in the market

• RBI decreased the Policy Repo Rate to 4.75% and Reverse Repo Rate to 3.25%. This encouraged banks to borrow more money from the RBI and Deposit less money with the RBI respectively which further led to an increase in liquidity in the market.
• RBI provided a special refinance facility to banks up to 1% of their total deposit. This encouraged banks to borrow more money from the RBI and increase liquidity
• For increasing the Foreign Currency Reserve, Interest rates of non-domestic deposits were increased which encourage more foreign currency deposits. External Commercial borrowing restrictions were eased which encouraged companies to borrow more foreign currency and increase forex exchange.
• The Pre and Post-shipment rupee export credit limit was increased by 90 days each which gave more time to exporters to repay the credit, thus encouraging trade
• The Export Credit Refinance (ECR) limit of Scheduled Commercial Banks (SCB) was increased from 15% to 50% of their Outstanding export credit. This enabled banks to refinance capital for lending more to exporters
• RBI introduced a liquidity facility for NBCS (Non-Banking Financial Institutes) through a Special Purpose Vehicle (SPV) to infuse more liquidity into the market

Fiscal Policy Measures
The government announced three fiscal packages worth ₹80100 crores to boost economic growth. The first fiscal package focused on the direct increase in government expenditure. It had ₹20000 crores as additional expenditure, Central Excise duty was reduced to 4% and ₹2000 crores benefits for exporters.

The second fiscal package was focused on improving the supply of finance. It included a reduction in interest rates, liquidity enhancement to productive sectors, financial aid for the export sector, a boost for the infrastructure sector and easier access to External Commercial Borrowings (ECB).

The third fiscal package included a further tax cut of ₹29100 crores

Question 52

What is a Balance Sheet?

Answer 52

A Balance Sheet is a summary of all the financial statements of a company at a given point in time. It reflects the company’s overall financial health and helps investors to take investment decisions. A standard balance sheet of a company is divided into two parts, which include Assets on the left side and Liabilities and equity on the right side.

Assets- These include all the things that a company owns which have financial value. It includes current assets like inventory, cash, loans given for less than one year and Fixed assets like property or land, machinery, equipment, trade receivables etc
Liabilities- These include the amount owned by the company such as current liabilities like short-term borrowings, short-term provisions and trade payables and non-current liabilities like long-term borrowings, provisions, and deferred-tax liabilities.

Equity- It includes a portion of the company’s funding which is provided by the shareholders. This includes equity share capital of a company owned by the shareholders for providing finance to the company.

The Balance Sheet follows the basic accounting equation that Assets must be equal to Liabilities and Equity. This equation ensures that the company’s balance sheet should always be balanced and provide information about the financial health of the company. By analysing a company’s balance sheet, investors can gain insights into the company’s financial performance, liquidity and solvency.

Question 53

What is a Profit & Loss statement?

Answer 53

A Profit and Loss statement or Income Statement is a summary of the financial statements that shows the Revenues and Expenditure transactions of a company. It is used by the company, investors and analysts to measure the profitability and financial health of the company.

Features of a Profit and Loss Statement
1- Revenues: The income statement begins with total revenue or sales generated from the sales of goods and services. It includes income generated from both operating and non-operating sources
2- Cost of Goods Sold (COGS)- This includes the direct cost associated with producing or procurement of goods or services such as material cost, wages, machinery etc.
3- Gross Profit or Loss- This is calculated by subtracting Revenue from the Cost of Goods Sold (COGS). It gives the gross profit or loss generated from the core operation of a business and does not include non-operating revenues and expenses
5- Non-Operating Revenues and Expenses- This includes revenues and expenses that are not directly related to the core business operation. The non-operating revenue includes interests earned on investments, gain from the sale of assets, foreign exchange gain, rental income, dividend income, royalty income etc.

Non-operating expenses include loss on investment of shares, default on interest by the borrower, loss on foreign exchange, litigation expenses, loss on sale of assets etc.
6- Depreciation and Amortization- It includes the decrease in the value of assets due to wear and tear and expiry. A decrease in the value of tangible assets such as machinery, building, equipment etc is called depreciation and a decrease in the value of intangible assets like copyright, patents, trademarks and licenses is called Amortization.

At the bottom of the statement, the net income or net loss is calculated by subtracting the total revenue from the total expenses. A positive net income reflects that the company has generated profit while a negative net income indicates that the company has generated loss.

Question 54

What is a Cash Flow Statement?

Answer 54

The Cash Flow Statement is a financial statement that provides information about the inflow and outflow of cash from different activities of the company. It shows how the changes in a company’s Balance Sheet affect Cash and Cash equivalents. It is particularly used to measure the short-term viability of a company to pay for its expenses.

A company can report a profit on its Income Statement but still may have insufficient cash to operate. Thus, the Cash Flow Statement is an important financial statement to measure the short-term viability of a company.

Components of Cash Flow Statement
1- Operating Activities: It includes the flow of cash from the day-to-day core operations of the business. The cash inflow in operating activities includes cash received from the sales of goods and services. Cash outflow includes payments given to suppliers for raw materials, salaries to employees and taxes paid to the government

2- Investment Activities- These include the flow of cash from the procurement and disbursement of long-term assets or Fixed Assets. Cash Inflow includes the sale of assets, interest received from dividends and other investments and recovery of loans. Cash Outflow includes the purchase of assets, disbursement of loans etc.

3- Financing Activities- These include the flow of cash due to the raising or disbursement of money from the lenders and shareholders. The Cash inflow includes raising money by issuing equity such as shares and bonds. Cash Outflow includes interest payment on various forms of borrowing such as debt repayment, dividend payment and Share repurchasing.

At the bottom of the Cash Flow Statement, the Net Cash flow is calculated by calculating the difference between the total cash inflow and total cash outflow from all three activities. A positive Net Cash Flow indicates that the company’s cash is increased while a negative Net Cash Flow indicates that the company’s cash is decreased.

Question 55

What are Financial Ratios, explain Turnover Ratio?

Answer 55

Financial ratio is the analysis of two different numerical values taken from a financial statement of a company such as the Balance Sheet, Income Statement or Cash Flow statement. Financial ratios are used to assess different aspects of the company such as profitability, solvency, Liquidity and efficiency. The different types of financial ratios are

Turnover ratio, also known as the Activity Ratio, Efficiency Ratio or Asset Management Ratio is the financial ratio that assesses the efficiency of a company in utilising its Assets or Resources to generate sales or revenue. It helps in evaluating how effective is a company’s operation or productivity. The types of Turnover Ratios are:

1- Inventory Turnover Ratio- It measures the effectiveness of a company in managing its inventory. It evaluates how fast the company is selling or replacing its inventory. The formula for calculating the Inventory Turnover Ratio is “Cost of Goods Sold/Average Inventory”. A high inventory turnover indicates that the company is quickly selling its inventories

2- Accounts Receivable Turnover Ratio- It assesses how effective a company is in collecting its debts and extending credit for its business operations. It also indicates the effectiveness of a company’s credit and collection policies. The formula for calculating Accounts Receivable Turnover Ratio is “Net Credit Sales/Average Accounts Receivables”. A high Accounts Receivable Turnover ratio indicates that the company is collecting its payments from customers frequently.

3- Assets Turnover Ratio- It measures how effectively a company is utilising its assets to generate sales or revenue. The formula for calculating the Assets Turnover Ratio is “Net Sales/Average Total Assets”

4- Fixed Assets Turnover Ratio- It measures how effective a company is in generating sales or revenue from its Fixed assets or long-term assets such as plant & machinery, equipment, property etc. The formula for calculating the Fixed Assets Turnover Ratio is “Net Sales/Average Fixed Assets”.

Question 56

What is a Profitability Ratio?

Answer 56

The Profitability Ratio assesses a company’s ability to generate profit and Rate of Return. Profit Margin ratios show the relationship between the company’s revenue and profit while the Rate of return ratios shows the relationship between investments and profit. The types of Profitability ratios are

1- Gross Profit Margin Ratio- It measures the ability of a company to generate profit from its core business operations. It is measured by deducting the Cost of Goods Sold (COGS) from the Revenue. The formula for calculating the Gross Profit Margin Ratio is “Revenue- COGS/ Revenue”

2- Net Profit Margin Ratio- It measures the overall ability of a company to generate profit after excluding COGS, Expenses, Interest, Taxes and other Costs. It is calculated by “Net Income/Revenue”

3- Return on Assets (ROA)- It measures the ability of a company’s assets to generate profit. It evaluates the profitability of the company’s assets. The formula for calculating ROA is “Net Income/Average Total Assets”

4- Return on Equity (ROE)- It measures the ability of a company to utilize its shareholder’s Equity to generate profit. It evaluates the quality of equity investments made by the company. The formula for the Return on Equity (ROE) is “Net Income/Average Shareholder’s Equity”.

5- Return on Investment (ROI)- It measures the overall investment profitability of the company. It includes both debt and equity investments. The formula for finding the ROI is “Net Profit/Cost on Investment”

Question 57

What is a Liquidity Ratio?

Answer 57

Liquidity ratio assesses the ability of a company to meet its short-term financial obligations like its ability to generate cash and meet its immediate financial obligations. The three main types of Liquidity ratios are

1- Current Ratio- It measures the company’s ability to meet its short-term financial viability by using current assets. The formula for calculating Current Ratio is Current assets/Current Liabilities.

2- Acid-Test Ratio- The Acid-Test ratio or Quick asset ratio is a more stringent way than the Current Ratio to measure the short-term financial viability of a company. It takes the most liquid current assets and excludes inventory which is considered to be the least liquid component of Current Assets. The formula for calculating the Acid-Test ratio is Current Assets- Inventory/Current Liabilities.

3- Cash Ratio- It is the most stringent method to measure the short-term financial viability of a company as it takes only cash and cash equivalents. Cash and Cash equivalents such as cash-in-hand, bank balance, and securities like treasury bills, commercial papers etc are taken. The formula for calculating the Cash Ratio is Cash and Cash Equivalents/ Current Liabilities.

Question 58

What is a Leverage Ratio?

Answer 58

The leverage ratio or Solvency Ratio is used to assess the extent of a company’s financing through debt and the extent of utilisation of its debt financing. It also measures the long-term financial obligation of a company such as its long-term ability to pay expenses. The types of Solvency ratios are

1- Debt-Equity Ratio- It compares a company’s debt financing with its Shareholder’s equity. It shows the proportion of the company’s financing that comes from creditors compared to shareholders. The formula for calculating the Debt-Equity ratio is “Total Debt/Shareholder’s Equity”. A higher Debt-Equity ratio indicates that there is a higher reliance on debt financing than Equity financing

2- Debt-Assets Ratio- It shows the proportion of a company’s Assets that are financed by Debt. The formula for the Debt-Assets ratio is “Total Debt/Total Assets”. A higher Debt-Assets ratio indicates that a higher proportion of a company’s Assets are financed by Debt.

3- Interest Coverage Ratio- It shows the ability of a company’s earnings to pay its interest expenses on outstanding debts. The formula for calculating Interest Coverage Ratio is “Earnings Before Interest and Tax/ Interest Expense”. A higher Interest coverage ratio indicates that the company has sufficient earnings to pay its interest expenses.

4- Debt Service Coverage Ratio (DSCR)- The Debt Service Coverage Ratio (DSCR) shows a company’s ability to meet its Debt-service obligations. Debt Service obligations include a combination of principal and interest payments that are required to be paid. The formula for calculating the DSCR is “Operating Income/Total Debt Service”

Question 59

Explain Debtor Days and Creditor Days ratios?

Answer 59

Debtor Days Ratio- is the average number of days a company takes to collect payment from its debtors. It shows the effectiveness of the debt-collection policy of the company. The formula for calculating Debtor Days is “Average Accounts Receivable / Credit Sales * Number of Days”. A low Debtor days ratio shows that the company is collecting its payments quickly from debtors while a high debtor days ratio shows that the company is taking more time in collecting debt.

Creditor Days Ratio- is the average number of days the company takes to give payment to its creditors or suppliers. It reflects the creditworthiness of the company. The Creditor days ratio is calculated by “Average Accounts Payable / Cost of Sales * Number of Days”. An excessive Creditor Days ratio reflects the bad creditworthiness of the company but a High creditworthiness also reflects that the company has more cash flow for utilization for its management.

Question 60

What are NIDHI companies?

Answer 60

A NIDHI is a type of Non-banking Financial Company (NBFC) that borrows and lends money to its members and works on the principle of mutual benefit. NIDHI companies do not require a licence from the RBI and are registered under Section 406 of the Companies Act, 2013. Nidhi companies are popular in South India. The features of NIDHI company are:
- ¬Should have a Minimum of 200 members
- Minimum paid-up equity share capital should be ₹10 lakhs and Net Owned Funds should be ₹20 lakhs
- NIDHI companies cannot deal with Chit-funds, hire-purchase finance, leasing finance, insurance or security business
- NIDHI companies are regulated by the Ministry of Corporate Affairs (MoCA)