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FINANCIAL MARKETS AND SERVICES(F){5TH SEM}

UNIT-4 NON FUND FINANCING SERVICES:

CONCEPT OF CREDIT RATING

 Credit rating is an analysis of the credit risks associated with a financial instrument or a
financial entity. It is a rating given to a particular entity based on the credentials and the
extent to which the financial statements of the entity are sound, in terms of borrowing
and lending that has been done in the past.

 Usually, is in the form of a detailed report based on the financial history of borrowing or
lending and credit worthiness of the entity or the person obtained from the statements
of its assets and liabilities with an aim to determine their ability to meet the debt
obligations.
 It helps in assessment of the solvency of the particular entity. These ratings based on
detailed analysis are published by various credit rating agencies like Standard & Poor's,
Moody's Investors Service, and ICRA.

ADVANTAGES OF CREDIT RATING

Benefits to Investors
(1) Safeguards against bankruptcy:
Credit rating of an instrument done by credit rating agency gives an idea to the investors about
degree of financial strength of the issuer company which enables him to decide about the
investment. Highly rated instrument of a company gives an assurance to the investors of safety
of instrument and minimum risk of bankruptcy.
(2) Recognition of risk:
Credit rating provides investors with rating symbols which carry information in easily
recognisable manner for the benefit of investors to perceive risk involved in investment.
It becomes easier for the investors by looking at the symbol to understand the worth of the
issuer company because the instrument is backed by the financial strength of the company
which in detail cannot be provided at the minimum cost to each and every one and at the same
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time they cannot also analyse or understand such information for taking any investment
decisions..
(3) Credibility of issuer:
Rating gives a clue to the credibility of the issuer company. The rating agency is quite
independent of the issuer company and has no “Business connections or otherwise any
relationship with it or its Board of Directors, etc. Absence of business links between the rater
and the rated firm establishes ground for credibility and attract investors.
(4) Easy understandability of investment proposal:
Rating symbol can be understood by an investor which needs no analytical knowledge on his
part. Investor can take quick decisions about the investment to be made in any particular rated
security of a company.
(5) Saving of resources:
Investors rely upon credit rating. This relieves investors from the botheration of knowing about
the fundamentals of a company, its actual strength, financial standing, management details,
etc. The quality of credit rating done by professional experts of the credit rating agency reposes
confidence in him to rely upon the rating for taking investment decisions.
(6) Independence of investment decisions:
For making investment decisions, investors have to seek advice of financial intermediaries, the
stock brokers, merchant bankers, the portfolio managers etc. about the good investment
proposal, but for rated instruments, investors need not depend upon the advice of these
financial intermediaries as the rating symbol assigned to a particular instrument suggests the
credit worthiness of the instrument and indicates the degree of risk involved in it.
(7) Choice of investments:
Several alternative credit rating instruments are available at a particular point of time for
making investment in the capital market and the investors can make choice depending upon
their own risk profile and diversification plan.
In addition to above, investors have other advantages like: Quick understanding of the credit
instruments and weigh the ratings with advantages from instruments; quick decision making for
investment and also selling or buying securities to take advantages of market conditions; or,
perceiving of default risk by the company.
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Benefits of to a Company
(1)Lower cost of borrowing:A company with highly rated instrumet has the opportunity to
reduce the cost of borrowing from the public by quoting lesser interest on fixed deposits or
debentures or bonds as the investors with low risk preference would come forward to invest in
safe securities though yielding marginally lower rate of return.

(2) Wider audience for borrowing:A company with a highly rated instrument can approach the
investors extensively for the resource mobilisation using the press media. Investors in different
strata of the society could be attracted by higher rated instrument as the investors understands
the degree of certainty about timely payment of interest and principal on a debt instrument
with better rating.

(3) Rating as marketing tool:Companies with rated instrument improve their own image and
avail of the rating as a marketing tool to create better image in dealing with its customers feel
confident in the utility products manufactured by the companies carrying higher rating for their
credit instruments.

(4) Reduction of cost in public issues:A company with higher rated instrument is able to attract
the investors and with least efforts can raisefunds. Thus, the rated company can economise and
minimise cost of public issues by controlling expenses on media coverage, conferences and
other publicity stunts and gimmicks. Rating facilitates best pricing and timing of issues.

(5) Motivation for growth:Rating provides motivation to the company for growth as the
promotors feel confident in their own efforts and are encouraged to undertake expansion of
their operations or new projects.With better image created though higher credit rating the
company can mobilise funds from public and instructions or banks from self assessment of its
own status which is subject to self-discipline and self-improvement, it can perceive and avoid
sickness.
(6) Unknown issuer:Credit rating provides recognition to a relatively unknown issuer while
entering into the market through wider investor base who rely on rating grade rather than on
‘name recognition’
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7) Benefits to brokers and financial intermediaries:Highly rated instruments put the brokers at
an advantage to make less efforts in studying the company’s credit position to convince their
clients to select an investment proposal.This enables brokers and other financial intermediaries
to save time, energy, costs and manpower in convincing their clients about investment in any
particular instrument.

DIFFERENT KINDS OF CREDIT RATING ARE LISTED BELOW:

(1) Bond/debenture rating: Rating the debentures/ bonds issued by corporate, government
etc. is called debenture or bond rating.

(2) Equity rating: Rating of equity shares issued by a company is called equity rating.

(3) Preference share rating: Rating of preference share issued by a company is called
preference share rating.

(4) Commercial paper rating: Commercial papers are instruments used for short term
borrowing. Commercial papers issued by manufacturing companies, finance companies, banks
and financial institutions and rating of these instruments are called commercial paper rating.

5) Fixed deposits rating: Fixed deposits programmes are medium term unsecured borrowings.
Rating of such programmes is called as fixed deposits rating

6) Sovereign rating: Is a rating of a country which is being considered whenever a loan is to be

extended or some major investment is envisaged in a country.

CREDIT RATING PROCESS

A detailed flow chart of CRISIL's rating process for credit rating assignments is as below:

A detailed flow chart of CRISIL's rating process for credit rating assignments is as below:
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CRISIL Rating Process Chart

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FACTORING CONCEPTS
 Factoring is defined as “an outright purchase of credit approved accounts receivables,
with the factor assuming bad debt losses.

 The modern factoring involves a continuing arrangement under which a financing

institution assumes the credit control/protection and collection functions for its client,
purchases his receivables as they arise (with or without recourse to him for credit losses,
i.e., customer’s financial inability to pay), maintains the sales ledger, attends to other
book-keeping duties relates to such accounts receivables and performs other auxiliary
functions.

 Factoring is an asset based method of financing as well as specialized service being the
purchase of book debts of a company by the factor, thus realizing the capital tied up in
accounts receivables and providing financial accommodation to the company.

 The book debts are assigned to the factor who collects them when due for which he
charges an amount as discount or rebate deducted from the bills. Thus, the factor is an
intermediary between the supplier and customers who performs financing and debt
collection services.

 Factoring can be both domestic and for exports. In domestic factoring, the client sells
goods and services to the customer and delivers the invoices, order documents, etc. to
the factor and inform the customer of the same.

 In return, the factor makes a cash advance and a statement to the client. The factor
then sends a copy of all the statements of accounts, remittances, receipts, etc. to the
customer, on receiving them, the customer sends the payment to the factor.

 In case of export factoring two ‘factors’ are involved. The factor in the customer’s
country is called “Import Factor” while the one in the client’s country is called the
“Export Factor”.

 All the transactions remain similar in the case of international factoring, the only
difference being that the export factor has to send the shipping documents to the
import factor and the import factor has to pass on the ultimate collection to the export
factor.

Features of Factoring:

(i) Credit Cover: The factor takes over the risk burden of the client and thereby the client’s
credit is covered through advances.
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(ii) Case advances: The factor makes cash advances to the client within 24 hours of receiving
the documents.

(iii) Sales ledgering: As many documents are exchanged, all details pertaining to the transaction
are automatically computerized and stored.

(iv) Collection Service:The factor, buys the receivables from the client, they become the factor’s
debts and the collection of cheques and other follow-up procedures are done by the factor in
its own interest.

(v) Provide Valuable advice:The factors also provide valuable advice on country-wise and
customer-wise risks. This is because the factor is in a position to know the companies of its
country better than the exporter clients.

TYPES OF FACTORING:

The types of factoring are discussed below:

(i) Recourse Factoring

(ii) Non-Recourse Factoring

(iii) Advance Factoring

(iv) Confidential and Undisclosed Factoring

(v) Maturity Factoring.

(vi) Supplier Guarantee Factoring

(vii) Bank Participation Factoring

The detail about the Types of Factoring is as follows:

(i) In Recourse factoring the credit risk remains with the client though the debt is assigned to
the factor, i.e., the factor can have recourse to the client in the event of non-payment by the
customer.

(ii) The Non-Recourse Factoring also called as ‘Old-line factoring’. It is an arrangement whereby
he factor has no recourse to the client when the bill remains unpaid by the customer. Thus, the
risk of bad debt is absorbed by the factor.
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(iii) Where the payment is made by the factor immediately is called Advance Factoring Under
this type of factoring, the factor provides financial accommodation apart from non-financial
services rendered by him.

(IV) In confidential and undisclosed factoring the arrangement between the factor and the
client are left un-notified to the customers and the client collects the bills from the customers
without intimating them to the factoring arrangements.

(v) In maturity factoring method, the factor may agree to pay an amount to the client for the
bills purchased by him either immediately or on maturity. The later refers to a date agreed
upon on which the factor pays the client.

(vi) Supplier Guarantee Factoring is also known as ‘drop shipment factoring’. This happens
when the client is a mediator between supplier and customer. When the client is a distributor,
the factor guarantees the supplier against the invoices raised by the supplier upon the client
and the goods may be delivered to the customer. The client thereafter raises bills on the
customer and assigns them to the factor. The factor thus enables the client to make a gross
profit with no financial involvement at all.

(vii) In bank participation factoring the bank takes a floating charge on the client’s equity i.e.,
the amount payable by the factor to the client in .respect of his receivables. On this basis, the
bank lends to the client and enables him to have double financing.

FUNCTIONS OF FACTORING
1) MAINTENANCE OF SALES LEDGER
A factor is responsible for maintaining the sales ledger of the client. So all the sales transactions
of the client are taken care of by the factor.

2) FINANCING
The factor finances the client by purchasing all the account receivables.

3) CREDIT PROTECTION
In the case of non-recourse factoring, the risk of non-payment or bad debts is on the factor.

4) COLLECTION OF MONEY
The factor performs the duty of collecting funds from the client’s debtors. This enables the
client to focus on core areas of business instead of putting energies in the collection of money.

MERCHANT BANKING:

A merchant bank is historically a bank dealing in commercial loans and investment. In modern
British usage it is the same as an investment bank. Merchant banks were the first modern banks
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and evolved from medieval merchants who traded in commodities, particularly cloth
merchants. Historically, merchant banks' purpose was to facilitate and/or finance production
and trade of commodities, hence the name "merchant". Few banks today restrict their activities
to such a narrow scope.

In modern usage in the United States, the term additionally has taken on a more narrow
meaning, and refers to a financial institution providing capital to companies in the form of share
ownership instead of loans. A merchant bank also provides advisory on corporate matters to
the firms in which they invest.

Merchant Banking is a combination of Banking and consultancy services. It provides consultancy

to its clients for financial, marketing, managerial and legal matters. Consultancy means to
provide advice, guidance and service for a fee. It helps a businessman to start a business. It
helps to raise (collect) finance. It helps to expand and modernize the business. It helps in
restructuring of a business. It helps to revive sick business units. It also helps companies to
register, buy and sell shares at the stock exchange.

Functions of Merchant Banking Organization

1. Raising Finance for Clients : Merchant Banking helps its clients to raise finance through
issue of shares, debentures, bank loans, etc. It helps its clients to raise finance from the
domestic and international market. This finance is used for starting a new business or project
or for modernization or expansion of the business.

2. Broker in Stock Exchange : Merchant bankers act as brokers in the stock exchange. They
buy and sell shares on behalf of their clients. They conduct research on equity shares. They
also advise their clients about which shares to buy, when to buy, how much to buy and when
to sell. Large brokers, Mutual Funds, Venture capitalcompanies and Investment Banks offer
merchant banking services.

3. Project  Management  : Merchant bankers help their clients in the many ways. For e.g.
Advising about location of a project, preparing a project report, conducting feasibility
studies, making a plan for financing the project, finding out sources of finance, advising
about concessions and incentives from the government.

4. Advice on Expansion and Modernization : Merchant bankers give advice for expansion and
modernization of the business units. They give expert advice on mergers and amalgamations,
acquisition and takeovers, diversification of business, foreign collaborations and joint-
ventures, technology up-gradation, etc.

5. Managing Public Issue of Companies : Merchant bank advice and manage the public issue
of companies. They provide following services:Advise on the timing of the public
issue.Advise on the size and price of the issue.Acting as manager to the issue, and helping in
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accepting applications and allotment of securities.Help in appointing underwriters and

brokers to the issue.Listing of shares on the stock exchange, etc.

6. Handling Government Consent for Industrial Projects : A businessman has to get

government permission for starting of the project. Similarly, a company requires permission
for expansion or modernization activities. For this, many formalities have to be completed.
Merchant banks do all this work for their clients.

7. Special Assistance to Small Companies and Entrepreneurs : Merchant banks advise small
companies about business opportunities, government policies, incentives and concessions
available. It also helps them to take advantage of these opportunities, concessions, etc.

8. Services to Public Sector Units : Merchant banks offer many services to public sector units
and public utilities. They help in raising long-term capital, marketing of securities, foreign
collaborations and arranging long-term finance from termlending institutions.

9. Revival of Sick Industrial Units : Merchant banks help to revive (cure) sick industrial units.
It negotiates with different agencies like banks, term lending institutions, and BIFR (Board
for Industrial and Financial Reconstruction). It also plans and executes the full revival
package.

10. Portfolio Management : A merchant bank manages the portfolios (investments) of its clients.
This makes investments safe, liquid and profitable for the client. It offers expert guidance to
its clients for taking investment decisions.

11. Corporate Restructuring : It includes mergers or acquisitions of existing business units, sale
of existing unit or disinvestment. This requires proper negotiations, preparation of documents
and completion of legal formalities. Merchant bankers offer all these services to their clients.

12. Money Market Operation : Merchant bankers deal with and underwrite short-termmoney
market instruments, such as:Government Bonds.Certificate of deposit issued by banks and
financial institutions.Commercial paper issued by large corporate firms.Treasury bills issued
by the Government (Here in India by RBI).
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