Tag: Stock Valuation

Management Notes

Price to Cash Flow Ratio, Importance, Components, Formula, Advantages, Limitations

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The Price to Cash Flow (P/CF) Ratio is a financial valuation ratio used to compare a company’s market price with the cash flow generated by its operations. It helps investors assess whether a company’s shares are reasonably valued based on its ability to generate cash. Unlike the Price to Earnings Ratio, which uses accounting profit, the P/CF Ratio focuses on cash generation and may provide a different view of financial performance. A lower ratio may indicate that the shares are relatively inexpensive compared with operating cash flow, while a higher ratio may indicate higher market expectations. It is commonly used alongside other valuation ratios for investment analysis.

Importance of Price to Cash Flow Ratio:

1. Measures Market Valuation

The Price to Cash Flow Ratio helps investors assess how the market values a company’s shares in relation to the cash generated from its operations. It compares the market price of the company’s equity with its operating cash flow per share. A lower P/CF ratio may indicate that the shares are relatively less expensive compared with their cash generation, while a higher ratio may reflect stronger market expectations. Therefore, the ratio provides a useful valuation indicator. However, it should be interpreted along with profitability, growth prospects, financial risk and other valuation measures.

2. Focuses on Cash Generation

The P/CF Ratio focuses on cash generated from operating activities rather than accounting profit. This makes it useful when accounting earnings are affected by non cash expenses such as depreciation and amortisation. A company may report lower accounting profit while generating strong operating cash flow. By focusing on cash generation, the ratio can provide additional information about the company’s ability to generate funds through its normal business operations. Therefore, P/CF complements profit based valuation ratios and helps investors develop a broader understanding of the company’s financial performance and market valuation.

3. Useful for Company Comparison

The Price to Cash Flow Ratio can be used to compare the valuation of companies operating in the same industry. Investors can examine whether companies with similar business characteristics have significantly different market valuations relative to their operating cash flows. A lower ratio may indicate a comparatively lower market valuation, while a higher ratio may suggest greater investor expectations. However, differences in growth, risk, capital requirements and business models should be considered before making conclusions. Therefore, P/CF provides a useful starting point for relative valuation and comparison among companies.

4. Reduces Impact of Accounting Policies

The P/CF Ratio can reduce the influence of certain accounting choices on valuation analysis because operating cash flow is less directly affected by some non cash accounting expenses. Items such as depreciation and amortisation reduce accounting profit but do not involve current cash outflows. Consequently, companies with different depreciation policies or asset structures may report different profits while generating similar operating cash flows. P/CF can therefore provide an additional perspective when comparing such businesses. However, operating cash flow can also be affected by working capital movements and other factors, so the ratio should not be used independently.

5. Helps Identify Potentially Undervalued Shares

Investors may use the P/CF Ratio as one tool for identifying shares that appear relatively inexpensive compared with the company’s operating cash generation. A lower P/CF ratio may attract attention when the company’s cash flows are stable and sustainable. However, a low ratio does not automatically mean that a share is undervalued. Weak future growth, high debt, declining operations or temporary cash flow improvements may explain a low valuation. Therefore, investors should examine the reasons behind the ratio and compare it with industry averages, historical levels and other financial indicators before making investment decisions.

6. Useful for Cash Flow Based Analysis

The P/CF Ratio supports cash flow based financial analysis by connecting the market value of equity with operating cash generation. Investors can use the ratio to understand how much the market is willing to pay for each unit of operating cash flow generated by the company. This provides a different perspective from ratios based on sales or accounting earnings. Analysing P/CF over several years can also reveal changes in market valuation relative to cash generation. Thus, the ratio is useful for understanding the relationship between a company’s operating cash performance and its share price.

7. Supports Investment Decisions

The P/CF Ratio provides useful information for investors when evaluating potential investments. By comparing the ratio with industry peers, historical levels and other valuation measures, investors can assess whether the current market price appears reasonable relative to operating cash generation. It can be particularly useful for companies where accounting earnings fluctuate but operating cash flows remain relatively stable. However, investment decisions should also consider growth prospects, debt levels, profitability, business risks and future cash flows. Therefore, P/CF is best used as part of a broader financial analysis rather than as a standalone investment measure.

8. Useful When Earnings Are Low

The P/CF Ratio can be useful when a company reports low or volatile accounting earnings. A company may have reduced net profit because of high depreciation, amortisation or other non cash expenses while still generating substantial operating cash flow. In such situations, a traditional Price to Earnings Ratio may provide limited valuation insight or may become difficult to interpret when earnings are negative. P/CF can provide an alternative perspective by focusing on operating cash generation. Therefore, the ratio can be particularly useful for analysing asset intensive or temporarily low profit businesses.

Components of Price to Cash Flow Ratio:

1. Market Price per Share

Market Price per Share represents the current price at which a company’s equity share is traded in the stock market. It is the numerator of the Price to Cash Flow Ratio. The market price reflects investors’ expectations regarding the company’s future profitability, growth, risk and cash generation. A change in the share price directly changes the P/CF ratio when operating cash flow remains constant. A higher market price generally results in a higher P/CF ratio, while a lower market price reduces the ratio. Therefore, market price is an important component of the company’s market based valuation.

2. Operating Cash Flow per Share

Operating Cash Flow per Share represents the operating cash generated by the company for each outstanding equity share. It is generally used as the denominator of the Price to Cash Flow Ratio. It shows how much cash from normal business operations is attributable to each share based on the selected calculation method. Higher operating cash flow per share generally results in a lower P/CF ratio when the market price remains unchanged. Therefore, this component connects the company’s operating cash generation with its market valuation and helps investors evaluate the price paid for each unit of operating cash flow.

Formula:

Operating Cash Flow per Share = Operating Cash Flow ÷ Number of Outstanding Shares

3. Operating Cash Flow

Operating Cash Flow represents the cash generated or used through the company’s normal business activities. It includes cash flows related to customers, suppliers, employees and other operating activities. For the P/CF Ratio, operating cash flow is important because it provides the underlying cash generation figure used to calculate cash flow per share. A company with strong and sustainable operating cash flow generally has a stronger denominator, which can result in a lower P/CF ratio at the same market price. Therefore, the quality and sustainability of operating cash flow are important when interpreting the ratio.

4. Number of Outstanding Shares

The number of outstanding shares represents the equity shares currently held by shareholders and is used to calculate operating cash flow per share. Operating cash flow is divided by the number of outstanding shares to determine the cash flow attributable to each share. Changes in the number of shares due to new share issues, buybacks, mergers or other corporate actions can therefore affect operating cash flow per share and consequently the P/CF ratio. A consistent and appropriate share count is important for meaningful comparison. Thus, the number of outstanding shares connects total operating cash generation with individual shareholder ownership.

Formula:

OCF per Share = Total Operating Cash Flow ÷ Outstanding Shares

5. Price to Cash Flow Ratio

The Price to Cash Flow Ratio combines market price per share and operating cash flow per share to measure the market valuation relative to operating cash generation. It indicates how much investors are paying for each unit of operating cash flow generated per share. A higher ratio generally indicates a higher market valuation relative to cash flow, while a lower ratio indicates a lower valuation. However, interpretation depends on industry characteristics, growth expectations and financial risk. Therefore, the P/CF ratio should be compared with historical values and industry peers for meaningful analysis.

Formula:

P/CF Ratio = Market Price per Share ÷ Operating Cash Flow per Share

Formula and Calculation of Price to Cash Flow Ratio:

1. Basic Formula

The Price to Cash Flow Ratio measures the relationship between a company’s market price per share and its operating cash flow per share. It shows how much investors are willing to pay for each rupee of operating cash flow generated per share. The ratio is calculated by dividing the current market price of one share by operating cash flow per share.

Formula:

P/CF Ratio = Market Price per Share ÷ Operating Cash Flow per Share

Operating Cash Flow per Share = Operating Cash Flow ÷ Number of Outstanding Shares

A lower ratio may indicate relatively lower valuation, while a higher ratio may indicate higher market expectations.

2. Calculation Example

Suppose a company has total operating cash flow of ₹20,00,000 and 1,00,000 outstanding shares. The current market price of each share is ₹240.

First, calculate operating cash flow per share:

OCF per Share = ₹20,00,000 ÷ 1,00,000

OCF per Share = ₹20

Now calculate the Price to Cash Flow Ratio:

P/CF = ₹240 ÷ ₹20

P/CF = 12 times

Therefore, the company’s Price to Cash Flow Ratio is 12 times. This means investors are paying ₹12 in market value for every ₹1 of operating cash flow generated per share.

Advantages of Price to Cash Flow Ratio:

1. Reduces Impact of Accounting Manipulation

The Price to Cash Flow ratio is less susceptible to accounting distortions and earnings manipulation compared to price-to-earnings ratios, since cash flow figures are harder to manipulate through non-cash accounting choices such as depreciation methods, provisions, or revenue recognition policies. Net income can be significantly influenced by management’s discretionary accounting decisions, whereas cash flow reflects actual cash movements within the business. This makes the ratio a more reliable indicator of a firm’s true financial performance and valuation, particularly useful for investors seeking to avoid companies that may be presenting an inflated or misleading picture of profitability through aggressive accounting practices.

2. Useful for Firms with Negative Earnings

The Price to Cash Flow ratio remains a meaningful valuation tool even for firms reporting negative net income, a scenario where the price-to-earnings ratio becomes inapplicable or meaningless. Companies experiencing temporary losses due to heavy depreciation, restructuring charges, or one-time write-offs may still generate positive operating cash flow, making this ratio a more practical measure of relative valuation. This advantage is particularly valuable when analyzing capital-intensive industries or firms in early growth stages where accounting losses are common despite healthy underlying cash generation, allowing analysts to continue comparing valuation across companies within a sector regardless of reported profitability.

3. Better Reflects Liquidity and Solvency Position

Since cash flow directly captures a firm’s ability to generate liquid resources, the Price to Cash Flow ratio provides better insight into a company’s capacity to meet short-term obligations, service debt, and fund operations without relying on external financing. Earnings-based metrics may not accurately reflect actual liquidity, as profits can exist on paper without corresponding cash availability due to timing differences in revenue and expense recognition. Investors and analysts use this ratio to gauge whether a firm’s market valuation aligns with its genuine cash-generating strength, offering a more grounded perspective on financial health beyond accrual-based profitability measures.

4. Facilitates Cross-Company and Cross-Industry Comparisons

The Price to Cash Flow ratio allows for more consistent comparisons across companies and industries, particularly those with differing depreciation policies, capital structures, or accounting treatments that can distort earnings-based ratios. Since cash flow calculations are less affected by variations in non-cash accounting choices, this ratio provides a more standardized basis for evaluating relative valuation across firms operating in different regulatory or accounting environments. This advantage is especially useful for global investors comparing companies across countries with varying accounting standards, as cash flow metrics tend to be more comparable and less influenced by jurisdiction-specific accounting rules or reporting practices.

5. Indicates Real Value Creation Potential

Cash flow is often regarded as a more accurate representation of a firm’s true value-creation capacity, since it reflects actual funds available for reinvestment, debt repayment, or shareholder distribution rather than paper profits. The Price to Cash Flow ratio, therefore, helps investors assess whether a stock’s market price is justified by its genuine cash-generating ability, offering a more conservative and realistic valuation perspective. This is particularly important for long-term investors focused on sustainable business performance rather than short-term earnings fluctuations, as strong and consistent cash flow generation is often a better predictor of long-term shareholder value creation.

Limitations of Price to Cash Flow Ratio:

1. Ignores Capital Expenditure Requirements

The Price to Cash Flow ratio, particularly when based on operating cash flow, does not account for capital expenditures necessary to maintain or grow the business, potentially presenting an overly optimistic view of a firm’s financial position. A company may show strong operating cash flow while simultaneously requiring substantial reinvestment in fixed assets, reducing the cash actually available for shareholders or debt repayment. This limitation can be particularly misleading in capital-intensive industries where ongoing asset replacement or expansion is essential for sustained operations. Analysts must therefore supplement this ratio with free cash flow analysis to get a more complete picture of a firm’s true financial flexibility and valuation.

2. Susceptible to Working Capital Timing Distortions

Operating cash flow, and consequently the Price to Cash Flow ratio, can be significantly influenced by temporary changes in working capital items such as receivables, payables, and inventory, which may not reflect the firm’s sustainable, ongoing cash-generating ability. A company might report an unusually high cash flow in a given period due to one-time working capital adjustments, such as delayed supplier payments or accelerated receivable collections, distorting the ratio’s usefulness for valuation purposes. This limitation requires analysts to examine multiple periods and understand the underlying drivers of cash flow changes rather than relying on a single period’s ratio in isolation.

3. Lacks Standardized Definition Across Analysts

Unlike earnings, which follow relatively standardized accounting definitions under applicable financial reporting frameworks, cash flow can be calculated using various methods, such as operating cash flow, free cash flow, or EBITDA-based approximations, leading to inconsistency in how the Price to Cash Flow ratio is computed and interpreted across different analysts or data sources. This lack of uniformity can create confusion when comparing ratios sourced from different platforms or reports, as the underlying cash flow figure used may differ substantially. Investors must carefully verify the specific cash flow definition applied before drawing conclusions or making cross-company comparisons based on this ratio.

4. Does Not Account for Debt and Financial Leverage

The Price to Cash Flow ratio primarily focuses on cash generation without directly incorporating the firm’s debt levels or financial leverage, potentially overlooking significant risks associated with highly leveraged companies. Two firms with similar cash flow figures may have vastly different risk profiles if one carries substantial debt obligations requiring significant interest and principal repayments, which are not reflected in this ratio. This limitation means investors relying solely on this metric might underestimate financial risk, necessitating supplementary analysis using leverage ratios, interest coverage ratios, or free cash flow after debt servicing to obtain a more comprehensive view of a firm’s financial health.

5. May Not Reflect Long-Term Sustainability

Cash flow figures used in this ratio typically reflect short-term, current period performance and may not adequately capture a firm’s long-term sustainability or future cash-generating potential, particularly in rapidly evolving industries. A company might show strong current cash flow due to temporary market conditions, one-time contracts, or cyclical upswings, which may not persist in subsequent periods, leading to potentially misleading valuation signals. This limitation underscores the importance of considering forward-looking cash flow projections, industry trends, and competitive positioning alongside historical Price to Cash Flow ratios when making long-term investment decisions rather than relying purely on trailing cash flow metrics.

Bangalore City University BBA Notes

Security Analysis & Investment Management Bangalore City University BBA SEP 2024-25 6th Semester Notes

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Management Notes

Determination of Liability in respect of Underwriting contract when fully Underwritten and Partially Underwritten with and without firm Underwriting

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Underwriting agreements in securities issuance can vary depending on the level of commitment made by the underwriter. The liability of underwriters in such contracts differs when the issue is fully underwritten versus partially underwritten, and further varies with or without firm underwriting.

Fully Underwritten Contract

In a fully underwritten contract, the underwriter or group of underwriters guarantees the entire issue. This means that regardless of how much of the issue is subscribed to by the public, the underwriter is liable to purchase the unsold portion of the securities at the agreed-upon issue price.

  • Liability of Underwriters: The underwriter assumes full liability, meaning they are legally bound to purchase any remaining shares that investors do not subscribe to. The underwriter’s risk is significant, as they are committed to taking on the entire offering if necessary. This type of underwriting provides a capital guarantee to the issuer, ensuring they will raise the full desired amount of funds.

  • Example: Suppose a company is issuing 1,000,000 shares, and the public subscribes to only 600,000. In a fully underwritten agreement, the underwriter would be responsible for purchasing the remaining 400,000 shares. If the shares are issued at a premium, the underwriter must pay the agreed price, regardless of how the market reacts.

Partially Underwritten Contract

In a partially underwritten contract, the underwriter agrees to guarantee only a portion of the securities being offered. The liability is therefore limited to the agreed-upon amount. The issuer may attempt to sell the remaining shares to the public or through other means, but if the public does not fully subscribe, the underwriter is only required to purchase their part of the issue.

  • Liability of Underwriters: Underwriters are only liable for their specific portion of the offering. This means that if, for example, the underwriter has agreed to purchase 60% of the shares and the public subscribes to 40%, the underwriter will be liable for the 60% they committed to, and the remaining 40% will need to be managed through other channels.

  • Example: In an offering of 1,000,000 shares, if the underwriter has agreed to underwrite 600,000 shares, and the public subscribes to 300,000, the underwriter’s liability would be limited to the 600,000 shares, even if the full offering isn’t subscribed.

Firm Underwriting

Firm underwriting involves the underwriter agreeing to buy a fixed number of shares from the issuer, even if the public does not fully subscribe. This type of underwriting involves a higher level of commitment than regular underwriting, and it’s typically used in situations where there is a need to ensure that the issuer raises the required capital.

  • Liability of Underwriters: In firm underwriting, the underwriter is committed to buying a specific number of shares regardless of public subscription. This differs from non-firm underwriting where the underwriter may back out if the subscription level is too low. The underwriter thus takes on more risk, especially if market conditions are unfavorable.

  • Example: If a company issues 1,000,000 shares and the underwriter commits to purchasing 500,000 shares on a firm basis, the underwriter must buy these 500,000 shares, even if the public subscribes to only 300,000 shares. This ensures that the issuer raises at least the required capital.

Non-Firm Underwriting:

Non-firm underwriting occurs when the underwriter agrees to purchase securities only if they are not subscribed to by the public. In this case, the underwriter has no obligation to buy the unsold portion if there is sufficient public subscription. Non-firm underwriting carries less risk for the underwriter as their liability is contingent upon the public’s interest in the offering.

  • Liability of Underwriters: The liability for the underwriter is contingent on the amount of the offering that remains unsold. If there is over-subscription by the public, the underwriter has no responsibility to purchase additional shares. However, if the offering is undersubscribed, they may be required to step in and buy the unsold shares.

  • Example: In an offering of 1,000,000 shares, if the underwriter agrees to underwrite 500,000 shares on a non-firm basis, and the public subscribes to 700,000 shares, the underwriter would have no further obligation to purchase any unsold shares.

Liability in Case of Over-Subscription and Under-Subscription

  • Over-Subscription: When the offering is over-subscribed, meaning the public subscribes for more shares than are available, the underwriter may reduce their liability proportionally. In a firm underwriting, the underwriter still needs to buy the agreed-upon amount, but in a non-firm underwriting, they may reduce their commitment.

  • Under-Subscription: In the case of under-subscription, the underwriter assumes liability for the unsold portion. In fully underwritten contracts, the underwriter is obligated to purchase all the unsold shares. However, in partially underwritten contracts, the underwriter only needs to buy their portion of the unsold shares, and the remaining unsold shares may be dealt with by other means, such as extending the issue period or reducing the offering.

Management Notes

Accounting for Issue of Shares at Par, Premium, Discount

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When a company issues shares, the accounting treatment varies depending on whether the shares are issued at par, premium, or discount. Let’s explore each of these methods in detail, including examples and accounting entries.

1. Issue of Shares at Par

When shares are issued at par, the nominal value (face value) of the share is the same as the price at which the shares are issued. For example, if a company issues 1,000 shares with a face value of ₹10 each, they will be sold to investors at ₹10 per share, meaning no premium or discount is applied.

Example:

  • Number of Shares Issued: 1,000

  • Face Value: ₹10 per share

  • Issue Price: ₹10 per share

  • Total Capital Raised: 1,000 shares × ₹10 = ₹10,000

Accounting Entry:

  • Bank Account Debit ₹10,000

  • Share Capital Account Credit ₹10,000

This reflects the cash received in exchange for shares issued at par.

2. Issue of Shares at Premium

When shares are issued at a premium, the price at which shares are sold is higher than their nominal (face) value. The excess amount received over the face value is known as the securities premium and is credited to a separate account called the Securities Premium Account.

Example:

  • Number of Shares Issued: 1,000

  • Face Value: ₹10 per share

  • Issue Price: ₹15 per share (₹10 face value + ₹5 premium)

  • Total Capital Raised: 1,000 shares × ₹15 = ₹15,000

  • Premium Received: 1,000 shares × ₹5 = ₹5,000

Accounting Entry:

  • Bank Account Debit ₹15,000

  • Share Capital Account Credit ₹10,000

  • Securities Premium Account Credit ₹5,000

The above entry records the receipt of cash from investors for both the face value and the premium.

3. Issue of Shares at Discount

When shares are issued at a discount, the price at which shares are sold is lower than their nominal (face) value. This results in the company receiving less money than the nominal value of the shares. In most jurisdictions, issuing shares at a discount is restricted and often requires specific approvals from regulatory authorities.

Example:

  • Number of Shares Issued: 1,000

  • Face Value: ₹10 per share

  • Issue Price: ₹8 per share (₹10 face value – ₹2 discount)

  • Total Capital Raised: 1,000 shares × ₹8 = ₹8,000

  • Discount Given: 1,000 shares × ₹2 = ₹2,000

Accounting Entry:

  • Bank Account Debit ₹8,000

  • Share Capital Account Credit ₹10,000

  • Discount on Issue of Shares Account Credit ₹2,000

The Discount on Issue of Shares account is a contra-equity account that reflects the reduction in the total capital raised from the issue of shares at a discount.

Summary of Accounting Entries for Share Issues

Issue Type Bank Account Share Capital Account Securities Premium Account Discount on Issue of Shares Account
At Par ₹10,000 ₹10,000 – –
At Premium ₹15,000 ₹10,000 ₹5,000 –
At Discount ₹8,000 ₹10,000 – ₹2,000
Management Notes

Calls in Arrears and Calls in Advance

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Calls in Advance refers to the amount paid by shareholders on their shares before it is officially called or due by the company. This payment is made by shareholders in advance of the scheduled installment or call. The company records this amount as a liability until the call is formally made, at which point it is adjusted against the amount due. Calls in Advance do not carry voting rights until the actual call is due, and the company may pay interest on these amounts at a predetermined rate as compensation to the shareholders for their early payment.

Characteristics of Calls in Advance:

  1. Prepayment by Shareholders

The fundamental characteristic of Calls in Advance is that shareholders voluntarily pay part or all of their outstanding share capital before the company makes an official call for the payment. This prepayment is often done to secure an investment or ensure prompt fulfillment of financial obligations related to their shares.

  1. Recorded as a Liability

When a company receives Calls in Advance, it records this amount as a liability on its balance sheet. This is because the payment is considered unearned revenue until the company officially calls for the payment. The liability remains until the call is made, at which point the amount is adjusted against the due call.

  1. Interest Payment

Companies may pay interest on Calls in Advance as a form of compensation to shareholders for providing funds earlier than required. The rate of interest is usually predetermined and is stipulated in the company’s Articles of Association. However, the company is not obligated to pay interest if it chooses not to, depending on its policies.

  1. No Voting Rights

One significant characteristic of Calls in Advance is that shareholders who have paid in advance do not receive any additional voting rights based on their early payment. Voting rights are only granted based on the paid-up share capital when the call is actually due.

  1. Adjustment Against Future Calls

The amount paid in advance is adjusted against the future calls made by the company. When the call is due, the company will deduct the amount already paid in advance from the total amount payable by the shareholder, reducing their financial obligation at the time of the call.

  1. Temporary Use of Funds

The company can temporarily use the funds received as Calls in Advance for its operational or capital needs. However, this use is limited by the fact that the company must treat these funds as a liability, meaning they must be available when the call is officially made.

  1. No Dividend Entitlement

Shareholders who pay Calls in Advance are not entitled to dividends on the amount paid in advance until it is officially called. Dividends are typically declared only on paid-up capital, which includes only those amounts that are due and payable.

  1. Flexibility for the Company

Calls in Advance provide the company with flexibility in managing its cash flow. The early receipt of funds can help the company meet its immediate financial needs or invest in short-term opportunities. However, this flexibility comes with the responsibility of managing these funds carefully, as they are liabilities that must be settled when the official call is made.

Calls in Arrears

Calls in Arrears refers to the amount that shareholders have not paid by the due date on their shares, despite a formal request or “call” from the company. When a company issues shares, it may request payment in installments. If a shareholder fails to pay any installment by the due date, the unpaid amount is considered a call in arrears. The company records this as a receivable on its balance sheet. Interest may be charged on calls in arrears, and in severe cases, the company may forfeit the shares if the arrears are not cleared within a specified period.

Characteristics of Calls in Arrears:

  1. Unpaid Amount

The primary characteristic of Calls in Arrears is that it represents an amount that shareholders owe to the company but have not yet paid by the deadline specified. This occurs when shareholders do not fulfill their financial obligation to pay the call on the due date as required by the company.

  1. Recorded as an Asset

In the company’s financial records, Calls in Arrears are recorded as an asset. Specifically, it is shown as a receivable on the balance sheet, reflecting the amount that the company expects to collect from shareholders. This receivable remains on the books until the amount is fully paid by the shareholders.

  1. Interest Charges

Companies often charge interest on Calls in Arrears as a penalty for late payment. The interest rate and terms are usually specified in the company’s Articles of Association. This serves as a deterrent to shareholders against delaying payment and compensates the company for the delay in receiving funds.

  1. No Voting Rights

Shareholders with Calls in Arrears do not enjoy voting rights for the unpaid shares. Voting rights are typically granted based on the paid-up share capital. As a result, shareholders who fail to pay on time may temporarily lose their influence in company decisions until they settle their dues.

  1. Possible Forfeiture of Shares

If the Calls in Arrears remain unpaid for an extended period, the company may initiate the process of forfeiting the shares. Forfeiture involves canceling the shareholder’s ownership of the shares, and the company may reissue or sell the shares to recover the unpaid amount.

  1. Impact on Dividend

Shareholders with Calls in Arrears are not entitled to receive dividends on the unpaid shares. Dividends are typically declared on fully paid-up shares, so until the arrears are cleared, the shareholder forfeits any right to dividends on those shares.

  1. Negative Impact on Shareholder Reputation

Calls in Arrears can negatively affect a shareholder’s reputation within the company and among other investors. Persistent arrears may lead to a loss of trust and potential exclusion from future investment opportunities within the company.

  1. Legal Implications

If the arrears are significant and remain unresolved, the company may take legal action to recover the outstanding amount. This could involve court proceedings or other legal remedies to enforce payment, depending on the jurisdiction and the company’s policies.

Key differences between Calls in Advance and Calls in Arrears

Aspect Calls in Advance Calls in Arrears
Payment Timing Before due date After due date
Balance Sheet Status Liability Asset
Interest May be paid to shareholders Charged to shareholders
Voting Rights No additional rights Suspended until paid
Dividend Rights Not entitled Not entitled
Company Benefit Early cash inflow Receivable expected
Shareholder Initiative Voluntary Obligatory
Financial Flexibility Increases for company Decreases for shareholder
Impact on Reputation Positive Negative
Legal Action None Possible if unpaid
Forfeiture Risk None High if unpaid
Impact on Share Price Neutral Negative
Accounting Treatment Deferred liability Accounts receivable
Disclosure Requirement In notes to accounts Directly shown in balance sheet
Management Control Easier More complex

Bangalore University BBA Notes

Corporate Accounting 3rd Semester BU BBA SEP 2024-25 Notes

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Unit 1 [Book]
Issue of Shares VIEW
Initial Subscription of Shares VIEW
Right Issue of Shares VIEW
Private Placement of Shares VIEW
IPO VIEW
FPO VIEW
Book Building VIEW
Prospectus VIEW
Red herring Prospectus VIEW
Issue of Bonus Shares, Reasons for issuing Bonus Shares, Legal Framework VIEW
Relevant Provisions of the Companies Act, 2013 for issuing Bonus Shares VIEW
Students are advised to go through some of the IPO documents which is available in the Public Domain) VIEW
Buyback of Shares Meaning, Objectives, Legal framework for Buyback under the Companies Act, 2013 VIEW
Unit 2 [Book]
Introduction, Meaning and Definition of Underwriting, Importance of Underwriting in Raising Capital VIEW
Types of Underwriting: Firm Underwriting, Conditional Underwriting, and Sub-Underwriting VIEW
Calculation of Liabilities and Commission: Gross Liability and Net Liability VIEW
Marked Applications and Unmarked Applications VIEW
Proportionate Liability in Syndicated Underwriting VIEW
Accounting for Underwriting: Treatment of Underwriting Commission in the Company’s Book and Settlement between Parties VIEW
Preparation of Statement of Underwriters Liability VIEW
** ****
Role of Underwriters in Capital Markets VIEW
Ethical Practices in Underwriting VIEW
Key Clauses in Underwriting Agreements VIEW
SEBI Guidelines on Commission Rates and Responsibilities VIEW
Unit 3 [Book]
Introduction Meaning and Need for Valuation of Shares VIEW
Factors affecting Value of Shares VIEW
Methods of Share Valuation illustration on:
Intrinsic Value Method VIEW
Yield Method VIEW
Earning Capacity Method VIEW
Fair Value Method VIEW
Rights Issue VIEW
Valuation of Rights Issue VIEW
Valuation of Warrants: Australian Model, Shivaraman-Krishnan Model VIEW
Unit 4 [Book]
Introduction, Meaning Concept of Profit (or Loss) Prior to the date of Incorporation VIEW
Pre-incorporation vs. Post-incorporation Periods VIEW
Calculation of Apportionment Ratios:
Sales Ratio VIEW
Time Ratio VIEW
Weighted Ratio VIEW
Treatment of Capital and Revenue Incomes and Expenditures VIEW
Ascertainment of pre-incorporation and post- incorporation profits by preparing statement of Profit and Loss (Vertical Format) as per schedule III of Companies Act, 2013 VIEW
Unit 5 [Book]
Statutory Provisions regarding Maintenance of Accounts by Company Section 128, 129, 134 VIEW
Fundamental Accounting assumption:  Going Concern, Accrual, Consistency VIEW
Annual Returns under Section 92, (Form AOC-4 & MGT-7A) VIEW
Preparation of Financial Statements of Companies as per schedule III to companies act, 2013 VIEW
Schedule 7 to Companies Act of 2013 for understanding the Rate of Depreciation on Key assets such as Plant and Machinery, Furniture and Fixtures, Office equipment, Vehicle, buildings, Intellectual Properties and Intangible Assets VIEW

>>Old Syllabus for 2024-25 Notes<<

Unit 1 [Book]
Introduction, Meaning of Shares VIEW
Types of Shares (Equity Shares and Preference Shares), Features of Equity & Preference Shares VIEW
Issue of Shares, Procedure for Issue of Shares, Kinds of Share Issues VIEW
Types of Share Issues, Issue of Shares at Par, at Premium and at Discount VIEW
Subscription of Shares, Minimum Subscription, Over-Subscription VIEW
Pro- Rata Allotment of Shares VIEW
Accounting for Issue of Shares at Par, Premium, Discount VIEW
Calls in Arrears and Calls in Advance VIEW
Unit 2 [Book]
Introduction, Overview of Redemption of Debentures Meaning, Importance and Objectives of Redemption VIEW
Methods of Redemptions:
Redemption Out of Profit VIEW
Redemption Out of Capital VIEW
Redemption by Payment in Lump Sum VIEW
Redemption by Instalments VIEW
Redemption by Purchase in the Open Market VIEW
Key Financial Adjustments in Redemption of Debentures VIEW
Provision for Premium on Redemption of Debentures VIEW
Treatment of Unamortized Debenture Discount or Premium VIEW
Accounting for Redemption of Debentures under Sinking Fund method VIEW
Journal Entries VIEW
Ledger Accounts VIEW
Preparation of Financial Statements VIEW
Post- Redemption as per Schedule III to Companies Act 2013 VIEW
Unit 3 [Book]
Introduction, Meaning of Underwriting VIEW
SEBI regulations regarding Underwriting VIEW
Underwriting Commission VIEW
Underwriter, Functions, Advantages of Underwriting VIEW
Types of Underwriting VIEW
Marked and Unmarked Applications VIEW
Determination of Liability in respect of Underwriting Contract when fully Underwritten and Partially Underwritten with and without firm Underwriting VIEW
Unit 4 [Book]
Introduction Meaning and Need for Valuation of Shares VIEW
Factors affecting Value of Shares VIEW
Methods of Share Valuation illustration on:
Intrinsic Value Method VIEW
Yield Method VIEW
Earning Capacity Method VIEW
Fair Value Method VIEW
Rights Issue VIEW
Valuation of Rights Issue VIEW
Valuation of Warrants: Australian Model, Shivaraman-Krishnan Model VIEW
Unit 5 [Book]
Statutory Provisions regarding Preparation of Financial Statements of Companies as per schedule III of Companies act. 2013 VIEW
List of the Companies follow Schedule III of companies Act 2013 VIEW
Preparation of Statement of Profit and Loss VIEW
Preparation of Statement of Balance Sheet VIEW
Management Notes

SEBI regulations regarding Underwriting

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Underwriting is a crucial aspect of the capital market, especially during public offerings like Initial Public Offerings (IPOs), Follow-on Public Offerings (FPOs), and Rights Issues. In the context of securities markets in India, underwriting refers to an arrangement in which a designated underwriter agrees to purchase shares from a company in case the public offering is not fully subscribed. The Securities and Exchange Board of India (SEBI), as the regulatory authority for the Indian securities market, has laid down certain guidelines and regulations for underwriting in order to ensure transparency, protect investor interests, and maintain market integrity.

Regulations on Underwriting by SEBI:

SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (ICDR Regulations)

Under the SEBI ICDR Regulations, which governs the process of public offerings in India, specific rules apply to underwriting arrangements:

  • Appointment of Underwriters: Companies issuing securities must appoint one or more underwriters to ensure that they can raise sufficient capital even if the issue does not receive full subscription from the public. These underwriters may be financial institutions, banks, or other recognized entities with the necessary expertise and financial backing.

  • Underwriting Agreements: An underwriting agreement is a formal contract between the issuer and the underwriter. The agreement must clearly specify the number of securities being underwritten, the terms of underwriting (including commission), and the conditions under which the underwriting agreement becomes effective.

  • Underwriting Commitment: The underwriter commits to purchasing any unsubscribed shares, thereby assuming the risk of the offering’s under-subscription. They will purchase the unsold shares at the issue price. If the issue is fully subscribed, the underwriter does not need to purchase any shares. If the issue is not fully subscribed, the underwriter buys the remaining shares and may later resell them in the secondary market or hold them as an investment.

Minimum Underwriting Requirement:

Under the SEBI regulations, for a public issue to proceed, there is a minimum underwriting requirement, ensuring that the issuer will not be left with an unsubscribed portion that cannot be filled. The minimum requirement depends on the type of issue and its structure.

  • Public Issues: If a company is making a public offering of equity shares, the minimum underwriting requirement is set at 100% of the portion of the issue that is to be underwritten. This means that underwriters must commit to purchase shares that are not subscribed by the public, ensuring that the company raises the necessary capital.

  • Rights Issues: Under the SEBI regulations, rights issues (where existing shareholders are offered new shares) also require underwriting, especially when the company anticipates that not all shareholders will subscribe to the offer. In such cases, the company is expected to make underwriting arrangements to cover any unsold shares.

Role and Responsibilities of Underwriters:

  • Due Diligence: Underwriters must conduct due diligence before agreeing to underwrite an issue. This includes evaluating the financial stability and business model of the issuing company to assess the risks involved in underwriting the issue.

  • Subscription of Shares: If there is an under-subscription in the public issue, the underwriter must step in and subscribe to the remaining shares as per the underwriting agreement.

  • Compliance with Disclosure Requirements: Underwriters must ensure that all necessary disclosures are made in the prospectus or offer document related to underwriting. They need to disclose the underwriting commitment, the percentage of the issue that is being underwritten, and any conflicts of interest.

  • Handling of Underwritten Shares: If the issue is undersubscribed and the underwriter has to purchase the remaining shares, they can either hold or sell the shares in the secondary market. The underwriter has to disclose how these shares will be dealt with.

SEBI Guidelines on Underwriting Commission:

Under SEBI regulations, the underwriting commission is allowed, but it is capped to prevent excessive charges that may harm investors. The commission is typically paid by the issuer to the underwriter in return for taking on the underwriting risk.

  • The maximum underwriting commission is determined based on the type and size of the issue. For example, for equity issues, the commission can range from 1% to 2% of the issue size, depending on the total amount being raised.

  • The underwriting commission is generally lower for large offerings as the risk is spread across a larger number of shares.

SEBI Guidelines on Underwriter’s Liability:

Underwriters must ensure that they are financially capable of fulfilling their commitments. They are held responsible for purchasing the unsubscribed shares if necessary, and their ability to meet this responsibility is a critical factor in maintaining market stability.

  • If the underwriter fails to fulfill its underwriting commitments, they may face penalties and enforcement actions from SEBI.

  • The underwriter’s liability is typically limited to the agreed-upon underwriting portion of the issue and does not extend beyond this.

SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011:

Underwriting in cases of public takeovers is also governed by the Takeover Regulations, which ensure that any underwriting agreements in takeover bids comply with the broader framework of the takeover law. These regulations specify how underwriters may participate in or affect the offer.

Management Notes

Underwriting Commission

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Underwriting commission is a fee paid by a company to underwriters for their role in guaranteeing the successful completion of a public offering, such as an Initial Public Offering (IPO) or a Rights Issue. The underwriters are financial intermediaries who commit to purchasing the shares in case the public does not fully subscribe to them. This commission compensates the underwriter for taking on the risk of underwriting the issue and for their involvement in ensuring that the offering is fully subscribed.

Role of Underwriters in Public Offers:

In the capital markets, underwriting is a critical function. Underwriters perform due diligence, evaluate the financial health of the issuing company, and determine the pricing and risk associated with the offer. They then agree to purchase any unsold shares from the issue if the public subscription falls short of the total number of shares offered. By guaranteeing the issue’s success, underwriters ensure that the company can raise the desired capital even if public interest is insufficient.

Understanding Underwriting Commission

The underwriting commission is the fee paid to the underwriters for assuming the risk of purchasing unsubscribed shares. This commission is typically expressed as a percentage of the total capital raised from the issue and varies depending on the size of the issue, the risk involved, and the market conditions.

How Underwriting Commission Works:

  1. Risk Compensation: The primary purpose of the underwriting commission is to compensate the underwriter for taking on the risk of purchasing any unsubscribed shares. If the public subscription is insufficient, the underwriter must buy the remaining shares at the offer price.

  2. Cost of Services: Besides taking on risk, underwriters also incur costs related to the due diligence process, market analysis, pricing strategy, and preparing the necessary documentation, all of which contribute to the overall commission.

  3. Market Conditions: In times of high demand for securities (bull market), the underwriting commission tends to be lower because the issue is likely to be fully subscribed by the public. In contrast, in bearish market conditions, when investor sentiment is lower, underwriting commissions may be higher due to the increased risk of an under-subscribed offering.

Regulations on Underwriting Commission in India:

In India, the Securities and Exchange Board of India (SEBI) regulates the underwriting commission, ensuring fairness and preventing excessive fees. The underwriting commission is capped under SEBI’s guidelines to protect investors and maintain transparency in the capital market.

SEBI Guidelines:

  1. Maximum Commission: SEBI specifies the maximum underwriting commission based on the size of the issue. For example, the maximum commission for a public issue of equity shares is generally in the range of 1% to 2% of the total issue size. For smaller issues, the commission might be slightly higher.

  2. Equity Issues: For equity-based public offerings, underwriters typically receive a commission of around 1% to 1.5% of the issue size, although this can vary depending on the complexity of the offer, the financial strength of the issuing company, and market conditions.

  3. Debt Issues: For debt securities or debentures, the underwriting commission is usually lower than for equity issues. This is because the risk involved in debt underwriting is typically considered to be lower, as bondholders have a fixed claim on the company’s assets in case of liquidation.

  4. Non-Equity Issues: Underwriting commissions for non-equity issues, such as preference shares or debentures, also fall under SEBI’s purview but tend to be lower than for equity issues due to their lower risk and fixed income nature.

  5. Payment and Terms: The underwriting commission is usually payable by the issuer after the offer is completed. The terms and conditions of the commission payment, including the percentage and any performance-related clauses, must be disclosed in the prospectus or the offer document.

Factors Influencing Underwriting Commission:

Several factors determine the amount of the underwriting commission that the issuer and underwriter agree upon:

  1. Issue Size: Larger offerings generally involve lower underwriting commissions because the risk is spread across a larger number of shares. In contrast, smaller offerings tend to carry higher commissions due to the higher relative risk for underwriters.

  2. Risk Profile: The perceived risk of the offering affects the underwriting commission. If the issuing company is perceived to have higher risk or there is a general lack of investor confidence in the market, underwriters may demand a higher commission to compensate for the increased risk of undersubscription.

  3. Market Conditions: During a bullish market, when investor sentiment is strong, underwriting commissions are often lower because public demand for shares is more predictable. Conversely, in bearish markets, where investor appetite is lower, underwriting commissions may rise as compensation for the potential risk of an under-subscribed issue.

  4. Issuer’s Reputation: The financial health and reputation of the issuing company can also influence the underwriting commission. If the company is financially stable and has a good market reputation, the underwriting commission will likely be on the lower end of the scale.

Benefits of Underwriting Commission:

The underwriting commission is an essential mechanism in public offerings, benefiting both the issuer and the underwriter:

  1. Issuer’s Perspective: The issuer benefits from a guaranteed capital raise, even in the event of an under-subscribed issue. They also receive the expert services of the underwriters, who manage the pricing and marketing of the offer.

  2. Underwriter’s Perspective: The underwriter assumes the risk of buying unsold shares in exchange for the underwriting commission. This compensation reflects the expertise and financial backing needed to ensure the success of the offering.

  3. Investor Protection: The regulatory cap on underwriting commissions ensures that the issuer is not paying excessive fees, thus protecting investors from higher issue costs that may be passed on to them through inflated prices.

Management Notes

Underwriter, Functions, Advantages of Underwriting

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An underwriter is a financial institution or individual that guarantees the purchase of any unsold shares in a public offering, such as an Initial Public Offering (IPO) or a Rights Issue. Underwriters play a key role in ensuring that the company raising funds will meet its capital-raising goals, even if the public does not fully subscribe to the offering. They assess the risk, determine pricing, and market the securities. In return for assuming this risk, underwriters are paid a commission, which compensates them for their services and financial commitment to the issue.

Functions of Underwriter:

  • Risk Assessment

One of the primary functions of an underwriter is to assess the risk involved in a public offering. Before agreeing to underwrite an issue, the underwriter evaluates the financial health, market conditions, and business prospects of the issuing company. This assessment helps the underwriter determine the likelihood of the offering being successful and identify any potential risks that might affect the sale of shares. Based on this evaluation, they decide whether to underwrite the issue and the terms of underwriting.

  • Pricing of Securities

Underwriters play a crucial role in determining the price at which securities are offered to the public. This involves market research, understanding investor demand, and analyzing the company’s financial position. The underwriter sets the issue price to balance the issuer’s goal of raising capital and attracting investor interest. An accurately priced issue ensures that it is neither underpriced (leading to a loss of capital for the issuer) nor overpriced (leading to poor investor demand).

  • Marketing and Promotion

Marketing and promotion of the offering is another key function of the underwriter. They are responsible for creating an awareness campaign and ensuring that potential investors are well-informed about the company’s offering. This involves roadshows, presentations, and other promotional activities to generate interest. Underwriters leverage their relationships with institutional and retail investors to ensure the offering is adequately subscribed. Effective marketing directly impacts the success of the offering by creating demand and enhancing visibility.

  • Managing Subscription Process

The underwriter is responsible for managing the subscription process during an offering. This includes handling investor applications, collecting payments, and ensuring the shares are allocated correctly. The underwriter coordinates with stock exchanges and regulatory bodies to comply with all procedural requirements. They must ensure that the subscription is conducted smoothly, and that any oversubscription or undersubscription is dealt with effectively, including the allotment of shares to investors as per the rules and regulations.

  • Underwriting Commitment

Underwriters provide a guarantee to the issuing company that they will purchase any unsold shares in the event that the public does not fully subscribe to the offering. This is referred to as the underwriting commitment. If the offering is undersubscribed, the underwriter steps in and buys the remaining shares at the agreed-upon price. This commitment ensures that the issuer will raise the desired amount of capital, even if there is low investor interest in the offering.

  • Due Diligence

Underwriters are responsible for performing due diligence to ensure that the issuing company’s financials and disclosures are accurate and compliant with regulatory requirements. This includes verifying financial statements, business operations, and legal standing. Due diligence is crucial in protecting investors and ensuring that the information provided in the offer document is truthful and transparent. A thorough due diligence process reduces the risk of legal disputes and protects both the underwriter and the issuer from potential liabilities.

  • Stabilization of Market Price

After the securities are issued, the underwriter may be involved in stabilizing the price of the securities in the secondary market. This involves buying and selling shares to prevent excessive price fluctuations immediately after the offering. The underwriter’s role is to ensure that the market price of the shares remains stable and does not fall below the issue price. This helps maintain investor confidence and prevents volatility that could harm the issuer’s reputation and the investors’ interests.

Advantages of Underwriting:

  • Capital Guarantee

Underwriting ensures that the company raising capital will receive the full amount of money it requires, even if the public does not fully subscribe to the offering. This capital guarantee helps reduce uncertainty for the issuer, providing confidence that the financial objectives of the offering will be met, regardless of investor demand.

  • Expert Guidance

Underwriters bring in-depth market knowledge and expertise, helping the issuing company set the right price for the securities and strategize on how to attract investors. Their experience in market conditions, pricing, and risk management ensures the offering is attractive, thereby maximizing the chances of success for both the company and investors.

  • Enhanced Market Credibility

Having a reputable underwriter associated with an issue enhances the company’s credibility in the market. Investors often feel more confident in subscribing to an offering that has been underwritten by well-known financial institutions. This can help increase investor interest and trust, potentially leading to higher subscriptions and a successful offering.

  • Risk Mitigation for Issuers

By assuming the risk of underwriting, underwriters protect the issuer from potential losses if the offering is undersubscribed. This is especially important during volatile market conditions where public interest may be lower than expected. The issuer is assured of receiving the required funds, even if the shares do not sell as anticipated.

  • Investor Protection

Underwriters perform due diligence to ensure that the information provided in the offer document is accurate, complete, and compliant with regulatory standards. This protects investors by ensuring they have access to reliable and truthful information when making investment decisions. It reduces the likelihood of fraud or misinformation, fostering a safer investment environment.

  • Market Liquidity

By underwriting the offering, financial institutions contribute to the liquidity of the stock market. They help ensure that shares are not only sold initially but that they are also available for subsequent trading. This liquidity helps maintain the efficiency and stability of the market, providing investors with opportunities to buy or sell securities as needed.

Disadvantages of Underwriting:

  • High Costs

Underwriting involves substantial fees, including commissions paid to the underwriters, as well as legal, administrative, and marketing expenses. These costs can be significant, especially for large public offerings. For smaller companies or those with limited capital, these expenses may be prohibitive and could diminish the funds raised through the offering.

  • Underwriter Risk

Underwriters assume a significant amount of financial risk, especially when market conditions are unfavorable. If the public does not subscribe to the offering as expected, the underwriter is left with unsold shares. This risk may lead to financial losses, particularly if the market price of the shares falls below the issue price, impacting the underwriter’s profitability.

  • Potential for Overpricing

Underwriters, in their role, set the issue price, which may sometimes be overestimated based on market conditions or overly optimistic projections. Overpricing can lead to poor investor demand, resulting in undersubscription. An improperly priced issue may also harm the company’s reputation, as investors may feel the offering was not accurately valued.

  • Conflicts of Interest

In some cases, underwriters may have conflicts of interest. They might prioritize their financial gain over the interests of the issuer or investors. For instance, underwriters may push for a higher issue price or aggressively market the shares to boost their commission, which can negatively affect the long-term success of the company and its stock performance.

  • Limited Control for Issuer

Once an underwriter is hired, the company may lose a degree of control over the terms of the offering. The underwriter typically takes the lead in setting the price, timing, and other key aspects of the issue. This can be problematic if the issuer’s vision does not align with the underwriter’s strategies or market approach.

  • Increased Regulatory Scrutiny

Underwritten offerings are subject to strict regulatory scrutiny, particularly regarding the due diligence process and disclosure requirements. While this ensures transparency, the complexity and compliance costs can be burdensome for the issuer. Regulatory bodies, such as SEBI in India or the SEC in the U.S., monitor the underwriting process closely, increasing the time and effort needed to complete the offering.

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