The statement of cash flows is one of the most important financial statements, if not the most important. It acts as a bridge between the Balance Sheet and Profit & Lossstatement to let the analyst know where the cash has been used. It tells what is the source of cash and where is its application. Cash is the most liquid form of asset for any company. Any entity with poor cash flow management can go bust within years.
The Structure
The three components of Cash Flow Statements are:
Cash from operating activities
It reflects how much cash is generated from a company’s core business. Activities pertaining to the core business of a company is known as operating activities. Example of operating activities are:
Salaries paid out to employees
Interest income and dividends received
Income tax paid and interest paid
Display advertisements to attract new customers
2. Cash from investing activities: Just like individuals, a company also makes certain investments to take benefits in the future. The cash inflows and outflows pertaining to investment comes in this criterion. Cash flows from buying and selling long-term assets are also counted in this criterion. Example of Investing activities are:
Proceeds from the sale of PP&E.
Acquisitions of other businesses
Purchases of marketable securities
Sale of fixed assets
3. Cash from financing activities: Activities such as issuing dividends, paying interest to debt taken and raising fresh debt, etc come under this criterion. Any change in equity capital and borrowing is included in this segment. Example of financing activities are:
Exchange-Traded Funds or ETFs are listed and traded on exchanges like stocks. It is a fund that pools the financial resources of several people and uses it to purchase shares, bonds, derivatives, etc. The trading value of an ETF is based on the net asset value (NAV) of the stocks that are present in the fund. Thus, an Exchange-Traded Fund is said to have qualities of both shares and mutual funds.
One of the main benefits of ETF is diversification. When an investor invests in a stock, he does not have a space to limit his risk. If the company fails to perform, the investor will make losses. Now, an ETF helps you to keep your finances spread over the equities of different companies. If one of the stocks performs poorly, other stocks might act to limit the risk exposure by performing well. If other assets perform exceptionally well, an investor would still be earning profits.
Exchange-Traded Funds vs Mutual Funds
Exchange-Traded Funds
Mutual Funds
Market orders can be placed
Market orders cannot be placed
Traded intra-day like stocks
Traded at the end of the day
Generally, a lower expense ratio than mutual funds
Generally, a higher expense ratio when compared to ETFs
Common types of ETFs
Gold ETF – Gold is a commodity. This makes the ETF a commodity ETF. A gold ETF is based on gold prices and it invests in gold bullion. Purchasing shares in this ETF makes you a virtual owner of gold.
Equity ETF – As the names suggest, these ETFs invest in the shares of different companies to earn interest and reduce risk exposure.
Currency ETF – The main objective of a currency ETF is to reduce the exposure to foreign exchange (forex)currencies.
If you are a beginner in the stock market or a conservative investor, index funds can be a great way to diversify your investment portfolio with minimal cost and effort. In this article, we’ll cover everything you need to know about index funds, starting from the basics to choosing the suitable one. We will also discuss how it differs from actively managed funds.
What is an Index Fund?
An index fund is a type of mutual fund or exchange-traded fund (ETF) that tracks and replicates the performance of a specific market index (like NIFTY50/Sensex in India or S&P500 in the US). These funds replicate the performance of an index regardless of the state of the markets. When you invest in an index fund, you automatically own a tiny piece of all the companies in the index. So, if the companies in the index perform well, your investment does too. These funds provide exposure to the broad market at a low cost.
Veteran investor Warren Buffet has recommended index funds as an investment option to park savings for retirement. He argues that investing in an index fund is more sensible for an average investor than picking and investing in individual stocks. This is because index funds provide exposure to the market as a whole.
How do Index Funds Work?
Consider an index fund that replicates/tracks NSE’s Nifty50 Index. There will be 50 stocks in this fund’s portfolio, all of which will have the same weightage as in Nifty50. When you put money in this index fund, that cash is used to invest in every company that makes up the particular index. It gives you a more diverse portfolio than if you were buying individual stocks. The fund’s value rises and falls in sync with the index it’s based on.
The low expense ratio of an index fund is one of its main unique selling points (USPs). The expense ratio is a small portion of the fund’s total assets that the fund house charges investors for fund management services.
Benefits of Investing in Index Funds
A few of the benefits of Index funds compared to individual investment in stocks are:
1. Diversification
By investing in an index fund, you gain exposure to a broad range of assets (stocks or bonds) within the chosen index. All indices other than sectoral indices are well-diversified, and you can reduce the risk of one stock performing poorly.
2. Lower Cost
Index funds are known for their low expense ratios, meaning they have lower fees compared to actively managed funds.
3. Historical Performance
Over the long term, index funds tend to match or outperform many actively managed funds.
4. Time Saver
Investors don’t have to spend hours researching stocks since the stocks in index funds are copied from the index in the same proportion.
5. Transparency
Index funds provide full transparency into their holdings, allowing investors to see exactly what they own.
Types of Index Funds
There are index funds available for a wide range of market indices, covering different asset classes and regions. Here are some common types:
1. Equity Index Funds
These track stock market indices like the Nifty50 and Sensex. In the past, large-cap stocks have generally outperformed inflation. But they have also shown significant volatility over short and medium-term timeframes.
2. Bond Index Funds
Bond index funds replicate the performance of bonds or fixed-income securities. For example, the S&P BSE India Bond Index tracks local currency-denominated government and corporate bonds from India. This type of index fund is ideal for investors looking for stability in investments and regular interest payments.
3. Sectoral Index Funds
Sectoral index funds provide exposure to specific sectors of the economy like banking, technology, healthcare, or real estate. For example, an index fund based on Nifty Financial Services is a sectoral index fund that tracks the performance of financial services companies in India.
However, these funds are generally riskier than diversified funds because they are more narrowly focused. The fund’s performance relies on how well that particular sector does.
4. Global Index Funds
Global index funds invest in global indices such as the S&P500 and NASDAQ 100. These funds offer an opportunity to easily invest in multi-national companies.
5. Commodity Index Fund
Commodity Index Funds track commodity indices. You can invest in commodities such as gold, oil, or agricultural products easily through these funds.
How to Choose the Right Index Fund?
Selecting the right index fund is crucial for achieving your investment goals. A few points to keep in mind while choosing an index fund are:
1. Determine Your Goal
The first step before choosing an index fund is to determine your investment goal. College fees, buying a dream car or home, securing retirement funds, etc. can be examples of investment goals. Your goal will influence which index fund is best for you.
2. Risk Tolerance
Consider how comfortable you are with risk. If you prefer lower risk, consider bond index funds. On the other hand, if you can handle some fluctuations (volatility) in your investments, equity index funds might be the better choice for you.
3. Expense Ratios
Compare the fees across various index funds. Lower fees result in more of your money being invested. The expense ratio is a metric that reflects the fees and additional costs you incur with the mutual fund company.
4. Track Record
Check the fund’s historical performance. While past performance doesn’t guarantee future results, it can provide valuable insights. It’s important to note that the performance of an index fund will never exceed the chosen index because expenses reduce the overall returns it generates.
5. Diversification
Ensure the index fund aligns with your desired level of diversification for your investment portfolio.
Index Fund vs Actively Managed Funds
The key differences between index funds vs. actively managed funds are:
Index Funds
Actively Managed Funds
Replicates the holdings of a specific index
Fund managers make decisions based on research and analysis
Expense ratio is generally lower due to passive management
Expense ratio will be higher due to active management and research costs
Lower risk due to broad diversification
Risk varies depending on the fund manager’s decisions
Discourages market timing, focuses on long-term investing
May involve market timing and tactical allocation
Generally aims to match the performance of the index
Seeks to outperform the market or a benchmark index
Historical Performance of Index Funds
Index funds typically deliver returns that closely mirror the performance of the underlying indices they track. Looking at historical data, it’s evident that the majority of actively managed funds have struggled to outperform these indices, which is why many investors opt for index funds.
Over the past 30 years, index funds based on the S&P 500 have delivered a Compounded Annual Growth Rate (CAGR) of 10.7% per year. Meanwhile, index funds based on Nifty50 have given a return of 12% CAGR in the last 15 years.
To learn more about the best index funds to invest in India, click here.
How to Invest in Index Funds in India
Here’s a simple guide on how to invest in index funds in India:
Start by selecting a reliable brokerage platform (like Zerodha or Groww). Ensure that the broker offers access to a variety of index funds.
To invest in index funds, you’ll need a Demat and trading account. These accounts will hold your investments electronically and enable you to buy and sell index fund units.
Research and pick an index fund that aligns with your investment goals and risk tolerance. Popular choices include Nifty 50 index funds, Sensex index funds, and sector-specific index funds.
Use your broker’s trading platform to place buy orders for the index fund you’ve chosen. Specify the number of units or the amount you wish to invest.
Index funds are designed for long-term investing. Stay committed to your investment strategy and avoid making impulsive decisions based on short-term market fluctuations.
Tax Considerations on Index Funds
Taxes on index funds are levied both on capital gains and dividends. Dividends are combined with the investor’s taxable income and taxed according to their income category. Capital gains, on the other hand, are subject to separate taxation.
EBITDA, or earnings before interest, taxes, depreciation, and amortization is a measure of a company’s overall financial performance and is used as an alternative to the net income in some circumstances. It is a measure of profitability.
Amortization refers to spreading payments over multiple periods in case of debt. It also refers to a reduction in the value of intangible assets such as goodwill, a patent, or a copyright.
Depriciation on the other hand refers to the decrease in value of a tangible asset (Car, Bike, Machinery) with time.
How Do I Calculate EBITDA?
EBITDA=Net Income + Interest + Taxes + Depreciation + Amortization
Operating Profit = The profit earned from the business operation before the deduction of taxes and payable interest.
Why EBITDA?
EBITDA is to be used to analyze and compare profitability among companies and industries. It eliminates the effects of financing and capital expenditures.
Financing expenditures are essentially the interest, and other charges involved in the borrowing of money to build or purchase assets.
Capital expenditures (capex) are funds used by a company to acquire or upgrade physical assets such as property, buildings, or equipment.
The EBITDA metric is commonly used as a proxy for cash flow. It can give an analyst a quick estimate of the value of the company, as well as a valuation range by multiplying it by a valuation multiple obtained from equity research reports, industry transactions, or M&A.
In addition, when a company is not making a profit, investors can turn to EBITDA to evaluate a company. Many private equity firms use this metric because it is very good for comparing similar companies in the same industry. Business owners use it to compare their performance against their competitors.
Drawbacks of EBITDA
Ignores Costs of Assets
Unlike Free Cash Flow (FCF), every company needs a certain amount of money to ensure that its operations continue to run. One such example is when a textile loom buys a machine, it needs to pay for transportation, labour wages, installation and testing of the machine.
Ignores Working Capital
EBITDA also leaves out the cash required to fund working capital (the capital of a business which is used in its day-to-day trading operations) and the replacement of old equipment
Varying Starting Points Make It Unreliable
While subtracting interest payments, tax charges, depreciation, and amortization from earnings may seem simple enough, different companies use different earnings figures as the starting point for EBITDA. In other words, EBITDA is susceptible to the earnings accounting games found on the income statement.
What is EBIT? How is it Different From EBITDA?
EBIT or Earnings before interest and taxes is a measure of a firm’s profit that includes all incomes and expenses except interest expenses, income tax expenses, amortization and depreciation.
EBIT = Net Income + Interest Expense + Tax Expense
EBITDA is particularly useful in cases of firms with very heavy capital investments. In these cases, depreciation and amortization can make the company’s operating budget look far less healthy than it actually is, even to the point of showing operating losses despite a steady cash flow.
EPS or Earnings per share is one of the most important terms in the finance domain. Especially, if you are an investor or a shareholder, you should special focus on this number and the trend it is following.
Earnings per share (EPS) is the part of a company’s profit which is allocated to each outstanding share of the stock. It is a very useful metric which can help in judging a company’s financial health.
EPS is calculated by taking net income and subtracting the preferred dividends from it. The value obtained has to be divided by the average number of outstanding shares. Preferred dividends are those paid on a company’s preferred stock.
A higher EPS indicates that the company is profitable and is also able to pay money to its shareholders.
Types of EPS
Trailing EPS: It is the most commonly used form of EPS because it represents what happened in the past with certainty. Correctly predicting the future is very difficult. Thus, this form of EPS uses the earnings number of the previous four quarters.
Current EPS: In this, current earnings are taken to calculate EPS. Some quarter of earnings data may have been out already, and some of that is yet to come. Thus, current EPS uses some of the actual data and some of the factual data.
Forward EPS: As the name suggests, EPS calculated in this form takes into the estimates of earnings that may come in the future. Earnings are forecasted by the analyst. Based on these forecasted earnings, forward EPS is calculated.
Calculating Earnings per Share
EPS = net income – preferred dividends / average outstanding common shares
Example : Let Net Income = Rs 10,00,000 and Preferred Dividends = Rs 2,00,000. If Average outstanding common shares = 5,00,000 then, EPS = (10,00,000 – 2,00,000)/5,00,000 = Rs 1.6
Just like liquidity ratios, solvency ratios are a key component when conducting company’s financial analysis. It tells whether the company is capable enough to pay its long-term dues from the cash flow generated.
Long-term liabilities are those debt obligations which are not due to be paid in this year but in the coming years. Both Solvency and liquidity are equally important for a company’s financial health.
Remember, liquidity ratio deals with the short-term debts and solvency ratio deals with the long-term debts. To know more about liquidity ratios, clickhere.
Solvency Ratio Metrics
Debt to equity ratio = Total Debt/ Total Shareholder’s Equity
This is a very commonly used solvency ratio. It is one of the most important metrics when understanding a company’s financial leverage. Debt-to-equity ratio tells how capable a firm is to cover all of its debts with the shareholder’s equity. A value states that the company is using debt for fuelling its growth. Lower D/E ratio is better as it shows higher solvency of the business.
Interest Coverage Ratio = EBIT / interest payments due on debt
EBIT stands for Earnings before interest and tax. This ratio indicates whether the company can pay interest on the outstanding debt obligations. Higher the interest coverage ratio, more stable the company is to pay the interest related to debts from its earnings.
Imagine two companies, company ABC with an Interest coverage ratio of 1.5 and company XYZ with interest coverage ratio 2.5. In this situation, XYZ is considered to be in a better situation to pay the interest payment of its debt obligation when compared to company ABC. When doing financial analysis, it would be better if the company’s solvency ratios are compared to the those of its competitors in the industry.
DVR or differential voting rights shares are like ordinary equity shares but with differential voting rights. Shares can have higher or lower voting rights as compared to ordinary equity shares. Since Indian regulations do not permit companies to issue equity shares with higher voting rights Indian DVR shares provide for lower voting rights as compared to ordinary equity shares.
DVR shares are highly illiquid, they do not trade in high volumes as compared to ordinary shares.
Why would a company issue DVR Shares?
Prevention of a hostile takeover, different from the company’s interest
It also helps strategic investors who do not want control but are looking at a reasonably big investment in a company due to its low price and high dividend.
When Tata Motors had declared its dividend in 2006, it gave the DVR holders a dividend of six per cent and the ordinary shareholders one per cent. For example, the Tata Motors DVR shares were trading at Rs 689.80 on the National Stock Exchange (NSE) and the ordinary ones at Rs 1,255.75 on Wednesday.
A company can raise money from three platforms: 1) Acquiring debt 2) Selling equity 3) Looking at their reserves. A qualified institutional placement (QIP) is one of the ways through which a company raise funds by selling equity.
A company sells its shares by issuing an IPO. In an IPO, retail investors, Non-institutional bidders, Qualified Institutional Bidders (QIB’s) and Anchor Investors bid to acquire shares. QIP is a tool for raisingcapital from the market but only available to Qualified Institutional Bidders.
Who are Qualified Institutional Bidders (QIB’s)?
QIBs are those institutional investors who are considered to have financial knowledge and capability to invest through capital markets. Mutual funds, venture capital fund, Alternative Investment Fund, Provident Funds with minimum corpus of Rs.25 crores, ULIP schemes of insurance companies and pension schemes, all are considered to be in the QIB category.
Why QIP?
Qualified institutional placements follow a relaxed set of regulations when compared to an IPO. It allows an Indian-listed company to raise capital without filing any pre-issue notice to the regulators. Another main reason why SEBI allowed QIPs was that the companies do not over-depend on the foreign capital for the funding.
As QIPs follow a lesser number of rules and regulations, companies save a lot of costs. During IPOs, a company incurs fees in several stages, for example, legal fees. QIP, as a tool, passes on through less number of checks and thus act as a cost-efficient tool to raise money.
Recently in news
Private sector banks, ICICI Bank, Axis Bank and Housing Development Finance Corp Ltd (HDFC), have raised over Rs 30,000 crore from QIPs this year(2020). The ICICI Bank launched its QIP to raise Rs 15,000 crore. They were followed by, Axis Bank stated that their QIP has helped them in raising Rs 10,000 crore. HDFC also procured Rs 14,000 crore of funds via QIP. This shows, that even amidst COVID-19, the investors are backing the banks and are willing to buy their stakes.
Every company has some or other liabilities. These liabilities are short-term and long-term. Short-term liabilities refers to those which are due to pay within 12 months. Long-term liabilities, as understood, refers to those which have to be paid after the running financial year.
Liquidity Ratios gives an idea of how capable a firm is to pay its short-term dues. This financial ratio tells how competent an entity is to pay these obligations with their current assets and without any financial assistance. Higher the liquidity ratio, better for a company.
Liquidity Ratio Metrics
Current Ratio: Current Assets/ Current Liabilities
This ratio indicates a company’s ability to pay off its current liabilities (short-term liabilities) with its current assets. These current assets consist of cash, inventories, marketable securities and accounts receivables.
Quick Ratio: (Current Assets – Inventories)/ Current Liability
As the name suggests, quick ratio involves those current assets that can be easily converted into cash. Inventories are part of current assets but are not the most liquid form of current assets. Inventories may take time to be sold and thus quick ratio does not take inventories into account. Thus, this ratio is also known as “Acid-test ratio.”
Cash Ratio: Cash/Current Liability
Company’s most liquid assets are cash. Cash Ratio indicates the ability of the firm to pay its short-term liabilities with its most liquid form of asset. Generally, investors trust a company more with higher cash ratio. They believe that the company has enough cash to pay them even if the business doesn’t turn out to be profitable.
Example
Imagine a company ABC has following particulars:
Cash
10000
Inventories
5000
Accounts receivables
5000
Current Liabilities
25000
Current Ratio = (10000+5000+5000)/25000 = 0.8 (In Current Ratio, all the current assets are taken.)
Quick Ratio = (20000-5000)/25000 = 0.6 (Inventories are not a part of quick assets, hence it is subtracted from current assets.)
Cash Ratio = 10000/20000 = 0.5 (Cash Ratio considers only cash as the current assets, as it is the most liquid form of assets)
While reading company results we often come across the terms “Consolidated Results” and “Standalone Results”. The big question is, which one should you use to assess a company’s health? Let’s find out what the terms mean.
Consolidated Statement
Consolidatedstatements represent the financial position of a company and its performance including its subsidiaries, joint-ventures and associate companies.
For example: Let us assume the example of HDFC Bank. HDFC Bank (Parent Company) has many subsidiaries like HDFC Life Insurance, HDFC Asset Management Company (AMC), NextGen Publishing to name a few. For the purpose of understanding, let us just take three.
Now HDFC Bank performs regular retail banking operations along with running subsidiaries such as an AMC, an insurance company and a publishing house. Each of these subsidiaries adds wealth to their parent company i.e. HDFC Bank LTD.
When we consider the consolidated statements of HDFC Bank Ltd. we also consider the contribution of its subsidiaries in consideration along with the HDFC retail banking activity i.e. AMC, insurance company and publishing house plus the functioning of the bank.
Standalone Statement
Standalone financial statements consider the functioning of the company as a single entity and do NOT include the contribution of its subsidiaries.
For example: When you go through the standalone financial statements of a company, you read the financial position of the company with respect to its banking functions ONLY or all those functions which only HDFC Bank Ltd. performs as a separate entity not taking into consideration the contributions of its subsidies generally.
Consolidated or Standalone financials. What to use?
As a rule of thumb, if you want to know the total overall financial strength of the company you mostly read the Consolidated financials of the company.
When would the need to read standalone financials arise? Generally, when there is no direct business-related intervention into its subsidiaries and associates you consider the standalone statement of the company. Otherwise, when you wish to analyse the financial health of the parent company as a separate entity you may read the stand-alone statements
A good investor analyses BOTH consolidated and standalone statements to figure out shortfalls in the companies or any of their subsidiaries.
Companies often employ various strategies to reward their shareholders and strengthen their market position. Bonus shares are a way in which companies reward their existing shareholders. In this article, we will discuss what a bonus issue is, how it works, and its benefits to the company. We will also examine how it differs from dividends and stock splits.
What is a Bonus Issue?
A bonus issue is a corporate action wherein a company gives additional shares to its existing shareholders at no extra cost. These shares are proportionally allocated to their shareholding as of the record date. [To be eligible for receiving bonus shares, investors must be shareholders of the company before the record date]. The primary object of issuing bonus shares is to capitalise on the company’s retained earnings and reserves while rewarding shareholders.
A bonus issue does not increase a company’s market capitalisation, but the number of shares increases. Thus, the price reduces in the same proportion. The face value (FV) of the stock remains the same after a bonus issue.
How do Bonus Shares Differ From Regular Dividends?
Although both bonus shares and regular dividends are ways to reward shareholders, they are entirely different corporate actions. Dividends involve distributing a portion of the company’s profit in cash directly to the shareholders’ bank accounts. On the other hand, bonus issues do not provide any immediate monetary benefits. Instead, they increase the number of shares owned by each shareholder. The additional shares improve the potential earning capacity of the shareholders.
Why Do Companies Issue Bonus Shares?
Capitalisation of Profits
Accumulated profits, also known as retained earnings, are the cash that remains after a company distributes dividends to its shareholders. Bonus issues allow companies to capitalise their accumulated profits or reserves and convert them into share capital. The company can then use the capital to fund expansion, investments, and other activities.
Enhancing Liquidity
A bonus issue increases the number of outstanding shares in the company. An increase in the number of shares will dilute the share price and improve its liquidity, potentially attracting more investors.
Rewarding Shareholders
Unlike cash dividends, bonus issues are a way to reward shareholders without affecting the company’s cash reserves. It helps maintain investor confidence.
Steps in Bonus Issue
The process of a bonus issue involves the following steps:
1. Board Approval
A company’s board of directors hold a meeting to discusses whether they are in a position to issue bonus shares. If yes, the board approves the bonus issue proposal and puts the decision up for shareholder vote.
2. Shareholder Approval
Once shareholders approve, the information is made public and communicated with the Securities and Exchange Board of India (SEBI) and other organisations, including stock exchanges (NSE and BSE).
3. Bonus Ratio
A bonus ratio specifies how many bonus shares will be issued for each existing share in the company. For example, a bonus ratio of 2:1 implies that shareholders will receive 2 additional shares for each share they hold, taking the total shares held to 3 (1+2).
How is the Bonus Ratio Determined? The bonus ratio is determined by considering various factors, including the company’s financial performance, capital requirements, and market conditions. The amount of reserve or retained earnings to be capitalised also determines the bonus ratio.
4. Record Date
A record date is set to identify eligible shareholders who will receive bonus shares. Only shareholders on record on this date are entitled to the bonus. The company collects the names and details of shareholders as on the record date from depositories.
5. Issuance of Bonus Shares
After the record date, bonus shares are allotted to the shareholders in the bonus ratio.
How Do Bonus Issues Impact Shareholders?
A bonus issue affects the shareholders as on the record date as follows:
Increased number of shares
Existing shareholders receive additional shares, which increases the total shares they hold in the company. However, there won’t be any change in shareholding patterns and ownership.
No change in face value
A bonus issue does not reduce the face value of the shares.
Change in market price
The share price of the company adjusts downward after a bonus issue due to the increased supply of shares. However, this adjustment is usually temporary and will stabilise over time.
Example of a Bonus Issue
Berger Paints Ltd had recently declared the issuance of bonus shares in a 1:5 bonus ratio, which means that a shareholder as of the record date will receive one bonus share for every 5 shares held. The record date for the bonus was September 23, 2023.
If you had held 5 shares of Berger Paints Ltd on September 23, 2023, you would have received one bonus share from the company.
On the record date, the stock fell 8.65%. It fell 16.85% till October 4, 2023, when it started to stabilise. However, the fall in the stock price was purely due to the bonus adjustment that we discussed.
Benefits of Bonus Issue
Bonus shares are exempt from taxes.
It multiplies returns in the long term.
Bonus shares are free of cost to the investors.
From the company’s point of view, it helps to enhance the company’s value and image in the market. Additionally, the company will have more free-floating shares in the market with the issue of bonus shares.
How is a Bonus Issue Different From a Stock Split?
Although both bonus issues and stock splits result in an increase in the number of shares, they are completely different corporate actions with different purposes. A stock split is a corporate action in which a company divides its existing shares into multiple shares of a smaller price. On the other hand, a bonus issue is a corporate action wherein a company gives additional shares to its existing shareholders at no extra cost.
A bonus issue is a method to reward shareholders whereas a stock split is done to increase share liquidity, reduce share price and make it more affordable for more investors.
In a bonus issue, the face value of the shares does not change. However, its face value reduces in the same ratio in a stock split.
Regulatory & Compliance Requirements of Bonus Issues
In India, all corporate actions are governed by the Companies Act of 2013. According to the act, a company can only issue bonus shares to its members out of its:
1. Free reserves
2. Securities premium account
3. Captial redemption reserve account
Given below are some of the mandatory requirements that a company should comply with to issue bonus shares:
The company shall capitalise its profits or reserves for the purposes of issuing fully paid-up bonus shares subject to the following [Section 63(2) and Regulation 293]:
Authorisation by the Articles of Association
Approval of its Shareholders/Members by passing a special resolution in a duly convened general meeting, basis recommendations of the Board
No default in payment of interest or principal in respect of fixed deposits or debt securities so issued
No default in payment of statutory dues of the employees, such as, contribution to provident fund, gratuity and bonus
Make all the outstanding partly-paid-up shares on the date of allotment as fully paid-up
None of its promoters or directors is a fugitive economic offender.
The company shall abstain from withdrawing from the decision of its board recommending a bonus issue if it has been announced. (Rule 14)
The Issuer Company shall implement the bonus issue:
Within fifteen days from the date of the board meeting where shareholders’ approval is not required for capitalization of profits or reserves for making the bonus issue
Within two months from the date of the board meeting where shareholders’ approval is required for capitalization of profits or reserves for making the bonus issue. (Regulation 295)
You can read more about the regulatory and compliance requirements related to bonus issues here.
Tax Implications of Bonus Issues
In bonus issues, the shareholders receive additional shares at zero cost. However, bonus shares are subject to capital gains tax when sold. The cost of acquisition or purchase price of the bonus shares will be ₹0 as it is free. Bonus shares are subject to capital gains tax.
For example, assume you are holding 100 shares of a company that you had bought at ₹100 per share. After a 1:1 bonus issue, you will receive 100 additional shares, taking the total number of shares held to 200.
No. of shares originally held
100
Bonus Ratio
1:1
Total number of shares post-bonus
200
Purchase price of original shares
₹100
Let us assume that you sell 100 shares at ₹150 before 1 year (short-term capital gain). The taxable short-term capital gain would be;
Selling Price (100 x 150)
₹15,000
Cost of Acquisition (100 x 100)
(₹10,000)
Capital gain on sale of original shares
₹5,000
A short-term capital gain tax of ₹750 (i.e. 15% of ₹5,000) is payable.
Now you sell the remaining 100 shares (bonus shares) within the same year at ₹150. The taxable short-term capital gain would be:
Selling price (100 x 150)
₹15,000
Cost of Acquisition (100 x 0)
(₹0)
Capital gain on sale of bonus shares
₹15,000
A short-term capital gain tax of ₹2,250 (i.e. 15% of ₹15,000) is payable.
In conclusion, bonus issues are a popular corporate action used by companies to reward shareholders, enhance share liquidity, and capitalise profits. It doesn’t change the total value of your investment, but it can affect the share price temporarily. It is also crucial to be aware of the tax implications of bonus issues.
When companies wish to raise funds, they usually opt for an initial public offering (IPO) or debt issue (via bonds or debentures). But these are not the only viable options! They can also approach existing shareholders for additional funds through a method known as Rights Issue. In this article, we will explain what a rights issue is, its purpose, and how it works. Let’s also understand why companies opt for a rights issue compared to other options, its advantages and disadvantages.
Rights Issue: Explained
A rights issue is a method by which companies raise equity capital from their existing shareholders. This issue provides existing shareholders with securities known as rights. Rights give its holders an option to buy additional shares in the company at a discount. The holders can choose whether to exercise the right. Right is not an obligation to buy shares, but a mere option. Therefore, rights are valued similarly to how options are valued.
Additionally, a rights holder can sell the rights shares via the open market. There are two types of rights: renounceable and non-renounceable rights. If the rights are renounceable, you can sell them on the market like any other security.
The difference between a rights issue and fresh issues or offers for sale (OFS) is that rights issues do not dilute the ownership of existing shareholders.
What is the Purpose of a Rights Issue?
The primary reason for a rights issue is to raise money. It is a method of raising equity capital. The proceeds from the issue will fund various financial initiatives of a company, such as servicing or reducing debt, funding new projects, or simply increasing their cash reserves.
Why Do Companies Opt for Rights Issues?
Compared to other methods, a company may opt for rights issues mainly to retain control and ownership. Issuing new equity shares will dilute the ownership of the existing shares. Dilution occurs because a rights offering spreads a company’s net profit over a larger number of shares. Thus, the company’s earnings per share (EPS) decreases as the allocated earnings result in share dilution.
Before raising new capital from outsiders and diluting the existing shares, a company provides its existing shareholders (including promoters) the opportunity to participate in the capital raising. Therefore, this type of issue is more favourable to the existing shareholders.
Dilution of ownership will also reduce the voting rights of the current shareholders, especially promoters. The discount offered will compensate the investors for the ownership dilution.
How do Rights Issues Work?
Here’s a step-by-step explanation of how a rights issue typically works:
1. Rights Issue Announcement
Before announcing, the company’s board of directors have to approve the decision to raise capital through a rights issue. The number of shares to be issued and the price at which they will be offered is calculated. The price will be at a discount to the current market price. Once all the procedures are completed and the compliance requirements are satisfied, the company will announce the right issue. The announcement will be through various channels such as a regulatory filing with the exchanges, email, and other forms of media.
The issue will also be guaranteed or underwritten by underwriters.
Legal Requirements to Issue Rights
In India, companies are governed as per the Companies Act. Section 62 of the Companies Act, 2013, relates to the ‘further issue of share capital’ and lays down the regulatory or legal framework for rights issues. You can read about the legal requirements here.
2. Declaration of Record Date
The company will establish a record date. Only the shareholders that hold the company’s share on the record date will be eligible for the rights issue. If you own shares before this date, you’ll generally receive rights based on your existing ownership.
3. Issuance of Rights
On the specified date, the company issues rights to existing shareholders based on their current holdings. Each right represents the opportunity to buy a certain number of new shares at a discounted price.
4. Trading of Rights
If the rights are renounceable, they can be traded in a secondary market. The period during which these rights can be traded is known as the “rights trading period.” Shareholders who may not wish to buy more shares can sell their rights to other investors interested in acquiring the discounted shares.
5. Decision by Shareholders
Shareholders have the option to do one of the following during the rights issue:
Exercise Rights: Shareholders can use their rights to buy new shares at a discounted price. This maintains their ownership stake in the company, preventing dilution.
Sell Rights: Shareholders can sell their rights to other investors. This allows those investors to buy the discounted shares.
Do Nothing: Shareholders who neither exercise nor sell their rights may let them expire. This results in the dilution of their ownership stake.
6. Proceeds to the Company
The company collects funds from shareholders who choose to exercise their rights. These funds are used for the intended purpose, such as debt repayment, expansion, or other corporate initiatives.
7. New Share Issue
After the rights issue period concludes, the company issues new shares to those shareholders who exercise their rights. The number of new shares issued corresponds to the total rights exercised.
8. Ownership Changes
Shareholders who exercise their rights will not be subject to an ownership dilution. Shareholders who did not participate in the rights issue will experience dilution of their ownership stake as a result of the new shares issued.
What Happens When a Company Announces a Rights Issue?
A rights issue increases the number of shares in the market. This will reduce the company’s Debt-to-Equity ratio as there is an increase in equity. This makes it availing additional debt easier for the company.
More importantly, the Earnings Per Share (EPS) of the company reduces. EPS is essentially the profit generated by the company for each of its equity shares. It is calculated by dividing the net profit attributable to equity shareholders by the weighted average number of equity shares for the year. A reduction in the EPS is unfavourable.
Terms in Rights Offering
Rights Issue Ratio
A rights issue ratio specifies how many new shares a shareholder is entitled to purchase or subscribe to for each share they currently own. It determines the proportion of new shares that existing shareholders can acquire.
For example, a 1:10 rights issue means that an existing shareholder can buy 1 share for every 10 shares currently held.
Subscription Price
The subscription price refers to the price at which existing shareholders can purchase additional shares as part of the rights offering. It is also known as the exercise price and offer price.
What is an Ex-Rights Date?
The ex-rights date is the date on which the shares of the company begin trading without the attached rights to purchase additional shares at the discounted subscription price.
How to Subscribe to a Rights Issue?
When you are an existing shareholder on the record date, you get Rights Entitlement (RE) shares in your account. The RE will be in the form of temporary Demat securities that will expire if not used for the application or sold. If you do not wish to avail it, you can either usually sell the RE shares in the secondary market, or let it lapse.
To apply for a rights issue, shareholders can use the Applications Supported by Blocked Amount (ASBA) process if their bank supports it. It is very similar to applying for an IPO.
Alternatively, the company’s Registrar and Transfer Agent (RTA) will send a Composite Application Form (CAF) via courier to those who cannot apply online. The filled form can be submitted at a Self-Certified Syndicate Bank (SCSB) branch. The forms can also be downloaded from the BSE and NSE websites.
Advantages & Disadvantages of Rights Issue
Advantages
Disadvantages
Prevents ownership dilution of existing shareholders (if the right is exercised)
This may result in concentrated investor positions compared to those who didn’t exercise the right
It shows the company’s commitment to its existing shareholders
Additional required filings and procedures associated with the rights offering
A quick way to raise equity capital
Can only raise limited capital
Example of Rights Issue and Outcome
In 2020, Reliance Industries Ltd (RIL) announced a rights issue to raise capital for reducing debt and funding its ambitious expansion plans, particularly in the digital and retail sectors. The company issued one right share for every 15 shares held by existing shareholders. The subscription price was ₹1,257 per share, which was significantly lower than the market price at that time.
For instance, if an investor held 150 shares of Reliance Industries before the rights issue, they were entitled to purchase 10 additional shares at ₹1,257 each. This opportunity allowed existing shareholders to increase their stake in the company at a discounted rate.
The rights issue was part of RIL’s broader strategy to become a global digital and retail powerhouse. The offering was a massive success, receiving overwhelming participation from existing shareholders and even attracting interest from institutional investors. The proceeds from the rights issue, which amounted to around ₹53,124 crore, provided RIL with the financial strength to continue its ambitious growth initiatives.
