How to Evaluate Banking Stocks

It is said that the banking sector reflects the economy's health. The sector acts as a funnel providing the funds that corporates need to expand their business. When the economy is expanding, as is happening in India currently, banks lend more and hence profit more. Since a bank's business model is different from that of a manufacturing company, the way you go about analysing banking stocks is also different.

A bank's basic business is to accept deposits and give out loans. It makes money by charging a higher rate of interest on its loans than the rate it pays its depositors. This difference in interest rates is called 'spread'. The money that a bank earns from its deposit-taking and lending activities is referred to as 'net interest income'.

In addition, banks also earn money by offering a variety of services (say, distributing mutual fund and insurance products, offering wealth management services, and many more) for which they charge a fee. They also make money by buying and selling debt securities (referred to as their treasury operations). The money they earn by these means is reflected in their profit and loss statement under 'other income'.

The Reserve Bank of India (RBI), the regulator for the banking sector, imposes certain prudential norms on banks. For instance, it requires banks to maintain a certain percentage of their deposits with RBI as cash reserve ratio (CRR). Whenever there is too much liquidity within the system and inflation threatens to go out of control, the central bank announces a CRR hike. This reduces the amount of funds available with banks for lending. This is referred to as sucking liquidity out of the system. But since banks earn no interest on their CRR deposits, a hike in the CRR rate affects their profitability adversely.

RBI's prudential norms also require Indian banks to invest a part of their funds in government securities (G-Secs). These holdings are referred to as statutory liquidity ratio or SLR holdings.

And finally, given their importance to the system, banks can not be allowed to run short of liquidity. So the central bank runs an overnight liquidity window for them. Whenever banks need money for the short term, they borrow from the central bank at what is known as the repo rate. And when they have excess money, they deposit it with the central bank at a rate known as the reverse repo rate. These act as benchmark rates for short-term interest rates in the system.

Managing risk
Banks manage three types of risk: credit risk, liquidity risk, and interest-rate risk.

Credit risk. This is the core risk that banks run. To get an idea of how a bank is faring on this count, look at the trend of gross and net non-performing assets (NPAs) over a long period of time. Also keep track of a bank's capital adequacy ratio (CAR, which is capital that banks maintain to be able to absorb losses on their activities). When a bank's NPAs increase and its CAR falls below the stipulated level, it signifies a looming crisis.

To mitigate credit risk, banks try to diversify their loan portfolios. They do so either by making varied types of loans (so that a high proportion of their loans don't go bad at the same time) or by buying and selling loan portfolios from other players.

Another method by which banks safeguard themselves against credit risk is by employing sophisticated credit approval systems and processes to reduce default. A conservative approach to lending may lower earnings but usually works in a bank's favour over the long haul.

Liquidity. Banks are also expected to provide liquidity management services. For instance, there could be a company that is due to receive a large payment from a client in a few days but is in urgent need of money now. It can go to a bank, sell its receivables to it at a discount, and get immediate cash in return.

Many businesses also pay a regular fee to a bank to avail of overdraft facility.

All this makes it necessary for banks to have sufficient liquidity to be able to meet the demands made on them. Hence the prudential norms (such as CAR) that are imposed on them and the overnight lending window provided by RBI.

Interest-rate risk. The third major risk that banks face is interest-rate risk. Most people think that higher rates are good for banks and lower rates are bad. This is an oversimplification. The effect of interest-rate movements depends on whether at a given point of time a bank is asset sensitive or liability sensitive. Asset sensitivity means that the bank can change the interest rate on assets like loans more quickly than the interest rate on liabilities. In such a case, rising interest rates translate into greater profitability for the bank.

When a bank can change its deposit rates more quickly than its loan rates, it is said to be liability sensitive. In such a scenario, rising interest rates will hurt its margins. Interest-rate swaps are used nowadays by banks to mitigate the impact of interest-rate fluctuation.

In a rising rate scenario, as interest rates reach high levels, it becomes difficult for banks to raise their loan rates further and hence their net interest margin (NIM) begins to get compressed. In such a scenario, banks with a high CASA ratio (proportion of total deposits accounted for by low-cost current and savings accounts) tend to do well because of their access to low-cost deposits. When analysing a banking stock, pay heed to its CASA ratio. Banks with a large branch network have a higher CASA ratio.

Economic moats in banking
One of the biggest deterrents that prevent more players from entering the banking industry is the tough regulatory requirements that all banks are supposed to comply with. In India, in any case, bank licenses are given out by RBI only from time to time and after much due diligence.

Banking is also a capital-intensive business; hence not too many players can enter it.

Economies of scale also give greater muscle to a bank. A State Bank of India (SBI) or a Citibank (internationally) enjoys scale-based advantages that are difficult for smaller players to match.

A large branch network, as mentioned earlier, is another key advantage. Punjab National Bank's (PNB) large branch network in north and central India gives it access to low-cost deposits that is hard for smaller players to match.

Going by the numbers
Capital base. In case of Indian banks, check their credit to deposit ratio (CDR). This ratio indicates the funds lent out of the total amount raised through deposits. A higher ratio indicates more optimal utilisation of funds. Check the bank's CDR vis-à-vis the industry range.

Next, look at a bank's capital adequacy ratio (CAR). The RBI has stipulated that the minimum capital adequacy ratio should be 10. This ratio ensures that banks do not expand their business without having an adequate buffer of capital.

Tier I capital + Tier II capital
CAR = ---------------------------------
Risk-weighted assets

Keep an eye on the reserve provisions made for bad loans relative to non-performing assets (NPAs). Net NPA ratio is a measure of the overall quality of the bank's loan book. A higher ratio reflects rising incidence of bad loans.

Net non-performing assets
Net NPA ratio = ---------------------------------
Loans given

Profitability. Return on equity (RoE) and Return on Assets (RoA) are the standard metrics for checking a bank's profitability.

A red flag should go up in your mind if a bank's RoE or RoA shows excessive deviation from that of its peer set. It is easy for a bank to boost its earnings in the short term by under provisioning for bad loans or by leveraging the balance sheet. This increases the risk over the long term. The recent financial crisis in the US is an example of all that can go wrong when excess leverage is employed by financial institutions.

Net profits
ROA = ---------------
Avg. total assets

Efficiency ratio. Check the operating profit margin of the bank you are evaluating. If a bank is able to keep its expenses under check, that is a positive sign.

Operating profit for banks is calculated after deducting administrative expenses (which include salary cost and network expansion cost) from its net interest income.

Net interest income (NII) - operating expenses
OPM = ---------------------------------------------
Total interest income

Controlling overheads is critical. This can be done through branch rationalisation and technology upgradation. The cost to income ratio indicates how good a job a bank is doing at controlling costs:

Operating expenses
Cost to income ratio = ---------------------------
NII + non interest income

Net interest margin. Net interest margin (NIM) is the net interest income as a percentage of average earning assets. It shows how profitable a bank's lending and deposit-taking activities are. Keep a tab on the long-term trend in a bank's NIM.

Interest income - Interest expenses
NIM = ------------------------
Average earning assets

Price-to-book. This is the key measure of valuation for banking stocks. Compare the bank's current P/B with its historical P/B levels (say median for past three years). Also compare it with that of its peers. This will tell you how expensive its valuation is.

Courtesy: VROL

How new tax code affects individuals

What does the proposed Direct Taxes Code hold for the common man? A look at visible effects and implications of the proposals on our monies.

The draft of the Direct Taxes Code bill 2009 and the Discussion paper have been made public recently. In the words of the finance minister "the thrust of the code is to improve the efficiency and equity of our tax system by eliminating distortions in the tax structure, introducing moderate levels of taxation and expanding the tax base".

A very valuable input from the finance minister has been "It will specially meet the aspirations of our young and professionally mobile population. So what exactly is all the excitement about and will it really "change" things as they are?

What does it say about income tax rates?

The most remarkable point which would be a great cheer for all individuals is the revision in the income tax rates. The change is not only in terms of the slabs but also the simplicity in calculations. The Code proposes to create 4 slabs for the sake of income tax calculations.

For Men

Slab 1: Total income is lesser than Rs 160,000

The income tax for the above slab is proposed to be nil. This is what currently exists and hence does not in any way change anything for individuals earning below 160,000.

Slab 2: Income is between 160,001 and Rs 10,00,000

This is the most drastic change proposed. The tax for the above slab is proposed to be 10 percent of the amount by which the total income exceeds 1, 60,000. Meaning, if your income is 572,000/- then, the income tax would be 10% of (Rs 572,000-Rs 160,000). Although for individuals who were earlier earning between Rs 160,000 and Rs 300,000 this does not bring about any change, it brings great cheer for individuals earning between Rs 300,000 and Rs 500,000 as they straight away save 10% of any income that exceeds Rs 300,000, but is lesser than Rs 500,000. Today they have to pay 20% on this amount!

For individuals who are today earning above Rs 500,000, this would bring even more cheer as they save a flat Rs 20,000,plus 20% of any amount above Rs 500,000 and lesser than Rs 1,000,000!

Example: Ram's income today is Rs 7 00,000

Income tax as per present rates = Rs 118,450 (excluding surcharges and any cess)

Income if new code comes into effect = Rs 54,000, a saving of Rs 61000

Slab 3: Income is between Rs 10,00,001 and Rs 25,00,000

The code proposes the income tax for this slab to be Rs 84,000 (10% of 840,000) plus 20% of any amount above Rs 10,00,001 but lesser than Rs 25,00,000. This would also bring about happy tidings for people who are currently earning above Rs 1,000,000 as they save around Rs 100,000 plus 10 per cent of any income which exceeds 10,00,000.

Slab 4: Income exceeds Rs 25,00,000

The code proposes the income tax for this slab to be Rs 384,000 plus 30% of any amount exceeding Rs 25,00,000. People currently earning above 25,00,000 would expect savings of over 40% of their current tax liabilities.

Away with 'assessment and previous year'

The new code has proposed to do away with the concept of using 'previous year' to denote the year in which you earned the money and 'assessment year' the year in which you pay the self assessment tax and file your return.

The new proposal is to use the simpler terminology of Financial Year (FY). For example if you earned income in FY09-10 then, your pay advance tax in FY09-10 and any balance tax and returns in FY10-11.

Source of income defined:

The income is proposed to be bifurcated into 'special sources' and ordinary sources. The special sources include items like lotteries, games and non residents etc which will be charged on the basis of a rate schedule.

Thus while calculating the total income we will have to add total income from ordinary sources and total income from special sources.

Source based versus Residence based taxation:

Source based taxation is a process in which the income tax is calculated on the basis of the source of income whereas residence based taxation calculates income on the basis that individuals are taxable in the country or tax jurisdiction in which they are residing.

The debate has been for long on which methodology to use. The new code proposes to use residence based taxation for residents and source based taxation for non-residents.

It states 'a resident in India will be liable to tax on his worldwide income and a non-resident will be liable to tax in India only in respect of receipts in India'.

What this means is that if you have been out of India for more than 183 days you would be treated as a non-resident and you need not pay tax on income which has already been taxed in the country where you get the income from and also if it's not taxed there.

But, in case of residents the income which has not been taxed in another country will be taxed in India upon repatriation.

Capital gains

The new code proposes two important ideas.

The concept of long term and short-term defined by the period of holding of a capital asset will be removed.

Instead, for any capital asset which is transferred, to get a gain, anytime after one year from the end of the financial year in which it was acquired, the cost of acquisition and cost of improvement wil be adjusted on the basis of cost inflation index to reduce the inflationary gains?

The base date for calculation of cost of acquisition of a capital asset has been proposed to be shifted from 01-01-1981 to 01-04-2000. This would be a big disadvantage to people who had brought the assets very long ago.

The reason is that you would have brought it for very low prices but the capital gains will be calculated based on the price of the asset on 01-04-2000.

The above discussions are some of the very visible proposed changes in the Direct Taxes Code which would affect individuals. The idea behind the whole exercise is for the public to give their feedback regarding their views before the discussion document is presented to the parliament.

If you have any comments/suggestions you could mail to the IT department at: directtaxescode-rev@nic.in and hopefully the finance minister might consider it important to be a part of the new code!

- BankBazaar.com

Mirage In The Markets

There are 2 opposing sentiments that need to play out in world stock markets in general. The bulls believe that the world is returning to ‘normal’, while the bears believe that the world can still come to an end. At the moment, the bulls have an upper hand, but I have certain behavioural indicators that suggest that the bears may have a point. You can’t increase global Money Supply by an estimated 25 per cent, take the Fiscal Deficit to 12-15 per cent in major countries, and not increase inflationary expectations. Ignore this at your own peril….

So, then what explains the rally so far? Call it the return of ‘animal spirits’, people who have just got tired of waiting, and who don’t know what to do with their freshly-earned cash; maybe the stimulus money waiting to go somewhere. Or just late-stage momentum…? The return of the stock market ‘tipster services’, the revival of brokerages and the quick resurgence of day-traders tells me that this is a late-stage bull rally already, with little change by way of fundamentals. That would suggest that market (volatility) risk has gone up dramatically.

Let us look at how fundamentals have changed since 2007. First, the Asian savings glut. China is no longer buying US Treasuries, and the US Current Account Deficit has halved (to $400 bn). So the supply of limitless liquidity with low inflationary expectations has gone; it has been temporarily replaced by the promise of Government Fiscal Stimulus, which will fuel inflationary expectations if they actually happen. Governments are already working hard at promising Bond markets that these funds will never be let loose, otherwise the world is headed for a 1971-like inflationary shock. Look at what the G8 just said; no further talk about pumping cash, but some pious statements about how to pull them back in, once things return to normal.

If China is no longer there to drive down Treasury yields, who subscribes to those US Bonds at the margin? The US citizen now has a 5 per cent savings rate, but he expects inflation at 3-5 per cent, which means T-bills go at 7 per cent. That is above the historical average, in the middle of the worst recession since 1929. Hardly the stuff that promises recovery…!!! More important, if the supply of T-bills continue, it could fuel inflationary expectations, driving the US into a hyperinflation loop with a Dollar collapse.

The DXY Index is falling, despite a halving of the Current Account Deficit. That suggests capital flight, and we can see where the money is going: to commodities (like oil) and Emerging Markets, especially those who are seen as ‘commodity currencies’ like Brazil and now Russia. India, one of the beneficiaries of low oil prices, could see one of the false rallies, as oil prices go back up, the Current Account Deficit balloons and its invisibles account sees a dip because of the weakening purchasing power of the Dollar (which reduces IT flows).

A key threat to the Dollar’s destiny is the Bond market’s view on the $12 tn (83 per cent of GDP) that the US Fed has committed. The Fed now has to convince the Bond markets that this money will never be released, else there will be a run on the Dollar. This is the key theme running through currency markets just now. Contrarians are punting on the possibility of the Fed actually raising rates just now (even with 9+ per cent unemployment) to get back some Dollar strength. If the dam breaks on the other side, it may be impossible to retrieve Dollar credibility. Will the Fed do it? Let us look at what happens if it doesn’t. You will have a clear bubble in oil, even with falling demand. This will anyway fuel inflation and affect growth, puncturing the famous India story, for example. It will also push global stagflation, hardly the stuff recoveries are made up of.

Why should you worry about Dollar weakness? A desperate Euro, with 9.6 per cent unemployment and 2 sovereign defaults within its community, is trading at a 2-Sigma high (it has been higher only 5 per cent of the last 5 years). Does this look normal?

The traditional formula of increasing Money Supply only works till people feel that money is valuable. At some inflexion point, if people lose that faith, you become a Zimbabwe. This is called Rational Expectations Theory, and is the exception to the Keynesian “pay money to dig holes” prescription for coming out of a recession.

There is a point at which you need to focus on building the credibility of the currency, like Paul Volcker did when he triggered the 1987 recession with 14 per cent government bond rates, but clearly stood on the side of a ‘strong Dollar’. This credibility was subsequently destroyed by Greenspan. Maybe the cycle has to repeat itself….

So is there a genuine demand-led recovery anywhere in the world, which needs to be discounted in its stock markets? I can’t see it anywhere, despite the specious media arguments that ‘we are an exception’. This is no different from the ‘India Shining’, ‘India Decoupled’ and ‘India Great’ arguments, where a cricketing victory has been seen as indirect evidence of future Indian greatness, justifying a bull market.

The property market is even more ridiculous, mainly because more people have property than have shares. This last property boom-bust was larger, more widespread and deeper than ever before. Why would the cycle be shorter than ever before? It normally takes 3 years to run out inventory; this time, if anything, it should take longer because of weaker incomes and lesser availability of good credit.

This bull market is more the creation of the mutual fund industry and the media than anything else I have ever seen. If you can trade your way out of this shallow and artificial ‘bull run’, go for it. If you have the courage and the skills, get in with a trader’s eye, and ride a big spike in stock prices that could leave you richer but unhappier than before. A trader’s life is not a good one, because you have to learn to live with losses.

Most retail investors lose money to the markets. Japan, Korea and Taiwan, even China have seen huge economic growth, but volatility in the stock markets has never created wealth for its citizens, just as Las Vegas has never made the gamblers rich. Long-term wealth in stock markets is created for the retail investor only by good companies that grow without volatility, like the “FERA companies” created wealth for our parents through a generation of bonuses and dividend payouts. Remember Colgate and HLL? The difference is made by Corporate Governance and a culture of sharing with minority investors, not the absolute amount of profits generated. This is missing in Asian companies, but thankfully, we have some honourable Indian exceptions (like the Tatas, Infosys and Bharti).

Warren Buffet has fed the notion that long-term investors in general make money. This is not true, unless you have the skills and perspicacity of Buffet. With the exception of GE, no company has lasted long enough to make sustainable money for its investors. Yes, markets may appreciate over the long term, so investors who invest in Index Funds might make money, but not buy-and-sleep investors who invest in cos.

If you think this rally is for real, you are making a mistake and should get out as soon as possible. If you lost money in 2007-08, then history is not on your side….

- ValueResearchOnLine

Calculation of Financial Ratios

EBITDA

Profit/(loss) before depreciation, amortisation and write-downs

EBITDA, % of net sales

EBITDA x 100
Net sales

Operating profit/(loss) before goodwill amortisation (EBITA)

Operating profit/(loss) before goodwill amortisation

Operating profit/(loss) before goodwill amortisation (EBITA), % of net sales

Operating profit/(loss) before goodwill amortisation x 100
Net sales

Profit/ (loss) before taxes, % of net sales

Profit /(loss) before taxes ² x 100
Net sales

Return on equity, % (ROE)

Profit/(loss) for the period ³ x 100
Equity (on average)⁴

Return on capital employed, % (ROCE)

Profit/(loss) before taxes ⁵ +interest charges and other financial costs x 100
Balance sheet total less interest-free debt (on average)

Return on net assets, % (RONA)

Operating profit/loss + goodwill amortisation_______________________________________x 100
Fixed assets⁶ – less goodwill + inventory + short-term receivables less short-term interest-free debt (on average)

Equity ratio, %

Equity ⁷ _____________________________________ x 100
Balance sheet total less received advance payments

Capital expenditure

The acquisition cost of tangible and intangible assets and investments belonging to the fixed assets including receivables from granted loans counted as fixed assets (not including corporate acquisitions)

Capital expenditure, % of net sales

Capital expenditure x 100
Capital expenditure

Capital expenditure

R&D costs x 100
Net sales

Gearing, %

Interest-bearing debt less cash and cash equivalents x 100
Equity⁸

Interest-bearing net debts

Interest-bearing debt less cash and cash equivalents
² FAS: Profit/(loss) before extraordinary items
³ FAS: Profit/(loss) before extraordinary items less taxes
⁴ FAS: Equity + minority interest (on average)
⁵ FAS: Profit/(loss) before extraordinary items
⁶ IFRS: Non-current assets less deferred tax assets
⁷ FAS: Equity + minority interest8 FAS: Equity + minority interest

- Salcomp

Free Cash Flow: Free, But Not Always Easy

The best things in life are free, and the same holds true for cash flow. Smart investors love companies that produce plenty of free cash flow (FCF). It signals a company's ability to pay debt, pay dividends, buy back stock and facilitate the growth of business - all important undertakings from an investor's perspective. However, while free cash flow is a great gauge of corporate health, it does have its limits and is not immune to accounting trickery.

What Is Free Cash Flow?
By establishing how much cash a company has after paying its bills for ongoing activities and growth, FCF is a measure that aims to cut through the arbitrariness and "guesstimations" involved in reported earnings. Regardless of whether a cash outlay is counted as an expense in the calculation of income or turned into an asset on the balance sheet, free cash flow tracks the money.

To calculate FCF, make a beeline for the company's cash flow statement and balance sheet. There you will find the item cash flow from operations (also referred to as "operating cash"). From this number subtract estimated capital expenditure required for current operations:

Cash Flow From Operations (Operating Cash) - Capital Expenditure --------------------------- = Free Cash Flow

To do it another way, grab the income statement and balance sheet. Start with net income and add back charges for depreciation and amortization. Make an additional adjustment for changes in working capital, which is done by subtracting current liabilities from current assets. Then subtract capital expenditure, or spending on plants and equipment:

Net income + Depreciation/Amortization - Change in Working Capital - Capital Expenditure ---------------------------- = Free Cash Flow

It might seem odd to add back depreciation/amortization since it accounts for capital spending. The reasoning behind the adjustment, however, is that free cash flow is meant to measure money being spent right now, not transactions that happened in the past. This makes FCF a useful instrument for identifying growing companies with high up-front costs, which may eat into earnings now but have the potential to pay off later.

What Does Free Cash Flow Indicate?
Growing free cash flows are frequently a prelude to increased earnings. Companies that experience surging FCF - due to revenue growth, efficiency improvements, cost reductions, share buy backs, dividend distributions or debt elimination - can reward investors tomorrow. That is why many in the investment community cherish FCF as a measure of value. When a firm's share price is low and free cash flow is on the rise, the odds are good that earnings and share value will soon be on the up.

By contrast, shrinking FCF signals trouble ahead. In the absence of decent free cash flow, companies are unable to sustain earnings growth. An insufficient FCF for earnings growth can force a company to boost its debt levels. Even worse, a company without enough FCF may not have the liquidity to stay in business.

Is Free Cash Flow Foolproof?
Although it provides a wealth of valuable information that investors really appreciate, FCF is not infallible. Crafty companies still have leeway when it comes to accounting sleight of hand.

Without a regulatory standard for determining FCF, investors often disagree on exactly which items should and should not be treated as capital expenditures. Investors must therefore keep an eye on companies with high levels of FCF to see if these companies are under-reporting capital expenditure and R&D. Companies can also temporarily boost FCF by stretching out their payments, tightening payment collection policies and depleting inventories. These activities diminish current liabilities and changes to working capital. But the impacts are likely to be temporary.

The Trick of Hiding Receivables
Let's look at yet another example of FCF tomfoolery, which involves specious calculations of the current accounts receivable. When a company reports revenue, it records an account receivable, which represents cash that is yet to be received. The revenues then increase net income and cash from operations, but that increase is typically offset by an increase in current accounts receivable, which are then subtracted from cash from operations. When companies record their revenues as such, the net impact on cash from operations and free cash flow should be zero since no cash has been received.

What happens when a company decides to record the revenue, even though the cash will not be received within a year? This question is inspired by telecom equipment maker Nortel Networks' year 2000 financial statements. The receivable for a delayed cash settlement is therefore "non-current" and can get buried in another category like "other investments". Revenue then is still recorded and cash from operations increases, but no current account receivable is recorded to offset revenues. Thus, cash from operations and free cash flow enjoy a big but unjustified boost. Tricks like this one can be hard to catch.

Conclusion
Alas, finding an all-purpose tool for testing company fundamentals still proves elusive. Like all performance metrics, FCF has its limits. On the other hand, provided that investors keep their guard up, free cash flow is a very good place to start hunting.

- Investopedia

Taxing Times

If you claim to be a smart investor, then you cannot view your investment solely on the basis of the return it can generate. You have to simultaneously check out the tax implications of that investment.

Is it an avenue that will help you save tax like the Public Provident Fund (PPF) or an Equity Linked Savings Scheme (ELSS)? Would you have to pay tax on the interest earned (fixed deposit) or is it tax free (PPF)? Would dividends be taxed or not? Would you be taxed if you made a profit on a sale (stocks, mutual funds or real estate)?

An investment made may seem fantastic, like a fixed deposit with an absolutely great interest rate. But since the interest earned is taxed, the yield drops. And, if you fall in the highest tax bracket, that is going to be your tax impact. All of a sudden, the investment sucks!

What we have done here is look at the tax implication on all investments made in mutual funds.

Where the tax angle is concerned, there are just two categories to consider - equity and debt. This should avoid any sort of confusion. Schemes that invest 65 per cent or more of their entire corpus in domestic equity (shares of companies listed in stock exchanges in India) are termed as equity schemes. The rest fall into the debt category.

Before we move on, let's just talk of one set of funds called the asset allocation funds. These funds have the mandate to be totally flexible in their asset allocation. They can move all their assets into equity or totally exit it, all at the discretion of the fund manager or a mathematically computed programme that takes the call. This makes their tax computation a bit difficult. Hence it is only at the end of the year that one gets to know where these funds have invested and accordingly determine their tax status.

Another area where we do have some ambiguity is in the case of arbitrage funds, which are categorized as "Hybrid: Arbitrage". These funds take advantage of a price mismatch between the cash market and the futures market. But, the asset allocation may also move between equity and debt as in the case of UTI SPrEAD. The average debt allocation has been in the vicinity of 68 per cent while equity has been around 6 per cent (March 2008 - August 2008). As on August 31, 2008, UTI SPrEAD had an equity allocation of 10.56 per cent, while the corresponding figures for JM Arbitrage Advantage and SBI Arbitrage Opportunities were 71.48 per cent and 71 per cent, respectively. JP Morgan India Alpha states in its Offer Document that this arbitrage fund should be treated as a debt fund.

GETTING A FIX ON CAPITAL GAINS
When an investor sells an asset and makes a profit, it is termed as a capital gain (capital loss should the reverse hold). This asset could be anything - home, land, stocks, mutual funds, fixed return instruments like fixed deposits, bonds and debentures, and even gold. The tax levied on this profit is called the capital gains tax.

Depending on how long you held the asset, it is broken up into Long Term Capital Gains (LTCG) and Short Term Capital Gains (STCG).

Where all mutual funds are concerned, LTCG comes into play if you sell your units after 12 months of holding. But, if you sell them within a year of buying, then STCG is applicable.

Equity
Where all equity mutual funds are concerned, the deal is identical for an individual or corporate.

The LTCG is not taxed. That's right, it is nil. So if you sell your shares or units of your equity fund after a holding period of a year, you pay absolutely no tax on the gain.But if you sell it before a year, then the STCG tax is 16.99 per cent. This includes the capital gains tax rate as well as the surcharge and cess (15%+10%+3%).

Debt
If you sell your debt fund before a year of holding, STCG comes into play. If you sell it after a year, then LTCG is relevant.

The good aspect with LTCG is that the income tax authorities give you the option to include the benefit of indexation. Indexation is the process by which inflation is taken into account when doing the tax calculation. This is excellent because it reduces the amount of capital gains and consequently the amount you end up paying as tax.

ARE DIVIDENDS TAXED?
There seems to be a lot of confusion concerning the Dividend Distribution Tax (DDT). It is a tax imposed only on the Asset Management Company (AMC) and not on the investor. However, the AMC will deduct the dividend tax from the money that will eventually go to the investors. So it's the investor that loses out in the end, not the AMC.

MAKING THE RIGHT CHOICE
Let's look at a basic dilemma facing investors: Is a growth option more viable or a dividend one? After looking at the tax implications, which one is the better option?

To answer this query, we will have to assume two scenarios, one where the investment is done for a period of less than 12 months, and the other for more than a year. This will enable us to better understand the short- and long-term capital gains impact.

Types of Equity Funds
Diversified: Funds that invest in Indian equity across sectors and market cap.
ELSS: Tax-saving funds that have a 3-year mandatory lock-in period.
Index: Such portfolios replicate the relevant index constituents. It also includes Exchange Traded Funds (ETFs).
Sector: Funds with a focus on a particular sector - FMCG, banking, auto, media, healthcare & pharma, technology, power.
Thematic: Focus on a theme like infrastructure.
Hybrid: Only the equity oriented ones.
Fund of Funds: Those funds that invest in the schemes of the other funds.

Types of Debt Funds
Medium Term: The maturity profile of the portfolio is more than 3 years.
Short Term: The maturity profile ranges from 1-3 years .
Ultra Short Term: Also termed as liquid funds, the maturity profile is less than 1 year.
Liquid Plus: 30% - 50% of the assets are in debt securities of maturity greater than 1 year, the balance maturity is less than a year.
Gilt: Short Term: The funds invest in government securities (G-Secs) with a maturity profile of less than 3 years.
Gilt: Medium-Long Term: G-Secs with a maturity profile greater than 3 years.
Floating Rate Short Term: Portfolio with floating rate debt instruments tilted towards short-term maturity.
Floating Rate Long Term: Portfolio with floating rate debt instruments tilted towards long-term maturity.
Hybrid: Those with an equity allocation of less than 65%.
Gold ETFs: Exchange Traded Funds take exposure to physical gold.
MIPs: With a max. equity exposure of 15%, their portfolio consists of bonds, CP, CDs, G-Secs and T-Bills.
International Funds: They invest in foreign equity, not domestic.
Fund of Funds: Those that invest in funds abroad do not fulfill the criteria of investing in domestic equity. FMPs:Fixed Maturity Plans are close-ended income schemes that invest in debt and money market instruments maturing in line with the tenure of the scheme.

IS AN STP WORTH IT?
In a Systematic Transfer Plan (STP), a fixed amount is switched from one scheme to another at regular intervals. In effect, it works out to be a combination of a Systematic Withdrawal Plan (SWP) and a Systematic Investment Plan (SIP).

A SWP is one where the mutual fund allows you to redeem units at regular intervals. A SIP, on the other hand, allows you to buy units periodically. Both the dates, and the amount to be withdrawn or invested, will be predetermined.

So how would a STP work? Let's say an investor puts a lump sum amount in a debt scheme. He then instructs the mutual fund to transfer a small amount from this debt scheme to an equity scheme every single month at a particular date. So it is a SWP from the debt fund but a SIP into the equity one.

Since the STP works on the principle of redemption and fresh investment, the tax implication would be same as capital gains (short-term or long-term) on the redemption of equity or debt funds.

WHAT IS THE STT?
The Securities Transaction Tax (STT) is levied on the value of a transaction. So when you redeem your units in an equity fund (not debt) or switch them to another scheme, STT of 0.25 per cent will be applicable.

- ValueResearch

Declaration, Ex-dividend And Record Date Defined

Have the workings of dividends and dividend distributions mystified you too? Chances are it's not the concept of dividends that confuses you; the ex-dividend date and date of record are the tricky factors. In this article we'll sort through the dividend payment process and explain on what date the buyer of the stock gets to keep the dividend.

Before we explain how it all works, let's go over some of the basics to ensure we have the proper foundation to understand the more complex issues. Some investment terms are thrown around more often than Frisbees on a hot summer day, so it's important that we define exactly what we're talking about.

Different Types of Dividends
The decision to distribute a dividend is made by a company's board of directors. There is nothing requiring a company to pay a dividend, even if the company has paid dividends in the past. However, many investors view a steady dividend history as an important indicator of a good investment, so most companies are reluctant to reduce or stop their dividend payments. (For more information on buying dividend paying stocks, see the articles How Dividends Work for Investors and The Importance of Dividends.)

Dividends can be paid in various different forms, but there are two major categories: cash and stock. The most popular are cash dividends. This is money paid to stockholders, normally out of the corporation's current earnings or accumulated profits.

For example, suppose you own 100 shares of Cory's Brewing Company (ticker: CBC). Cory has made record sales this year thanks to an unusually high demand for his unique peach flavored beer. The company therefore decides to share some of this good fortune with the stockholders and declares a dividend of $0.10 per share. This means that you will receive a check from Cory's Brewing Company for $10.00 ($0.10*100). In practice, companies that pay dividends usually do so on a regular basis of four times a year. A one-time dividend such as the one we just described is referred to as an extra dividend.

The stock dividend, the second most common dividend paying method, pays additional shares rather than cash. Suppose that Cory's Brewing Company wishes to issue a dividend but doesn't have the necessary cash available to pay everyone. He does, however, have enough Treasury stock to meet the requirements of the dividend payout. So instead of paying cash, Cory decides to issue a dividend of 0.05 new shares of CBC for every existing one. This means that you will receive five shares of CBC for every 100 shares that you own. If any fractional shares are left over, the dividend is paid as cash (because stocks can't trade fractionally).

Another type of dividend is the property dividend, but it is used rarely. This type of allocation is a physical transfer of a tangible asset from the company to the investors. For instance, if Cory's Brewing Company was still insistent on paying out dividends but didn't have enough Treasury stock or enough money to pay out all investors, the company could look for something physical (property) to distribute. In this case, Cory might decide that his unique peach beer would be the best substitute, so he could distribute a couple of six-packs to all the shareholders.

The Important Dates of a Dividend
There are four major dates in the process of a company paying dividends:

• Declaration date– This is the date on which the board of directors announces to shareholders and the market as a whole that the company will pay a dividend.
• Ex-date or Ex-dividend date– On (or after) this date the security trades without its dividend. If you buy a dividend paying stock one day before the ex-dividend you will still get the dividend, but if you buy on the ex-dividend date, you won't get the dividend. Conversely, if you want to sell a stock and still receive a dividend that has been declared you need to sell on (or after) the ex-dividend day. The ex-date is the second business day before the date of record.
• Date of record– This is the date on which the company looks at its records to see who the shareholders of the company are. An investor must be listed as a holder of record to ensure the right of a dividend payout.
• Date of payment (payable date) – This is the date the company mails out the dividend to the holder of record. This date is generally a week or more after the date of record so that the company has sufficient time to ensure that it accurately pays all those who are entitled.

Why All These Dates?
Ex-dividend dates are used to make sure dividend checks go to the right people. In today's market, settlement of stocks is a T+3 process, which means that when you buy a stock, it takes three days from the transaction date (T) for the change to be entered into the company's record books.

As mentioned, if you are not in the company's record books on the date of record, you won't receive the dividend payment. To ensure that you are in the record books, you need to buy the stock at least three business days before the date of record, which also happens to be the day before the ex-dividend date.



As you can see by the diagram above, if you buy on the ex-dividend date (Tuesday), which is only two business days before the date of record, you will not receive the dividend because your name will not appear in the company's record books until Friday. If you want to buy the stock and receive the dividend, you need to buy it on Monday. (When the stock is trading with the dividend the term cum dividend is used). But, if you want to sell the stock and still receive the dividend, you need to sell on or after Tuesday the 6th.

*Note: Different rules apply if the dividend is 25% or greater of the value of the security. In this case, the Financial Industry Regulatory Authority (FINRA) indicates that the ex-date is the first business day following the payable date. For further details on dividend issues, search FINRA's website.

A Money Machine?
Now that we understand that a dividend can be received by purchasing the stock before the ex-date, can we make more money? Nope, it's not that easy. Remember, everybody knows when the dividend is going to be paid, and the market sees the dividend payout as a time when the company is giving out a part of its profits (reducing its cash). So the price of the stock will drop approximately by the amount of the dividend on the ex-dividend date. The word "approximately" is crucial here. Due to tax considerations and other happenings in the market, the actual drop in price may be slightly different. In any case, the point is that you can't make free profits on the ex-dividend date.

Conclusion
The reasons for and effects of all these dates are by no means easy to grasp. It's important to clear up any confusion between ex-dividend and record dates. But always keep in mind that when you're investing in a dividend paying stock, it's more crucial to consider the quality of the company than the date on which you buy in.

- Investopedia