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The Speciality Economic Knowledge

Study programme


July 2015 Session



Chapter 1. Overview of financial management 8
1.1. Concept of financial management 8
1.2. Objectives of financial management 9
1.3. Functions of financial manager 11

Chapter 2. Capital flows of the enterprise 14

2.1. Financial flows of the enterprise 14
2.2. Equity capital 15
2.3. Debt capital 18

Chapter 3. Information Asymmetry 20

3.1. Efficient market hypothesis 20
3.2. Asymmetric information: moral hazard and adverse selection 22
3.3. Agency theory 23
3.4. Signalling theory 25

Chapter 4. General aspects on corporate financial decisions 27
Chapter 5. Corporate investment decision 30
5.1. Cash flow estimation 30
5.2. Discount-based choice criteria used for making investment decisions in a
certain environment 36

Chapter 6. Corporate financing decision 40

6.1. Equity cost 40

6.2. Medium and long-term debt costs 46
6.3. Corporate capital costs 50
6.4. Corporate capital structure 52

Chapter 7. Fundamental considerations on dividends and

dividend decisions 53
7.1. General considerations on dividends 53
7.2. Forms of dividend allocation applied by companies 55
7.3. Dividend decision practices 58



Chapter 1. Overview of the Financial System 62
1.1. Function of the financial markets 62
1.2. Structure of the financial markets 63
1.3. Financial markets instruments 64

Chapter 2. What is Money? 65

2.1. Meaning of money 65
2.2. Measuring money 66
2.3. Functions of money 66

Chapter 3. Fundamentals of Credit Activity 68

3.1. Basic concepts 68
3.2. Types of credit 71
3.3. The Romanian legal framework related to credit activity 80

Chapter 4. The Credit Analysis 81

4.1. Basic concepts 81
4.2. Main elements of the credit analysis 82
4.3. Credit scoring 85
Chapter 5. Banks and Bank Management 88

5.1. Bank balance sheets 88

5.2. T-accounts 91
5.3. Areas of bank management 93

Chapter 6. Central Banks and Tools of Monetary Policy 95

6.1. Introducing the Federal Reserve 95
6.2. Structure of the Fed 96
6.3. Tools of monetary policy 97

Chapter 7. Banking and the Management of Financial Institutions 98
7.1.The bank balance sheet 98
7.2.Basic banking 100
7.3.General principles of bank management 101
7.4.Managing credit risk 104

Chapter 8. Economic analysis of financial regulation 107

8.1.Asymmetric information and financial regulation 108
8.2.The single banking market in Europe 115


Chapter 1. General Consolidated Budget and Public Treasury 118
Chapter 2. State Loans and Public Debt 126

Chapter 3. The tax system 137
3.1. General considerations of the concept 137
3.2. Tax, the basic structure of the tax system 138
3.3. Methods and techniques of taxation 139
Chapter 4. Taxes and fees 140

4.1. Tax on Profit 140
4.2. Income Tax 147
4.3. Tax on Buildings 149



Chapter 1: Basics of Analysis 153

1.1. Definition and types of analysis 153
1.2. The main concepts used in economic-financial analysis 156
1.3. Influence factors 156
1.4. Financial statements 157
1.5. Statement of accumulation margins 160
1.6. Techniques and tools of analysis 161

Chapter 2: Financial Position Analysis 167

2.1. Financial Balance Sheet 167
2.2. Asset structure analysis 171
2.3. Financial structure analysis 174
2.4. Static financial balance analysis 177

Chapter 3: Output Analysis 182

3.1. Sales (turnover) analysis 182
3.2. Value added analysis 186

Chapter 4: Expenses Analysis 188

Chapter 5: Profitability analysis 192



Chapter 1. The need for insurance and insurance concept 196
Chapter 2. The functions and role of insurance 198
Chapter 3. Classification of insurance 199
Chapter 4. Insurance on the international markets of the
worldwide level 204
Chapter 5. The mandatory elements of the insurance contract 208
5.1. The interest of insurance 208
5.2. The object and the risk insured 209
5.3. The sum insured and the insurance premium 210
5.4. The damage and compensation (claim) 212

Chapter 6. Underwriting the insurance agreement 213

Chapter 7. The rights and obligations of the insured and insurer 215
Chapter 8. Cessation of insurance agreement 217
Chapter .9. Terms and concepts used in security portfolio
management 219

9.1. Saving 219

9.2. Investment 219
9.3. Financial market 220
9.4. Financial security 221
9.5. Income (gain) 221
9.6. Risk 222
9.7. Securities portfolio and its diversification 223
9.8. Stock indices 223

Chapter 10. Actual typology of the securities portfolio management 224

10.1.Active management 224
10.2. Passive management 224
10.3. Third way: focused investment 224

Chapter 11. Markowitz model 225



Chapter 12. Sharpe model 227
Chapter 13. Efficient market theory (E. Fama) 229
Chapter 14. Investment and portfolio management Buffet model 230
14.1.Market principle: business evaluation and intrinsic value update 230
14.2. Financial principle: added economic value or not? 230
14.3. Managerial principle: how managers are evaluated? 231

Chapter 15. Investments' mathematics 232

15.1. General consideration regarding probabilities theory 232
15.2. Probability subjective interpretation 232
15.3. Kelly optimization model 233
15.4. Probability's theory and the focused investor's market 233

Chapter 16. Investment psychology 234

16.1. Behavioural finances 234
16.2. Risk tolerance 237

Chapter 17. International investments 239

17.1. Foreign investments 239
17.2. Multinational companies 242
17.3. Payments balance 243

Chapter 18. Portfolios performance evaluation 247

18.1.Financial securities performance 248
18.2. Risk 248
18.3. Performance criteria 248
18.4. Portfolios components evaluation 249





conf. univ. dr. Laura VASILESCU:


conf. univ. dr. Dorel BERCEANU:



Chapter 1. Overview of financial management

1.1. Concept of financial management

The concept of financial management represented in the specialty literature, the

subject of many definitions, complete or less
complete, which puts the organization and the financial mechanism at the center of the
management of company.
The term of management was imposed in the economic field after the 50 s of last
century, due to the work of James Burnham: "The Managerial Revolution", published in New
York, in 1941. Burnham expressed the idea that in any society, irrespective of the ideological,
legal and political regime need managers, if wants its economy to develop in innovative and
creative rhythm.
At the microeconomic level, general management sets the objectives and general
development strategy of a company, taking in consideration all components of a business
activity: production, sales, marketing, promotion and advertising, general administration. The
general management should establish also the internal company policies, such as sales policy,
pricing, costing, depreciation method, commercial policy, financing policy, etc.
So, the financial management is a subsystem of the general management of the
Financial management is a set of methods, techniques, instruments, actions on which
are based the financial decisions and regards the modalities of using capital in order to
obtain profit in the context of achieving organizational objectives, formulated by a corporate
Therefore, financial management is the science through which is developed a system
of communication between specialists in economic and financial fields (economists,
accountants, financial analysts, etc.) and top-managers by its own financial reporting system,
adapted to requirements for business management.
The purpose of financial management is to ensure the financial resources necessary
for business activity, their allocation and use efficiently, ensuring the patrimony security and
increasing of firm value. Through these activities the financial manager plays an active role
in formulating the business strategy and in the analysis and control process.
The evaluation of financial management can be made based on the analysis of its
prescriptive and descriptive components. Thus, the financial management prescribe the rules
which may improve the managerial decision process. It also helps the managers in achieving
the knowledge of how various economic issues may affect the companies and in adoption of
methods for understanding the economic consequences of managerial behavior (figure nr.
Finance is the lifeblood of business organization. Every company should maintain the
adequate amount of finance for running the business and also for achieving the goal of the
activity (profit). The business goal can be achieved only with the help of efficient

Hirschey, M, Pappas, J.L., Whigham, D., Managerial Economics, European Edition, The Dryden Press,
London, 1993, pg. 4.

management of finance. The importance of the financial management regards the following
A) Financial Planning
Financial management helps to determine the financial requirement of the business
and leads to take financial planning. Financial planning is an important part of the activity,
which helps to ensure the funds for development of an enterprise.
B) Acquisition of Funds
Financial management involves the acquisition of required finance to the company.
Acquiring needed funds play a major part of the financial management, which involve
possible source of finance at minimum cost.
C) Proper Use of Funds
Proper use and allocation of funds leads to improve the operational efficiency of the
business. When the finance manager uses the funds properly, they can reduce the cost of
capital and increase the value of the firm.
D) Financial Decision
Financial management helps to take proper financial decision in the business.
Financial decision will affect the entire business operation of the company because there is a
direct relationship with various department functions such as marketing, production, human
resources, etc.
E) Improve Profitability
Profitability of the activity depends on the effectiveness and proper utilization of
funds by the business. Financial management helps to improve the profitability position of
the company with the help of strong financial control devices such as budgetary control, ratio
analysis and cost-profit analysis.
F) Increase the Value of the Firm
Financial management is very important in the field of increasing the wealth of the
investors and the value of the firm. The ultimate aim of any business is to the increase of the
value of the firm and implicitly, the wealth of shareholders.
Only by achieving its aims through the financial management functions, the
companies can consolidate and expand their positions on national and international markets.

1.2. Objectives of financial management

In order to identify the basic objective of the company, and thus, of the financial
management there were developed several theories. The neoclassical economic theory has
identified the firm value maximization2.
So, the financial manager must plan the acquisition and use of financial funds in order
to maximize the value of the enterprise. The aspects that need to be considered concern the
sources and uses of funds:
business forecasting and planning activity: the financial manager must develop the
plans that will define the future position of the company;
financial and investment decisions, based on long-term plans, the financial manager
must collect the necessary capital to finance the company, to take decisions regarding the use
of funds;

Stancu, I., - Finane, Piee financiare i gestiunea portofoliului, Investiii reale i finanarea lor, Analiza i
gestiunea financiar a ntreprinderii, Ed. Economic, 2002, pp. 34

coordination and control; the financial manager must act in a coordinated manner
to the managers of other departments since all business decisions within a company have
financial implications;
interaction with capital markets, the financial manager should act on monetary and
capital markets to attract and placement of financial resources;
by administration of financial resources, the financial manager is also involved in
human resource management ensuring staff stability.
To maximize the company's value should not be considered only in relation to its
heritage but also with its future projects and activities. So the expected value of the firm is an
anticipated value, it takes into account the actual value correlated with expected future
This is the reason the value of the firm can not be separated from the quality of the
projects in which is involved its patrimony. As well, the assessment is sensitive to all
perceived risks likely to affect the future stability of expected results. These risks may be
caused by the characteristics of the firm or market developments.
Maximizing the value of the firm is dependent on the performance provided by the
firm's activities and the degree of control the risk of bankruptcy and financial risks, in
general. Should be considered also the external environment of the firm: financial markets,
government regulations, competition, global economic situation.
In this context, the financial management regards the planning, acquisition, use and
control of company funds, so as to ensure the growth (maximize) of its market value, with the
ultimate goal to create as much value for shareholders3.
In its original form, the goal of firm value maximization was expressed as the profit
maximization, which was considered the main source for increase the firm value. Profit
maximization is also the traditional and narrow approach, which aims at, maximizes the
profit of the firm.
The following important points are in support of the profit maximization objectives:
(1) Main aim of each business is earning profit;
(2) Profit is the parameter of the business operation;
(3) Profit reduces risk of the business;
(4) Profit is the main source of financing;
(5) Profitability meets the social needs also.
Objective of profit maximization presents some limits:
- the profit maximization model is static, it lacks the temporal dimension and the
financial decisions should reflect this temporal dimension;
- the problem of the definition of profit arises: Why should maximize the firm, mass
profit or rate of return?;
- this objective does not allow to take into account the risk associated with the
alternative decisions as long as two projects with revenues in the future may differ
significantly in their degree of risk;
- the objective of maximizing profit in the short term can lead to overexploitation of
initial capital (reducing of maintenance costs of equipment and other fixed assets) and the
lack of firms development (elimination of research and development costs) because these
activities do not conduct to immediate profit;
- profit maximization could creates immoral practices such as corrupt practice, unfair
trade practice, etc.

Finane transnaionale: decizia financiar n corporaia modern, Ed. All Beck,
Bucureti, 2003, pp. 166

These limits of profit maximization objective imposed to the financial decident to
consider the objective of shareholders wealth maximization. Wealth maximization is one of
the modern approaches, which involves latest innovations and improvements in the field of
the business.
Shareholders wealth is measured by the market value of shares held by shareholders,
ie the price at which the shares are traded on the stock market. So, the objective is translated
into practice by maximizing the price of the shares issued by the company as a result of
decisions taken.
The objective of shareholders wealth maximization has some advantages:
- it allows to determine the appropriateness of financial decisions. Thus, if a particular
decision will generate an increased market value of the shares of the company, then it is a
positive, appropriate decision;
- shareholders wealth maximization is an impersonal objective. Shareholders are free
to sell their shares on favorable terms and to reinvest the funds;
- enable the financial manager to consider the risk in decision-making and also the
period of time;
- wealth maximization provides efficient allocation of resources.
There are also, some unfavorable arguments for wealth maximization:
- wealth maximization could create ownership-management controversy;
- only the management team have certain benefits;
- wealth maximization can be activated only with the help of the profitable position of
the business.
It is recognized that in a competitive market economy, the management team should
have to act in a way that is closely linked to that of maximizing shareholder wealth. If
managers are moving away from this goal, they risk to lose their privileged positions by
buying the company by third parties ("hostile takeover") or after a struggle between
shareholders and managers.
As well, should be established the extent that the profit maximization leads to
maximization of share price. For this, should be analyzed the total profits compared with
earnings per share.
Maximizing the earnings per share contribute to the increase of shareholder value but
should be considered also other factors, among which:
- frequency of gains that dependent on the time value of investor funds;
- the degree of risk depends to a large extent on how it is funded company (own
resources or credits);
- dividend policy, the best dividend policy is the one that maximizes the firm's stock
Therefore, the financial strategy of firms should be based on the principle of "net
income per share" which combines a proper dividends policy with a rational debt policy and
a rational capitalization policy.

1.3. Functions of financial managers

In a company, the financial managers should perform the followings key functions:
a. planning;
b. financial decision-making;
c. financial analysis;
d. control of the firms activity.

a. Financial Planning
In other words, financial planning is the process of determining the financial
objectives, procedures and strategies, programs and policies and budgets to deal with the
activities related to financial decisions of an organization.
Financial planning (i.e. planning for financing, investment and dividend decision)
must confront with external environment (industry level and country level factors: inflation,
liquidity, taxation) and internal environment (organizational level factors).
The important tools for financial planning which helps in planning the financing and
investment decisions are the followings:
- Capitalization refers to planning of financing decision, which means estimation of
total fund requirement to run the company.
- Financial forecasting includes preparation of projected income statement, projected
balance sheet, etc.
- Budgeting includes preparation of budgets and installation of proper budgetary
control system.
Financial planning leads to implementation of financial decisions.

b. Financial decisions-making refer to financial decisions, such as:

- financing decision (procurement of fund),
- investment decision (utilization of fund);
- dividend decision (distribution of fund).
1. Financing decision (procurement of funds) is categorized into two parts:
- working capital financing;
- project financing (financing for long term investment decision).
Both category of financing decision require following three key points to take into
(i) Sources. A finance manager has to identify the various sources available to him
through which he can raise the fund. It is the financial system which facilitates financing
decision in identifying/procuring short-term as well as long-term sources of finance.
(ii) Sources mix: The financial manager has to decide the composition of each source
in total capital;
(iii) Cost and other consequences. While raising fund, a finance manager must take
into consideration the cost and other consequences associated with each source.
2. Investment decision (application of fund)
Investment decision is also categorized into two parts:
- working capital investment (i.e. investment in current asset);
- long term investment (i.e. investment in project decision).
Both categories of investment decisions require following three key points to take into
(i) Assets. A finance manager has to identify what are the various assets required to
maintain for functioning of concerned organization.
(ii) Assets mix. The finance manager has to decide the composition of each asset in
total assets.
(iii) Profitability. While investing funds, a finance manager must take into
consideration the profitability associated with each asset. Profitability means ability to earn
3. Dividend decision (distribution of fund)
A finance manager has to decide what percentage of profit he has to distribute as
dividend among shareholders and how much to retain for further requirement. This aspect of
financial management is dealt under dividend policy.

The three decisions (financing, investment and dividend) determine the value of the
firm for shareholders. Given the objective of maximizing the firm's value, should be
considered the optimum combination of three interdependent decisions. The decision to
invest in a project requires investment funding and the financing decision, in turn, influences
and is influenced by the dividend policy because the retained profits to finance the investment
will represent the dividends foregone by shareholders (figure 1).

Investment Dividends
A company would Financing If the company fails to raise
like to undertake a It will need to raise funds in sufficient funds from outside the
large number of order to take up these company, it would need to cut
profitable investment projects. dividends in order to increase
projects. internal funding.
Financing Investment
Dividends A lower level of available If external financing is restricted
A company wants to internal cash flows might through partially financing the
pay a large dividend force the company to seek dividend, the company might need to
to shareholders. extra funds via external postpone some of the investment
financing. projects.
Financing Dividends
Due to high cost of
A company has been The companys ability to pay
financing, the number of
using a higher level dividends in the fuure may be
attractive investment
of external funding. adversely affected.
projects might be reduced.

Figure 1. Correlations between the investment, financing and dividend decision

c. Financial Analysis
Financial analysis refers to study of financial aspects from different interested groups
(management, employee, government, suppliers, lenders, investors etc.) point of view. Ratio
Analysis, Cost-Volume-Profit, Cash Flow Analysis are popular tools for financial analysis
which in turn further helps in financial planning for subsequent periods.

d. Financial Control
Financial control refers to comparison of actual activities related to financial decisions
with planned activities. In other words, it is reviewing financial performances as per planning
schedule in order to meet the set financial objective.
Budgetary control system or variance analysis are some popular tools, which help in
controlling activities related to financial decisions.
Apart from above-mentioned categories of finance function, finance department is
also responsible for support services, such as:
- Finance department has to make available the fund to other functional departments
whenever they need money in time.
- Finance department under financing activity has to negotiate with the lenders to
acquire the fund at optimum cost.
- Finance department analyzes the evolutions on stock market as stock market prices
reflect the performance of company.
So, the role of financial management is to create a favorable action framework in
order to establish natural connections between the financial objectives of the company, its
market value, means and instruments used to measure its financial performance. These are

necessary because once the company's objectives have been identified, defined and evaluated,
the performances of the firm should be analyzed, monitored and controlled.

Capital flows of the enterprise
2.1. Financial flows of the enterprise

Companies are organizational entities with triple character: technical-productive,

economic and social, where take place economic phenomena and processes in order to
produce goods or provide services required by the market.
The enterprises appear as a complex of internal relationships between its own
organizational and functional structures and of external ones, with the business environment:
suppliers, customers, banks, public bodies.
The economic processes in the enterprises are the results of conscious acts - decisions
which aim, in particular, to maintain and develop markets, and the resulting outputs are
goods, services and money. Therefore, the decisions generate numerous flows which, by their
nature, can be:
Real flows that have a material substance (goods and services);
Financial flows - flows arising as counterparty to the real flows or related to the
capital formation and tax payment.
Therefore, the financial flows of the company, which is the main subject of the
financial implications of firm, can be4:
A. Autonomous (independent) flows;
B. Complementary to real flows.
In order to achieve its activitys object (products, services) and its purpose (profit),
the company has links with the capital market the production factors (suppliers, labor), the
consumer market, and the state as a public authority (figure 2).
A. Autonomous flows (independent) are generated by the link of firm with the capital
market and the state.
I. The beginning of a business activity is related to the capital, formation
respectively, to the links with capital markets. By issuing shares, bonds and accessing bank
loans or by capitalizing a part of the results obtained, the firms constitutes or increases the
capital. So, the capital is formed through autonomous financial flows from earlier
accumulation or from outside the company, flows that originate in the independent
production operations.
II. The second category of autonomous financial flows is related to obtaining and
sharing the profit of the firm. In this case, it is established a relationship between the
company and the state for the payment of the tax obligation and other fees and contributions
to the state, but also for the receipt of budgetary subsidies and certain exemptions from tax
payment to the state.
B. Complementary financial flows are generated by the link of firm with the
production factors and the consumer markets.
Once constituted, the capital of the firm is used through complementary financial
flows. First, it is created the link with production factors markets. On the basis of contracts,

Sichigea, N. (coordinator), Gestiunea financiar a ntreprinderii, Ed. Universitaria, Craiova, 2006, pp. 1

the suppliers deliver machinery, equipment, raw materials, energy to the enterprise and, in
turn, on certain dates, receive their price. Therefore, there is a duality of flows: a real flow of
goods and services toward firm and a complementary financial flow to suppliers. The two
flows of different natures and opposite are balanced at the negotiated price.
The firm also hires the employees that, in exchange for their labor receive salary in
cash. It is achieved the duality real flow complementary financial flow, with different
natures and opposite, which balance at the negotiated salary.
II. In the manufacturing process, after obtaining the products or the services, the firm
enters into relationship with the consumer market. In this case, the real flow of goods or
services is from the enterprise to customers and the complementary financial flow,
representing the negotiated price, appears from customers towards the firm.

Complementary flows

Payment of equipments
Production factors Consumer market
Raw materials

Payment for products

- suppliers - companies
- labour Payment of raw materials - individuals

Products, services


Autonomus (independent) flows

Capital market
Capital STATE
- shareholders Tax payment
- banks
- firms
Payment of dividends,
credits, interest State subsidies

Financial flows
Real flows

Figure 2. Financial flows of the enterprise5

Highlighting the numerous real and financial flows conducted by the enterprise
activity can be concluded that the company is at the core of business processes, as the basic
cell of the economy and is the main factor in ensuring an appropriate monetary circulation.

2.2. Equity capital

The capital is reflected in the company's balance sheet. The balance sheet presents a
snapshot of the firms assets and the source of the funds that were used to buy those assets
(liabilities) (figure 3).

Sichigea, N. (coordinator), op.cit., pp. 2

The assets are formed by non-current assets (intanglible assets, fixed assets, financial
assets) and current assets (inventory, receivable, short term investment, cash and equivalents)
and they are listed on the left-hand side of the balance sheet.
The liabilities includes: the equity capital and the debt capital (long term debt and
current debt) and they are listed on the right side of the balance sheet.
Assets Liabilities

Non-curent assets Equity capital

Current assets Debt capital

Fig. 3. Balance Sheet structure

The equity capital is formed by share capital and a complex component, Share
premium, capital reserves, retained earnings.
Share capital is the basis condition of setting up a business. Share capital may be
subscribed through cash and in-kind contributions of the shareholders or associates and
remain permanently in their property. Therefore, at the liquidation of the company they will
recover the funds invested from the remaining part after payment all the creditors. Anyway,
the recovery of invested capital before bankruptcy can be done by selling shares or equity
interests to other persons.
The setting up and circulation of the share capital differ depending on the legal form
of companies. Thus, according to Romanian law, companies can be in the following forms6:
general partnership;
limited partnership;
joint stock company;
limited joint stock company;
limited liability company.
General partnerships are characteristic for small companies with a sole or a limited
number of investors. The associates contribution to share capital consists of equity interest
and they have an unlimited and joint liability. This means that first, the creditors will try to
recover its obligations from the company, and only if the company does not pay later than 15
days from the date of notice, it will act against its associates. Regarding the capital mobility,
the capital does not move freely because the equity interests are not negotiable.
Limited partnerships are those companies that have two types of partners (associates):
general partners and limited partners. General partners bear unlimited and joint liability and
limited partners only within the subscribed capital. The contribution to share capital consists
of equity interest and therefore, the share capital does not move freely on the market.
Joint stock companies are established through full and simultaneous subscription of
capital by the signatories of the Articles of Incorporation or by public subscription. The share
capital is formed by shares. The number of shareholders in a joint stock company can not be
less than 2 and the company's share capital can not be less than 25,000 Euro. The
shareholders liabilities are limited up to the subscribed capital. The movement of capital on
the market is free and joint stock companies can be listed on the stock exchange which can
ensure increased mobility of capital.
Limited joint stock companies combine the features of limited partnership with joint
stock companies. Thus, the capital is formed by shares and there are two categories of

Law No.31/1990 on companies - republished in the Official Gazette no. 1066/17.11.2004, art. 2

shareholders: general and limited. The capital consists of shares and can not be less than
25,000 Euro.
Limited liability companies are in general small or medium-sized enterprises, the
associates can not be more than 50. Share capital of a limited liability company can not be
less than 200 lei and it is divided into equal equity interests, which may not be less than 10
lei. The associates liability is limited to the subscribed equity interest. The share capital does
not move freely on the market.
The main way of capital formation is the issue of shares.
Shares are securities evidencing the ownership of the holders to a part of the share
capital and they give them the right to collect an annual dividend based on the net profit of
firm and the proportion of distribution decided by the Company Shareholders General
The shares are considered long-term securities because they have no maturity date.
They are also considered variable-income securities because in general, the dividends are
Taking into consideration the shareholder rights, in Romania the shares can be:
ordinary shares (common shares), which ensures the right to vote in the Company
Shareholders General Assembly and the dividends received will be variable, depending on
the financial performance of the issuing company;
preferred shares with preferred dividend without voting rights give the right to a
priority dividend on distributed profits before any other deductions and the right to attend the
Company Shareholders General Assembly, except the right to vote.
The share capital of the firm is calculated as follows:

Cs = Na x Vn
Cs = share capital;
Na = number of issued shares;
Vn = face value of the share.
After the issue, the shares are valued according to the result of supply and demand in
the market; the transaction price can be higher, equal or less than the face value.
Share capital from the setting up of the company can be modified later, depending on
needs and financing policy.
The share capital can be increased through several processes:
a) the issue of new shares;
b) incorporation of reserves;
c) debt conversion.
a) The issue of new shares
According to the Romanian legislation, the issue of new shares may be done only at a
price more or equal with the face value. After issue of share, it will result a new share price
determined as follows7:

Na Cba n Pe
Cbn =
Na n
Cbn = the new share price;
Na = number of shares before issue;
Cba = share price before issue;

Giurc Vasilescu L., Finanele firmei. Prelegeri i studii de caz. Editura Universitaria, Craiova, 2009, pp. 19

n = number of new shares issued;
Pe = issue price for new shares.
The new issued shares are offered, primarily for subscription to existing shareholders
accordingly with the number of shares they hold and with their obligation to exercise the
preferential right of subscription in a period settled up by the Company Shareholders
General Assembly. After this period, if the existing shareholders did not make their choice,
the shares with be offered to public subscription.
The subscription right is a protection for the interests of existing shareholders and it
reflects the value loss of the former share and its holder will be rewarded with this in order to
not be affected by the increase of capital. The subscription right (ds) is calculated as follows:

(Cba Pe) n
ds = Cba Cbn =
Na n

Existing shareholders have a preferential right to purchase new shares issued by the
company, at the issue price if they have a number of subscription rights (Nds), determined as
ratio between the number of former shares (Na) and the new shares (n) as follows:

Nds =
b) Incorporation of reserves is a way of raising capital that does not affect the
financial structure, only the equity capital structure by increasing the share capital and
reducing the same amount of reserves. The legal reserve and share premium can not be
incorporated into share capital.
The increase of share capital by incorporation of reserves can be done by increasing
of face value of the existing shares or by increasing the number of shares8.
c) Debt conversion involves increasing the share capital by incorporation of debts.
The classical way of transforming debt into equity is the conversion of convertible bonds into
shares, based on a fixed conversion ratio established when this type of bond was issued.

2.3. Debt capital

The equity capital is often insufficient to cover the overall financing need of the
company and this is forced to turn to other means: issue of bonds, bank loans, trade payables
and other debts.
The corporate bond is a contractual agreement between the seller (company) and the
buyer of the bond to pay fixed amounts at regular intervals (interest and principal payments)
until a specified date (maturity date), when the final payment is made.
The seller of the bond is the borrower and the buyer of the bond is the lender.
Bonds are also called fixed-income securities because the interest is fixed.
The bonds are characterized by a number of technical elements:
face value/par value is the amount of money a holder will get back once a bond
bond's price is settled on the capital market. When a bond trades at a price above
the face value, it is said to be selling at a premium. When a bond sells below face value, it is
said to be selling at a discount;

Sichigea, N., Giurca Vasilescu, L., Berceanu, D., Florea, N. Gestiunea financiara a intreprinderii, Ed.
Universitaria, Craiova, 2013, pp. 36

interest (coupon) is calculated by applying the interest rate on the face value of the
bond and paid to the bondholder. Sometimes there are physical coupons on the bond to tear
off and redeem for interest;
Yield to Maturity (YTM) refers to the expected rate of return the bondholders will
receive if they hold a bond until maturity;
maturity date is the date in the future on which the debtholder's principal will be
Compared with the issue of shares, the issuance of bonds has advantages and some
disadvantages. The main element to make the distinction between the two securities is: stocks
are equity while bonds are debt. Therefore, unlike stocks, bonds do not give an ownership
right in the issuing corporation.
From the perspective of the issuer, bond loan does not affect the structure of
From the view of the bondholder, the bonds provide steady interest paid by the
company issuing the bond till the maturity, regardless its financial situation - unlike dividends
that depend directly proportional on the issuer's profit.
In case of bankruptcy of the issuing company, the debtholders are not affected to the
same extent as shareholders having the right to get the loan at par value. The shareholders
will get only the difference remaining after payment of all debts.
In terms of business management, the bondholders do not have voting rights while the
shareholders are entitled to vote at Company Shareholders General Assembly.
The bonds are issued by companies that need funding. The issuer of a bond is a
crucial factor to consider, as the issuer's financial stability is the main assurance of getting
paid back.
In Romania, in order to access the bond market, a firm must be a joint stock company
and to have activity for a minimum number of years (2-3 years) reflected in the balance sheet
approved by the shareholders and the amount of subscribed bonds should be full paid 9.
Besides, the bond issue is decided by the Company Shareholders General Assembly, as an
additional measure of protection against companies that do not provide all necessary
guarantees for repayment of the loan.
Bond issuance by public offer is based on a issuing prospectus that will contain
information regarding the name, activity, location and duration of the company, share capital
and reserves; categories of shares issued by the company, the total amount of bonds to be
issued and those that have been issued, how to refund the face value of the bonds, their
interest, bond type.
In Romania, the face value of a bond may not be less than 2.5 lei (0.5 Euro) and the
face value of bonds convertible into shares should be equal to the shares. Value of the
subscribed bonds will be fully underwritten paid.
In order to increase the attractiveness of bonds and eliminate risks of future income,
there is a diversification of these. Thus, on the market can be found a wide variety of bonds
with different features and interest payments, such as:
- Fixed-rate coupons. The most common form of corporate bond is one that has a
stated coupon that remains fixed throughout the bonds life. The payment amount is
calculated as a percentage of the par value, regardless of the purchase price or current market
- Floating-rate bond. The coupon on a floating-rate bond changes periodically in
relationship to a predetermined benchmark (changes in market interest rates).

Sichigea, N., Giurca Vasilescu, L., Berceanu, D., Florea, N. op. cit, , pp. 44

- Zero-coupon bonds is a type of bond that makes no coupon payments but instead is
issued at a considerable discount to par value.
- Income bonds - only the face value is promised; interest is paid only when the
enterprise's earnings can cover the cost.
- Convertible bonds entitle their holder to convert, within a specified time period, the
bond into a share at a parity set at the time of issue. In Romania, the issuance of convertible
bonds can be done only by companies that have at least two years of activity and two
approved balance sheets. Convertible bond issue shall be decided by the Company
Shareholders General Assembly as the existing shareholders waived their preferential
subscription right to shares in the future in favor of holders of convertible bonds.
Bank loans is the important mode of financing by the company when the equity
capital is not sufficient. The bank loans may be divided into two types:
(a) Long-Term loans (more than one year);
(b) Short-Term loans (less than one year).
Loan finance can be raised through the following important institutions: commercial
banks, development banks, other financial institutions.
Commercial Banks normally provide loans for period between 1 and 25 years at an
interest rate. Given the risks assumed by banks loans, the eligibility conditions for the firms
that obtain such financing are strict and based on a technical and economic documentation
and guarantees.
Presently the commercial banks are providing all kinds of financial services including
development-banking services. And also, nowadays development banks and specialized
financial institutions are providing all kinds of financial services including commercial
banking services. Diversified and global financial services are unavoidable to the present day

Information assimetry

3.1. Efficient market hypothesis

Modern financial theory was based almost exclusively a long time on the assumption
that financial markets are efficient and all investors are rational and well informed. The
concept of efficient financial market ("Efficient Market Hypothesis") introduced and
developed by Eugene Fama (1970)10 is based on the idea of integration in the share price of
all information related to the issuing company. Under these conditions, a decrease of the
share price of the issuing company certifies an improper activity and vice versa.
Because of these assumptions, no market investor can earn money by speculating
imbalances between share price and the real value of the share. Also, all market participants
will be properly informed and the shareholders will be convinced that managers will take
correct decisions. Taking in consideration these assumptions, the share price becomes a
useful variable for investors decisions and the company management can be controlled
continuously by a simple analysis of the share price evolution.
Efficient financial market can be defined as that market where no investor can obtain
abnormal gains sistematicaly. Even on the developed financial markets there is information

Fama, E., "Efficient Capital Markets: a Review of Theory and Empirical Work", Journal of Finance, 25, mai

asymmetry, the shareholders will not be characterized by the same level of information as the
managers. It is important these imbalances to not be speculated in order to obtain abnormal
returns relative to the market.
The components considered as prerequisites for the existence of an efficient financial
markets are: allocational efficiency, operational efficiency and informational efficiency11.
Allocational efficiency considers the financial market in a Pareto equilibrium - a state
in which it is impossible to increase the utility of an individual without reducing the welfare
of at least one other individual (Pareto optimal).
Operational efficiency is determined by the elements that characterize the market
participants (investors), such as the overall pricing rules, the role of intermediaries in this
market, etc. It is considered that the investor are characterized by rational behavior and have
homogeneous expectations (i.e. identical forecasting for financial indicators).
Informational efficiency implies that prices of financial securities includes any
available information instantly and completely.
According to Eugene Fama the financial market can be structured in three categories
of informational efficiency:
weak-form efficiency; in this case the share price incorporate all past information
regarding the share, but the price does not reflect the public information or privileged
information (known only to people within the company, managers and senior staff members).
The weak-form efficiency can be represented mathematically in the following form:

Pt = Pt-1 + Va + E
P t = current share price;
Pt-1 = former share price;
Va = expected income for the shares;
E = random error occurred in the interval (t-1; t) and that can have a positive or negative
influence on the share price;
semi-strong-form efficiency; in this case in the share price are incorporated all
information from the past related to the share but also the public information from the
strong-form efficiency; in this case in the share price are incorporated all the
information related to the share from the past and present, both public and privileged, known
only to people within the company.
The theory of efficient financial markets related to the existence of the three forms of
informational efficiency (weak, semi-strong and strong) is questionable and there are
differences of opinion among specialists on this issue, as follows:
it is considered unnecessary to use the information contained in previous prices of
shares to predict their future evolution because, in the case of the weak efficiency, the
information from the past are reflected in the current price of shares;
the high competition among financial investors increases informational efficiency
on the market and determine the decrease of arbitrage opportunities between price and
nominal value. Therefore, the securities prices will have unpredictable, random evolutions;
in order to ensure an efficient financial market, the investors should undertake a
rational evaluation of their shares based on fundamental data analysis. Therefore the share
price should reflect correctly the information from the market;

Dragot, V., Ciobanu, A.M., Obreja, L., Dragot, M. - Management financiar, vol. I, Ed. Economic, 2003,
Bucureti, pp. 67

other specialists (Robert Schiler, 1989) argue that effective financial market theory
fails to explain correct the behavior of the shares price on the market because it does not take
into account the personality of the investors. The random evolutions of the share prices would
be the effect of cyclical issues caused by subjective reasons from person to person, and he
considers that elements of social psychology should be considered in analysis of financial
Therefore, although the mechanical application of numerous models elaborated in
developed countries is a common practice, it is recommended to test the effectiveness of a
financial market as a priori condition for the application of most classical models12.

3.2. Asymmetric information: moral hazard and adverse selection

Information asymmetry concerns the study of decisions in transactions where one

party has more or better information than the others. Information asymmetry often occurs at
company level, but also at the level of investors who must choose between different ways of
investing their financial resources.
In general, the managers have priviledge information in relation to shareholders or
potential financial investors. The latter receive the necessary information with a delay and a
specific cost. In addition, certain information is against the interests of the shareholders,
which should wait for the Company Shareholders General Assembly to appeal the decision
of managers.
The information asymmetry is the cause for two categories of risk according to the
American economist K. Arrow13:
Moral hazard risk occurs when under certain circumstances, individuals will
modify their behaviour and take more risks. Moral hazard can appear if:
- there is information asymmetry and one party holds more information than another;
- a contract affects the behaviour of two different parts.
It as problem of moral hazard when a risk-taking party to a transaction knows more
about its intentions than the party paying the consequences of the risk. More broadly, moral
hazard occurs when the party with more information about its actions or intentions has a
tendency to behave inappropriately from the perspective of the party with less information.
Adverse selection risk occurs because of information asymetries and difficulties in
selecting customers, for instance when a product or service is selected by only a certain group
of people who offer the worst return for the company.
G. Akerlof published in 1970 the book "The Market for Lemons", introducing the first
formal analysis of a market with information difficulties and adverse selection.
The arguments of Akerlof result from market analysis of a product where the seller
has more information than the buyer about the quality of product, namely, second-hand car
market ("lemon" - old cars). The market for used cars is used as an example of the problem
of quality uncertainty. Due to imperfect information of buyers, the cars are found to be
defective only after they have been bought. Thus, the sellers of bad quality cars can remove
other competitors from the market.
In conclusion, Akerlof consider that information difficulties can lead either to the
collapse of entire market, or to its transformation by adverse selection, being chosen poor
quality products instead of quality ones.

Giurca Vasilescu, L., Managementul financiar al corporaiilor, Ed. Universitaria, Craiova, 2008, pp. 38
Arrow, K.J., Uncertainty and the Welfare Economics of Medical Care, American Economic Review, 53,
December 1963, pp. 941-973

The key problem is at the investors; they may have strong incentives to counteract the
adverse effects caused by assimetric information. In these circumstances, many market
institutions are interested to propose a solution to the problems caused by asymmetric
information offering different types of contracts.

3.3. Agency theory

The agency theory elaborated by M. Jensen and W. Meckling14 analyses the

consequences of the two categories of risk (moral hazard and adverse selection) on financing
decisions and their impact on firms value.
Agency theory brings significant clarification in financial theory addressing the
company problems not as collective actor with a single utility function (maximizing of
enterprise value), but as an assembly of partners and opponents, each with their own interests.
Agency theory intends to structure the contractual relationships between managers,
shareholders, creditors, employees, suppliers that are related to the company. These
relationships can generate conflicts of interest, but these should be harmonized in order to
maximize the enterprise value.
In these circumstances, the manager is no longer considered exclusively concerned
with the shareholders objectives, but maximizing their own utility function. The agency
theory consider the delegation of responsibilities within the company which is a specific
phenomenon in the contemporary world.
Thus, according to the theory of agent, the company is regarded as an organization
that develops a set of contractual relations: one or more persons (the principal) hires another
person (the agent) to do certain services on their behalf, which implies a delegation of
authority related to certain decisions.
For example, in corporations, the principals are the shareholders of a company,
delegating to the agent (i.e. the management of the company), to perform tasks on their
Agency theory assumes both the principal and the agent are motivated by self-
interest. Thus, agents are likely to pursue self-interested objectives that deviate and even
conflict with the goals of the principal. Yet, agents are supposed to act in the sole interest of
their principals.
The divergence of interest between principal and agent determines the existence of
three types of agency costs:
- the monitoring cost by the principal, to control the agent;
- the bonding costs by the agent to demonstrates that he is right in his action;
- the residual cost represented by the loss of value due to conflicts of interest.
From this perspective, the company structure is more complex, taking into account the
principal-agent conflicts and the attempts to minimize agency costs. The objective of agency
theory is therefore to ensure a structure of agency relations in order to minimize costs and
value losses.
The level of agency cost is given by the following function:

A(M*, b*, *,I0) = (V* - I*) - (V0 - I0 - M* - b*)


Jensen, M., Meckling, W. "Theory of the firm: managerial behaviour, agency costs and capital structure",
Journal of Financial Economics, 1976

M* = optimal level of monitoring costs;
b* = optimal level of bonding costs to justify their own activities, done by manager;
* = optimal weight of equity share in the company capital, held by the manager-owner;
I* = optimal level of investment made by the company to ensure its desired size;
V* = value of the company in condition the manager has the same level of non-pecuniary
advantages which characterized him before selling a portion of its capital;
Vo = market value paid by foreign investors in condition they retain the right to make
monitoring expenses of the manager activity;
Io = investment level in conditions the external investors keep the right to make expenses for
monitoring the manager activity.
The level of agency costs vary from company to company, depending on the
preferences of managers, the way they can achieve personal benefit despite maximizing the
firm value and the cost of monitoring and bonding. Also, agency costs depend on the
evaluation costs of manager performance, the costs generated by the implementation a correct
remuneration system and the costs of introducing a general policy, accepted by all agency
The level of bonding costs to justify their own activity by manager and the level of
monitoring cost by shareholders should not exceed a certain optimum level, their growth
beyond this level could not produce beneficial effects.
The agency cost is minimized when two particular statements are true:
- the principal and the agent share common interests. Essentially, this means that both
the principal and the agent desire the same outcome;
- the principal is knowledgeable about the consequences of the agents activities. In
other words, the principal knows whether their agents actions serve in the principals best
If either of these statements is false, it follows that agency cost is therefore, likely to
Some of the mechanisms that force managers to act in favor of the shareholders are
the followings:
- monitoring the manager activities and establish the procedures to be forced to
explain his decisions (i.e. the progress reports submitted to the Company Shareholders
General Assembly);
- threat of dismissal. Although less practiced in the past, it has become a way of action
for important companies to force managers to reconsider their decisions;
- threat of takeover - by buying shares when the share capital of the company is
undervalued compared to its potential, due to wrong decisions of the management team.
Following this acquisitions, the company managers are generally dismissed or lose their
autonomy. This measure determine the managers to be directly interested to maximize the
share price;
- structured managerial incentives. Increasingly more companies relate the
remuneration of managers to the firm performances. This provides motivation for managers
to take decisions in order to ensure increased share price.
It is assumed that all incentive plans (stimulents for managers, profit sharing,
efficiency wages, etc.) have two roles:
provide incentives for managers to use the factors they can control so as to
contribute to maximization of share price;
can ensure executives of the highest quality.
The model elaborated by Jensen and Meckling is considered a milestone in financial
theory. Thus, it becomes increasingly obvious that the major objective of company to
maximize the shareholder wealth must be completed by an effective control mechanism.

On the other hand, it should be understood that the company is a group of individuals, each
characterized by its own utility function.

3.4. Signalling theory

The risk of moral hazard is the main theme of a new generalist theory: the signalling
Originally appeared on the product market (Akerlof, 1970) and labor market (Arrow,
1972), signalling theory was further developed by M. Spence and then expanded in many
other fields of economy and finance.
The bases of the theory elaborated by Michael Spence are the "market signals"15
which are activities or attributes of individuals in a market that can modify ideas and
communicate information to other individuals in the market.
The models developed in the signalling theory start from the relationship, rather
contradictory, between managers - better informed - and shareholders or creditors - less
informed than first. The difference of information reffers to the performance of the firm,
investment projects or ability to face possible risks. Based on this asymmetry of information,
the better informed can take advantage from others. The problem that should be solved
consist in implementation of an balancing information system and stimulating managers to
communicate messages so the market can distinguish the real situation of companies.
In addition to the asymmetry of information may be associated the imperfect
information: the better informed will transmit more or less correct signals to the less informed
or uninformed.
Consequently, should be sent signals that allow to clearly distinguish performant
companies from the non-performant ones, signals that can not be copied by companies with
poor management, as follows:
a firm with profitable investment projects will be recognized by a high
participation of managers in their funding. They, being better informed on the new projects
performance, managers will be the first to invest in these projects. The managers of non-
performant company that do the same, could risk their own money for an investment with a
high degree of risk.
a solid enterprise is considered one that can afford a high leverage ratio and a high
share of short-term loans to finance ambitious investment projects. This firm will be able to
reimburse the debts and pay interest, maintaining the payment capacity. Copying this
financial structure by a non-performant company can lead even to bankruptcy.
a performant company is considered the firm which has a constant debt rate and a
high dividends rate. For these companies, the payment of dividends to shareholders does not
affect the financial balance. In contrast, in the case of non-performing companies, the
dividend payment can affect the treasury and determine a decrease of promised dividend,
which will affect the company's image.
It is necessary, therefore, a system of bonuses and penalties to determine the
managers of performant companies to send the correct signals and information which may
not be copied by managers of non-performant companies. It is necessary also a classification
system (rating) to delimitate the non-performant companies from the performant ones based
on indubitable signals (performance indicators).
The main applications of signal theory in finance were formulated by Stephen Ross16
and Sudipto Bhattacharya17.
Spence, A.M., "Job Market Signaling", Quarterly Journal of Economics Vol. 87, No. 3, 1973, pp. 355-374
Ross, S., The determination of financial structure: the incentive-signalling approach, Bell Journal of
Economics, Vol. 8, No.1, 1977, pp. 23-40

Stephen Ross (1977) states that the financial structure may be used to identify quality
companies operating in the market and to classify them according to their performance18.
The model developed by Ross estimate that an optimum level of financial structure of
the company depends on:
- weighting coefficients of company values at present moment, respectively on the
future, accordingly to the specific incentives scheme adopted by managers;
- the penalty for the manager if the company will get bankruptcy;
- the estimated value of the firm.
It can be noticed that the model takes into account the value of the penalty. This
penalty not represents the total level of bankruptcy costs, but only the part that will affect
directly the manager. Besides, the penalty can be seen from another point of view, the
manager will be penalized indirectly, because the important companies will refuse to hire a
manager with an inadequate level of performance.
The model eleaborated by Sudipto Bhattacharya (1979) presents a new signaling
mechanism of firm performance (future cash-flows) through dividends distributed as cash to
The assumptions underlying the model are the followings19:
foreign investors have incomplete information on the company's profitability. This
hypothesis is a prerequisite for any application of the theory of signal;
dividends distributed as cash are taxed at a higher rate than the "capital gains
(earnings rate from growth of exchange rate). This hypothesis defines dividend as a signal;
assets in the market have a longer life than life of agents who invest in these and the
ownership on the securities can be transferred to other investors.
The Bhattacharya's model ignores other sources of information for shareholders, as
the financial statements, due to problems of moral hazard induced by them.
Accordingly to Ross and Bhattacharyas theories, the distribution of dividends or
capital structure could be, a priori, good signals for evaluation the enterprise performance.
These events can be equally false signals that intend to create another image of the company,
other than a real one. For such cases or for preventing such possibilities, there should be a
penalty system for false signals.

References (selection)
Brealey, R., Myers, S., Allen, F., Principles of corporate finance. 11th ed. Boston, McGraw
Hill, 2013
Dragot, V., Ciobanu, A.M., Obreja, L., Dragot, M. - Management financiar, Ed.
Economic, Bucureti, 2003
Giurca Vasilescu, L., Managementul financiar al coporporaiilor, Ed. Universitaria, Craiova,
Ross, A.S., Westerfield, R.W., Bradford, J.D., Fundamentals of Corporate finance, 10th Ed.,
McGraw-Hill/Irwin, 2013
Sichigea, N., Giurca Vasilescu, L., Berceanu, D., Florea, N. Gestiunea financiara a
intreprinderii, Ed. Universitaria, Craiova, 2013
Stancu, I., - Finane, Piee financiare i gestiunea portofoliului, Investiii reale i finanarea
lor, Analiza i gestiunea financiar a ntreprinderii, Ed. Economic, 2002

Bhattacharya, S. - Imperfect Information, Dividend Policy, and "The Bird in the Hand" Fallacy, The Bell
Journal of Economics, Vol. 10, No. 1, 1979, pp. 259-270.
Dragot, V., Ciobanu, A.M., Obreja, L., Dragot, M. - op. cit., pp.. 82
idem , pp. 226




Therefore, financial management is carried out by means of financial decisions,

defined as conscious acts through which certain measures for the settlement of an issue are
decided or which involve the programming of future events20.
Hence, a financial decision becomes the fundamental act of financial management, as
the result of a rational process of consciously choosing, out of a range of possible
alternatives, a solution which is considered optimal at the level of financial activities and
The definition supports the idea that time is the basic criterion for decision making, in
accordance with the amplitude of risks. Financial decisions must be seen in relation to the
expectations of the various companies. Since companies are competing on the financial
market, the effect of financial decisions should satisfy above all the expectations of fund
bidders (shareholders and financial lenders). These expectations are measured in terms of
return and risk, the latter concepts representing the ultimate rationale of financial decisions.
At the same time, the effect of financial decisions should also respond to the expectations of
the companys staff, who claim a suitable compensation and result-based incentives for their
Financial decisions ultimately are the fundamental act of management. They should
meet the following requirements:
being scientifically supported;
being adopted at the proper hierarchical level;
being coordinated with the other decisions;
being timely adopted;
being drawn up in a precise, clear and concise manner.
According to their time horizon, financial decisions may be grouped into:
strategic decisions;
tactical decisions.
Strategic financial decisions envisage a more remote time horizon and outline the
framework the company will operate within. They aim at reinforcing and developing the
companys market position. Concretely speaking, strategic financial decisions refer to the
volume of investments to be performed, an enhanced output of assets, a quicker rotation
of current assets, the companys pricing policy, etc.
Tactical financial decisions are corrective decisions aiming at adjusting conjunctural
influences with a view to following the established strategy. Obviously, they are implemented
during the period, depending on the new conditions arising during the supply, manufacture or
sale process.
According to their nature, financial decisions are classified into:

A. Giurgiu., Mecanismul financiar al ntreprinztorului, Dacia, Cluj-Napoca, 1995, p.16

investment decisions;
financing decisions;
dividend decisions.
An investment decision is a capital spending decision resulting in the purchase or
construction of an asset with a view to obtaining additional future cash flow.
Investment decisions are considered major since they affect capitals for a long time.
Implying a significant capital payment in the hope of future profits, investment decisions
should be based on:
the extent of participation in the increase of total investment value (the net present
value of investment);
the recovery time of invested capital and, implicitly, the moment when net profits
begin to result from such investment;
an alternative analysis between the further operation of the investment, or
divestment and searching for another form of placement (applying the decision tree method).
Investments increase a companys value, which is why the decision lying at their basis
is a strategic decision. Therefore, investment is opposed to consumption, which implies a
decrease in wealth, a loss of value. An increase in a companys value shows that an
investment is profitable and that its return exceeds its financing costs.
Two components of the companys assets are obtained pursuant to an investment
a main component, represented by the three forms of fixed assets: intangible,
tangible and financial assets, which will represent the companys equipment for a relatively
long time;
a complementary, accessory component, including current assets (inventory,
accounts receivable and short-term obtainable values, cash) required for the cycles of
operations and financial activities. Though they have a quick rotation, their permanence at a
certain level is important for the proper operation of a companys financial mechanism and
involves quite an important part of its capital.
Besides investment decisions, a company may also adopt, at some times, divestment
A divestment decision is the decision to sell a part of the companys assets, including
available fixed (especially tangible) assets, which no longer find a use in the company.
The rationale of divestment decisions is the same one used for investment decisions,
i.e. increasing a companys value or, in other words, the shareholders wealth. Thus, the
liquidities obtained pursuant to divestment decisions should be placed in a more profitable
manner, either through reinvestment in the company with the purpose of developing more
effective or more strategically-oriented activities, or through external investments with a view
to financially participating in the formation and control of other companies capital, or by
returning them to capital contributors.
Therefore, divestment decisions should be made after an in-depth analysis, since a
range of certain, but underperforming cash flows are given up in exchange for uncertain, but
better performing cash flows of the new investment.
Financing decisions refer to how the companys assets are financed, i.e. the sources
of procurement of required capital. Actually, a financing decision considers the following
a choice of capital structure, i.e. the division of the companys financial resources
into equity and debt;
a choice between internal financing, i.e. self-financing and external financing,
through capitals from shareholders or financial creditors;
dividend decisions, i.e. the choice to reinvest or distribute net profit;

For this reason, financing decisions are strategic decisions as well, since they directly
influence a companys value and the efficiency of its activity.
Dividend decisions, closely connected to financing decisions, refer to the
managements choice regarding the partial or total reinvestment of net profits, or their partial
or total distribution as dividends.
Dividend decisions are determined by the investors propensity to collect dividends on
an annual basis. Although, theoretically, in the conditions of a perfect market, dividend
decisions do not affect a companys value, more recent studies have proven the favourable
effect of maintaining and perhaps increasing the distribution rate on shares, .e. the dividend
signalling effect. Recent theories such as agent theory have also shown the role of dividend
distribution in the mitigation of conflicts between shareholders and managers on the one hand
and shareholders-managers and creditors on the other hand.
Though contradictory, both destinations of net profits are beneficial for the
shareholders, since the first one finances corporate development, and the second compensates
In terms of corporate finance, the first and most important (through its implications)
is the investment decision. Since the financial market is not perfect, an investment decision
should be substantiated along with the financing decision. The choice between equity and/or
borrowed capital also depends on dividend decisions.21
Financial decisions at a microeconomic level and their interdependence can be
represented in a financial circuit22, as seen in figure 1.

1.Financing EQUITY
FIXED 2a.Investments
operations 2b.Divestment 4a.Self-financing
OPERATING 3.Operating cash Managers
Operations creditors

4b. Allocation
Note: Net operating assets, i.e. current assets less operating debt.

Fig.1. The Financial Circuit Model

The financial circuit shows cash flows resulting from the various financial decisions.
In a first phase (1), the entities possessing cash provide the company with the capital
required for the performance of investment operations. Capital is established when the capital
demand is confronted with the supply of cash possessors (shareholders, banks, individual
investors) on the financial market. To this purpose, the company issues securities which may

I. Stancu, Finane, Editura Economic, Bucharest, 2002, p. 549
N. Sichigea, M. Drcea, D. Berceanu .a., Gestiunea financiar a ntreprinderii - manual universitar,
Universitaria, Craiova, 2001, p. 24

be ownership titles (shares) or receivable titles. Capital collection operations are financing
operations, and financing is external in this case.
In the second phase (2a), the managers decide to invest their capital in fixed assets. In
this case, we are talking about a flow determined by investment operations. Subsequently, the
company may assign various fixed assets and receive, instead, a cash flow represented by this
divestment flow (2b).
Investments in industrial and commercial assets is made with a view to subsequently
achieving cash flows (3) from operations (supply, production, marketing) involving the
purchase or creation of operating assets (current asset inventory, accounts receivable, etc.).
Such assets are partly financed from trade loans from suppliers. The cash flows resulting
from operations are then completed by the flows determined by financial assets (securities,
shares, etc.) and divestment operations. All these, after corresponding tax deductions, are
used either for self-financing (4a), or for covering obligations to capital contributors: interest-
based compensation of loans; loan repayment; payment of dividends to shareholders or
associates (4b).
Therefore, in a limited, asymmetrical and onerous market, there is an interdependence
between investment decisions and financing decisions, since the option for investments
determines the level of financing capital and the necessity to find relevant sources, but, at the
same time, the amount of financing sources is decisive when making an investment decision.
Optimal financial management implies a correlation between the maturity of the source and
the lifetime of the asset acquired therewith, so that no source gap may occur.


5.1. Cash flow estimation

The effectiveness of an investment project is correctly appreciated if the cash flows it
determines are fairly assessed:

cash outflows;
cash inflows;
payment savings due to the companys taxation system.
In turn, they are assessed:

in the initial phase (project accomplishment);

during the operation of the investment;
at the end of the operation.

Cash flows in an initial phase

The amount to be invested (investment value) is determined in this phase,
considering the direct and indirect costs related to the investment project, as well as the tax-
related incidence on amounts resulting from divestment operations required by the
accomplishment of the project. Thus, for a given investment project, the amount to be
invested includes the following cash outflows:
the price of the purchased tools and construction materials, or their cost in case
they are obtained within the company;
expenses for the transport, assembly and commissioning of tools;

expenses generated by the accomplishment of the project: research, staff training
additional required capital, determined by an enhanced production capacity due to
the project accomplishment (increases in inventory, accounts receivable, etc.);
opportunity costs, i.e. the revenues the company would have obtained if otherwise
investing the capital required for the project;
the difference between collected amount and the net accounting value of assets
whose sale or disposal is imposed by the project performance; for a positive difference, the
concerned flow of liquidities will decrease the invested amount.
In case above mentioned expenses were incurred in the past, along several years,
which happens quite frequently since such investments in tangible assets require significant
financing, they should be capitalised so that their present value can be calculated.

Cash flows during the operation of the investment

If cash flows occurring during the initial phase are easier to estimate, being
determined by the prices and fees of equipment and services or depending on the increased
production capacity and turnover for the additional operating capital required, which is a
percent of the turnover, cash flows occurring during the operation of the investment, which
are typically cash inflows, are established based on provisions with a high degree of
Therefore, we shall aim at determining the cash flows generated by the investment
project, trying to forecast the future.
A significant element in cash flow estimation is the identification of relevant cash
flow, represented by the group of those cash flows that should be considered for that
decision. Two rules help financial analysts avoid mistakes: 23
the decisions lying at the basis of investment budgets should start from cash flows,
not from the accounting revenues;
only incremental (discrete) cash flows, i.e. cash flows generated by project
acceptance are relevant for the acceptance or rejection decision.

The concept of free cash flow is found in scientific literature. It is the most suitable
for the assessment of an investment project or, by extension, of a company. In the following
we shall simply call it net cash flow.
There are two possibilities to forecast the net cash flow of a certain investment
determining the net cash flow exclusively generated by the analysed investment
determining the net cash flow generated by the project as a difference between the
cash flow obtained for the entire company after the decision to accomplish the investment is
made and the net cash flow that would have been obtained for the entire company when the
analysed project had not been invested in.
In this latter case, we are dealing with a marginal net cash flow, calculated as
NetCFmarginal = NetCF with investment NetCF without investment (1)

P. Halpern, J. Weston, E. Brigham, Finane manageriale, Editura Economic, Bucharest, 1998, p. 448
V. Dragot .a., Management financiar, Vol. II, Politici financiare de ntreprindere, Editura Economic,
Bucharest, 2003, p. 51

The idea our analysis should be based on is that a companys main activity is the operating
activity; it only performs capital operations, i.e. investment or divestment combined with new
financing or repayment of already contracted debt on an accidental basis.
Thus, the first step in determining the cash flows generated by an investment project
(the concept may be extended at the companys level) is to understand its operating cash
flow (OperCF). From a financial point of view, it can be calculated as:
OperCF = EBIT + Amo - Tax (2)
EBIT = earnings before interest and taxes
Amo = expenses with the amortisation involved by the analysed investment project;
Imp = the income tax resulting from the operation of the investment project.
In order to obtain a frequently used formula of operating cash flow, we consider the
following connections:
EBITDA - Amo = EBIT (3)
EBIT - Int = EBT (4)
EBT Tax = NP (5)
EBITDA= earnings before interest, taxes, depreciation and amortisation;
EBT = earnings before taxes;
Int = expenses for interests generated by the financing of the investment project;
PN = the net income to be generated by the analysed investment project; in principle, it
is profit, but losses may occur at certain moments and, then, maybe the wider idea of
net earnings would be more accurate.
Substituting in formula (2), we obtain:
OperCF = EBT + Int +Amo - Tax =
= NP + Tax + Int + Amo Tax =
= NP + Int + Amo (6)
Operating cash flow should generally be positive. If a company has a negative
operating cash flow for a long time, it is going through difficult times, as it does not generate
enough cash to pay for operating expenses.
However, the accurate indicator of the value of an investment project is net cash flow,
available after covering the subsequent economic growth of the investment project.25 This
refers to the net increase of fixed assets (investments or capital expenses) and the increase or
decrease of net current assets (changes in net working capital).
NetCF = OperCF Economic growth (7)
or, considering formula (6), we obtain:
NetCF= NP + Int + Amo Economic growth (8)
NetCF = NP + Amo + Int FixedAssets NetCurrAssets (9)
In formula (9), the sum of net profit and amortisation is what accountants call cash
flow after interest and taxes26 (accounting cash flow).
When a company has a quick growth rate, investments in fixed assets and expenses
for net current assets can be higher than accounting cash flow plus interest and, then, a
negative net cash flow is obtained. Even though this can be normal in the companys
development phase, during the maturity phase, the achievement of negative net cash flow

I. Stancu, Finane, Ediia a treia, Editura Economic, Bucharest, 2002, p. 583
S. Ross, R. Westerfield, J. Jaffe, Corporate finance, Second Edition, Irwin, Homewood & Boston, 1990, p. 31

should be seen as an alarm signal, suggesting real problems in the companys management or
Therefore, a proper cash flow forecast is based on a good and realistic forecast of
each component
net profit;
variation of capital investment (gross fixed assets);
variation of net current assets
Net profit
Analysing formulae (3), (4) and (5) we obtain:
NP = EBITDA Amo Int - Tax (10)
or, since:
it results:
NP = T VE FE Amo Int - Tax (12)
T = the turnover of the investment project;
VE = the variable expenses generated by the investment project;
FE = the fixed expenses generated by the investment project;
Imp = income tax.
One should not overlook the significance of a proper turnover forecast and a rigorous
structuring and, hence, forecast of fixed and variable expenses, for the determination of cash
flow and, subsequently, the evaluation of the investment project.

According to regulations in force, assets may be reassessed depending on the
inflation. Under these conditions, forecasts on amortisation, described in real terms (constant
prices), may use currently considered values (i.e. not affected by inflation). In case forecasts
are made in nominal terms (current prices), the considered amortisation shall take price
changes into account.27
Interest expenses should be properly analysed, actually taking into account only the
interest generated by the debt contracted for financing the analysed project. In order to
establish the relation between the real interest rate, the nominal interest rate and the inflation
rate, Fishers ratio will be used, as follows:

Rn Ri
Rr (13)
1 Ri
Rn Ri Rr (1 Ri ) (14)

Rr = the real interest rate;
Rn = the nominal interest rate;
Ri = the annual inflation rate.

V. Dragot et al., Management financiar, Vol. II, Politici financiare de ntreprindere, Editura Economic,
Bucharest, 2003, p. 48

Income tax
It is forecasted applying current or predicted taxation rates, provided that relevant
information is available regarding its change in the foreseeable future, upon predicted taxable
Capital investments
Additional investments in fixed assets only consider the payments and, possibly, the
revenues related to the fixed assets implied by the investment project. They are determined
by summing up the variation of net fixed assets (calculated as a difference between fixed
assets predicted to exist in the balance sheet at the end of the year and those at the beginning
of the year) and the current year amortisation:
FixedAssets = NetFixedAssets + Amo = (FixedAssets1 - FixedAssets0) + Amo1 (15)

Changes (variations) in net current assets

The changes in net working capital represent the variations of net current assets
generated by the investment project and are equal to the variation of permanent capital, less
the variation of net fixed assets.
According to the legislation in force, net current assets are calculated as follows:
NetCurrAssets = CurrAssets + DefExp STD - DefRev (16)
CurrAssets= current assets;
STD= short-term debt (debt to be paid within one year, operating debt, current debt);
DefExp= deferred expenses (settlement assets);
DefRev= deferred revenues (settlement liabilities)
Since deferred expenses and deferred revenues are used for settlement, with a lower
share in the balance sheet structure and accidentally appearing in a companys activity, the
following formula shall be considered for a proper forecast:
NetCurrAssets = CurrAssets - STD (17)
NetCurrAssets = CurrAssets STD (18)
According to the balance sheet formula:
CurrAssets + NetFixedAssets = STD + MLTD + Eq (19)
CurrAssets - STD = MLTD + Eq - NetFixedAssets (20)
or, since the sum of equity and medium and long-term debt represents permanent capital, we
CurrAssets - STD = PermC - NetFixedAssets (21)
CurrAssets - STD = PermC - NetFixedAssets (22)
MLTD = long-term debt, i.e. debt to be paid within more than one year;
Eq = equity;
PermC = permanent capital;
The variation of net current assets is predicted by qualified staff in the production
department (in order to establish the level of inventories of required raw materials,
inventories of products in progress and fixed assets involved in the manufacture process), the
marketing department (in order to establish the inventories of finished product and accounts
receivable) or the financial department (in order to substantiate debt).
The total net cash flow resulting from the investment project should compensate the
capital investors of such project (creditors and shareholders), so that it may be separated
cash flow payable to creditors;
cash flow paid to shareholders.

Cash flow paid to creditors includes the debt service thereto (payment of interest plus
principal, i.e. the instalments to be repaid for the financial debt contracted for the
analysed project), less the newly contracted debt:
Cash flow paid to creditors =
= Int + Previous financial debt repayment New financial debt =
= Int (New financial debt Previous financial debt repayment) =
= Int FinDEBT (23)
FinDEBT = variation in the financial debt contracted by the company for the investment
project; remember that only financial debt is included here, not operating debt.
Cash flow paid to shareholders includes the cash of shareholders (dividends allocated to
shareholders, plus the amount allocated for the buyback of a determined amount of shares
on the market), less the amounts obtained due to registered capital increases by issuing
new shares with contribution in cash.
Cash flow paid to shareholders =
Div + Shares buyback New shares issued =
Div (New shares issued Shares buyback) =
Div RegCAP (24)
Div = dividends allocated to shareholders;
RegCAP = variation in the registered capital.

Considering the above, it can be seen that cash flow is generated by the investment
project and paid to creditors and shareholders. This results in the following classification of
cash flow:

a) by sources:
operating cash flow;
cash flow from the variations in fixed assets;
cash flow from the variations in net current assets.
b) by destinations:
cash flow paid to creditors;
cash flow paid to shareholders.

Cash flows at the end of operation

At the end of the investments lifetime, the determined cash flows are inflows
including two elements:

the residual value of the investment, including the sales price or the price of the
materials and spare parts resulting from the product disposal, after deducting actual disposal
the recovered required working capital, due to the disappearance of the production
capacity created by the investment; at the end of the lifetime, this duration equals the initial
duration, possibly corrected with the variations occurring during investment operation.

5.2. Discount-based choice criteria used for making investment decisions in a certain
An option for investment implies the selection of investment projects according to
their profitability, comparing their cost to the sum of net cash flow resulting from their
operation. This comparison can be done without discount, according to the principle of the
algebraic sum of expected revenues and expenses for the entire lifetime of the good, or
comparing net cash flows by years to the investment expense, as brought at the moment of
the investment option. For this reason, the following are used when making an investment
no-discount option criteria, also called simple option criteria;
discount-based option criteria.
The following discount-based criteria may be used:
net present value;
net present value-based criteria;
internal rate of return.

5.2.1. Net present value (NPV)

In order to develop their activities under optimal conditions, as well as maintain
themselves on the market within the current competitive environment, at a microeconomic
level, companies need to make investments, such as purchasing, building or receiving
contributions of production and marketing assets.
Given the crucial importance of investment decisions, managers need a logical and
practical assessment procedure, that may help them assess available investment opportunities.
This procedure should promote the goal to maximise the shareholders wealth, even though
final analysis can also take other goals into account.28
The accomplishment of investments implies significant financing needs, resulting in
long-term commitment of resources. This is why the efficiency of investment projects should
be compared to the efficiency of placements on the capital market.29
Net present value is the criterion that best meets the basic objective of the companys
financial function, i.e. maximise the companys value.
Economic theories have established the law of the decreasing efficiency of investment
opportunities in business, which states that the marginal efficiency of an investment
decreases, i.e. the more one invests, the weaker is the return obtained for the last currency
unit invested. This is why a decision maker should know when to stop investing, even though
theories do not provide a clear answer, but only the basic characteristics for analysis. At the
same time, cash is placed on the market of goods and services (real investments) only if their
return is higher than the risk-free interest rate on the financial market. In Romania, the latter
is considered to be equal to the interest rate in CEC (fully state-backed bank) or the interest
rate for government securities.
Net present value is determined as a difference between present cash flow and
invested capital (investment value).

E.J. McLaney, Business Finance for Decision Makers, 2 nd edition, Ed. Pitman Publishing, London, 1994, p.
N. Sichigea, M. Drcea, D. Berceanu, article "Criterii de fundamentare a deciziei de investiii la nivel
microeconomic", "Finane, Credit, Contabilitate" Journal, issue 1/1998, p. 19

The issue at stake is to choose the discount rate. Thus, in order to be able to compare
future cash flows with current expenses in investments, cash flows are discounted by a
discount rate which, within a certain environment, may be:
an opportunity cost;
the inflation rate;
the weighted average cost of capital.
Discount rates such as opportunity costs include: the risk-less rate of return (the
interest rate for governmental securities, the interest rate in CEC or the interest rate in
commercial banks up to the deposit guarantee threshold), the interest rate for deposits applied
by one of the commercial banks, an average of the interest rates for deposits applied by the
commercial banks certified by the NBR, the average rate of return in the companys and the
investments business sector, the average rate of return of the economy.
These benchmark rates that can be classified as opportunity costs have been used
because it is easy to objectively identify them. Moreover, as shown in the previous
subchapter, investors have a natural tendency to compare the hypothetical return of the
investment project to the return provided by other investment opportunities available on the
The inflation rate is a minimal benchmark that can be considered a discount rate
since, for any investor, the major goal of maximising his/her wealth starts from a minimum
level represented by its preservation. Thus, a nominal rate of return should be at least equal to
the inflation rate, in order to have an actual rate of return that is higher than or equal to zero.
The use of the two previously mentioned categories of rates bears a significant
inconvenient, i.e. the fact that, practically, these rates have little or nothing in common to the
analysed project.
Considering that investments are financed both from equity and borrowed capital, the
weighted average cost of capital is recommended to be used as a discount rate. This is
calculated by weighing each financing source with the share of such source in the total
invested capital and then summing them up.
The formula for calculating net present value is:
n CFi
NPV= I (1)
i 1 (1 a )

n = the duration of operation of the investment;
CFi = the cash flow of year "i";
a = the discount rate;
I = the investment value.
A graphical representation of this relation is the following:







0 1 2 3 ......... n


Fig. 3. Analysis of the investment project at moment 0

If NPV > 0, the companys value increases and the company will choose to perform
the investment. Otherwise, the project is rejected.
It is important to remember that the initial investment has no direct relevance for the
investment decision, since only net present value is important. In other words, the analysis
refers to the net present value, not to the size of the investment. The only case when we
should consider the net present value in correlation to the invested amount is when we must
examine the financing sources of investment projects.
If two mutually exclusive projects are available for the same investment goal, the
project with the higher net present value shall be chosen.
The comparison of future cash flows and investments can also be done by expressing
the values to be compared at the purchasing power at the end of the investments lifetime.
Thus, the comparison criterion will be the net future value (NFV), i.e. the capitalisation of
NPV, for the investments lifetime (n).
The calculation formula:
NFV = CFi (1 a ) n i I (1 a ) n (2)
i 1
NFV =NPV(1+a)n (3)
Otherwise said, NPV is the present value of NFV for the same lifetime of the
investment (n):
NPV = (4)
(1 a) n

In practice, there is a tendency to use the NPV approach when making an investment
decision, to the detriment of NFV, even though, in essence, neither is superior to the other,
when investment opportunities are compared, if using net future value, one has to
know the number of years capitalisation is made for and difficulties may arise if opportunities
have different lengths;

as long as opportunity is assessed by establishing its effect on the companys value,
it seems much more logical to look at the present effect, than the future effect.
In formula (1), discount is, thus, made at moment 0 (the moment when the investment
is made). Having enough knowledge on what discount and capitalisation mean, the project
may be analysed in each of the points across the n years of lifetime of the investment.

5.2.2. The internal rate of return

The internal rate of return is a discount rate whose net present value is zero.
Thus, considering IRR = r, it can be determined according to the following formula:
n CFi
I 0 (1)
i 1 1 r

Knowing the expected annual cash flows for the investment project CFi, the value of the
investment I and its lifetime n, r can be determined by two methods:
the method of successive approximations;
by means of financial calculators and computers.
Even though, in principle, they are based on a formula of the same nature, the difference
between the NPV and the IRR criteria is that, for NPV, the discount rate is known along with
the other elements of the formula, and the net present value has to be determined, whereas,
for IRR, NPV is known and the IRR must be calculated that results in a null NPV.
If the internal rate of return for an investment project is r, the company providing
loans at a rate equal to r obtains no additional benefits from the investment compared to a
placement on the market at the level of such rate. For this reason, IRR should be higher than
the risk-free interest rate on the financial market, i.e. r d.

The method of successive approximations

IRR should be calculated by solving the n-degree equation (1), implying high
difficulties when n > 2. For this reason, it is simpler to use the almost linear character of the
curve VAN = f (a), as shown in figure 4.


x Discount rate
B (%)

Fig.4. Representation of NPV = f(a)

Thus, two values x% and (x+1)% are determined for r, which are consecutive,
so that in x, VAN >0 and in x+1, VAN<0.
Along the variation range of return rates from x to x+1, the NPV curve can be
approximated to a straight line, and IRR is determined by linear interpolation.

Approached in this manner, the IRR criterion is very time-consuming, especially
when we are dealing with long-term projects and, if calculations are made manually, the
procedure is highly difficult and ineffective. Using suitable software, calculations can be
made much more quickly, so that they should not be significantly difficult in general.
The determination by means of financial calculators and computers is highly
elegant and is more and more used by companies. One can use financial calculators including
functions such as NPV, IRR, etc., or software packages such as Excel or Lotus 1-2-3
including worksheets with the above mentioned functions.


6.1. Equity cost

Equity cost is equal to the rate of return demanded by the companys

shareholders or, in other words, is the rate of return that a company should achieve so
as to maintain its business value. If the rate of return is lower than the opportunity cost, the
business value increases and if the rate of return is higher than the opportunity cost, the
business value decreases.30
The cost of equity depends on a wide range of factors, such as:
future profits and the decision of the general assembly of shareholders or associates
regarding the distribution of the net profits of the exercise for dividends, i.e. expected
capital earnings;
the current market price of the share;
the risk-free rate of return;
the risks undertaken by the investor.
In other words, the equity cost is determined by predictable items, but which have a
high likeliness of achievement, unlike the debt cost, which can be calculated exactly,
especially for fixed interest rates.
The equity cost refers to total equity, irrespective of its origin (external or internal).
Two models are mainly used to determine equity cost:
the dividend discount model;
the capital asset pricing model.

6.1.1. The Dividend Discount model (DDM)

This is the traditional model of equity cost valuation, based on dividend discount
without explicitly considering risk.
According to the general discount model, the current price of a share (P0) is equal to
the discounted value of the future cash flows it generates: dividends and resale price.
The discount rate used is the rate of return expected by shareholders, considering the
companys prospects and the related risks.31
I. Anghel, Seminar de pregtire continu D 03 rata de actualizare-rata de capitalizare, ANEVAR,
Bucharest, 2005, p. 8
D. Berceanu, Politicile financiare ale firmei, Universitaria, Craiova, 2001, p. 215

n Di Pn
P0 (1)
i 1 1 R c
1 R c n
Di = expected dividend per share for year i;
Pn = the resale price of the share at the end of the n years;
n = the number of years of forecast, i.e. the investment horizon;
Rc = the rate of return expected by shareholders (the equity cost rate).
This formula is also called Irving Fishers fundamental formula.
Starting from formula (1), the following derived formula has been obtained:
n Di
P0 , with n (2)
i 1 1 R
This formula is applicable when the annual dividend per share can be estimated for a
long (infinite) forecast period, so that the resale price (the residual value of the share) can be
considered non-significant or even equal to zero. This formula is also called the dividend
discount model (DDM).
Starting from this model, four particular cases can be outlined, as follows:
the constant dividend growth model;
the zero dividend growth model;
the multiple (supernormal or inconstant) growth model);
the two-stage and three-stage models.
Our course will only present the constant dividend growth model.

The constant dividend growth model (the Gordon and Shapiro model)

Since the general discount model implies estimating dividends for the given operation
horizon of the investment, which is quite difficult, as well as the more difficult estimate of the
share resale price after n years, which has to take into account a multitude of conjunctural
factors, the economists M. J. Gordon and E. Shapiro proposed a more simplified model
(1956), starting from the same idea, i.e.: that shareholders will be exclusively compensated
from allocated dividends and the share will be practically held for a non-determined period
and will not be resold.
The two start from the following set of restrictive hypotheses:
absence of taxation and costs related to trading securities on the market;
a perpetual growth of dividends at a constant rate;
amortization is equal to the investments for maintaining the companys production
investments are only made by reinvesting net profit;
an infinite lifetime of the issuing company.32
This model will consider the dividend for the following year (D1) and a constant
annual growth rate of dividend/share for an infinite time horizon (g).
Thus, supposing that current dividend is D0 (in fact, we are dealing with the dividend
to be paid in the current year, for the financial earnings of the previous year, which are
certain data) and that its annual growth rate is g, we obtain:

I. Stancu, Finane, Editura Economic, Bucharest, 1997, p. 355

D1 D 0 1 g
D D 1 g D 1 g 2
2 1 0

D 3 D 2 1 g D 0 1 g

D n D n 1 1 g D 0 1 g n
Hence, the dividend discount model becomes:
D1 D2 Dn
1 R c 1 R c 2
1 R c n
= D0
1 g
1 g + +D 1 g =
2 n

1 R c 2 1 R c n
1 Rc
1 g 1 g 2 1 g

= D0 (4)
1 R c 1 R c 1 R c
1 g
If A= , we obtain:
1 Rc

P0= D0 A A 2 A n (5)

P0= D0A 1 A A n1 (6)
The parentheses include a geometric progression with a ratio A, the first term 1 and
the last term An-1, so:
1 A A n 1 1 An
P0= D0 A = D0 A (7)
1 A 1 A
Replacing A by its value, we obtain:
n n
1 g 1 g
1 1
1 g 1 Rc 1 g 1 R c
P0 = D0 = D0 =
1 Rc 1 g 1 R c 1 R c 1 g
1 Rc 1 Rc
1 g
D1 1 g
1 Rc
= D0(1+g) = 1 (8)
Rc g R c g 1 R c

1 g
In the simplifying hypothesis, g<Rc, lim 0 (9)
n 1 R
P0 = (10)
Rc g
Otherwise, for g>Rc, an infinite share price would result, which is completely unrealistic.
The obtained result is an easy to use tool for valuating shares, and it can be easily
adapted for considering lower horizon assumptions and more realistic growth schemes.
If the dividend of the current year has not been distributed, the formula above can be
written as follows:

P0 = D0 + (11)
Rc g
As for the equity cost rate, Rc, it is determined very easily, starting from formulae
(10) and (11).
Rc = 1 + g (12)
or: Rc = +g (13)
P0 D 0
Since formula (13) represents a particular case, in the following we shall analyse
formula (12), which represents the Gordon and Shapiro model or the constant growth
In this formula, equity includes two components:
shares output: 1 ;
increase of dividend/share: g.
Paradoxically, the rate of return expected by shareholders (the equity cost rate) does
not depend on the dividend policy, but on the companys prospects and specificities in terms
of operating risk and financial risk. According to the model, a higher growth rate of dividend
per share does not imply a higher cost of equity, since there is a compensation between
output and growth. A higher dividend distribution reduces growth and, the other way round, a
higher capitalisation of net profit accelerates growth.
The evaluation of equity cost through this model mainly raises the issue of
estimating the growth rate of dividend g. This estimation is done either by extrapolating
past tendencies, or by modelling the increase in the return expected by shareholders based on
the financial leverage effect.
The model can be applied and may succeed in the case of companies aiming at
adopting a constant-rate dividend growth policy.
Since financial creditors were compensated through the paid interests, the financial
return is the return expected by shareholders, i.e. the equity cost rate. If net profits are fully
reinvested, the dividend growth rate will be equal to financial return. However, usually,
according to the general assembly of shareholders, a rate b is deducted from the net profits
for capitalisation (self-financing) and a rate 1-b is distributed as dividends. Hence, the
dividend growth rate will be:
g = bRf (14)
The dividend/share growth rate is calculated and used as such only if the
number of shares remains constant. Otherwise, it should be adjusted. For instance, capital
increase implies an increase in the number of shares, implicitly resulting in a decrease of
dividend/share (because net profits do not change in the given conditions) and, hence, a
decrease of the dividend/share growth rate.

6.1.2. The capital asset pricing model (CAPM)

The previous section has presented the calculation of a companys equity cost,
starting from a certain number of variables (dividends, share price, dividend growth rate,
etc.), by using actuarial models, with a significant focus on the Gordon and Shapiro model.
It is obvious that these actuarial model are highly interesting in terms of practice.
However, they have a range of limitations.

Thus, firstly, they require the proper knowledge or anticipation of the companys
long-term growth rate, which is a pretty difficult and risky exercise. A forecast error in this
context will have very significant consequences on the calculation of a companys equity
Secondly, it can be seen that, to a certain extent, these models are disconnected
from the conditions of the financial market. The equity cost thus determined fundamentally
depends on the internal variables of the companys management.
Thirdly, one should not overlook that the great absent of such models is risk.
The model trying to mitigate such disadvantages to a certain extent and, at the same
time, provide another method for estimating equity cost is the capital asset pricing model
This model may be considered one of the core items of modern financial theory. It
allows to estimate the rate of return that is expected (demanded) by shareholders, i.e. the
equity cost rate starting from only three variables, i.e. the rate of return of a risk-free asset,
the rate of average return on the financial market and the risk coefficient (s), also termed as
the systematic risk of an asset.
The analyses performed on financial markets show that there is a direct correlation
between the return of the placement and the integrated risk. Belonging to the category of
explicative models, the model aims at determining capital cost in a methodical manner,
performing a comparison to investment alternatives, to the performances of the capital market
in general.
The capital asset pricing model shows the relation between return and risk and
valuates the risk premium for the investor, according to the following formula:
Rc = RF+ S(RM-RF) (1)
Rc = the equity cost rate;
RF = the rate of return of the risk-free asset or the risk-free rate (usually the rate of
governmental securities, the interest rate in CEC, a state-backed bank, or the rate of
placements in banking companies up to the deposit guarantee threshold);
S(RM-RF)= the risk premium of the investment (asset);
S = the sensitivity coefficient (valuating systematic risk); it measures the sensitivity of
an assets rate of return to the average return of the market;
(RM-RF)= the systematic risk premium (the market risk premium);
RM = the average rate of return on the financial market.
The graphical representation of formula (1) is a line named the securities market
line. For a balanced market, all the securities are placed on this line.
The securities
RC market line

I. Slope = systematic risk

1 S
Fig.5. The securities market line

Slope=tg= (2)

Also using (1) Slope=RM-RF=
Cov(R C , R M )
S= (3)
Cov(Rc,RM) = covariance between the rate of return of the asset and the market rate of
= the dispersion of the market rate of return.
The sensitivity coefficient s traditionally relates to the companys equity. It is equal
to 1, when the output of a placement corresponds to the average market return. The higher s
is, the more important the risk is. Securities with a risk coefficient higher than 1 have a higher
risk than average market risk, while securities with a sub-unit risk coefficient have a lower
The practical difficulties in the calculation and use of the sensitivity coefficient are
based on: the acquisition of information; the frequency and number of observations; the
choice of information suppliers; the utility of the sector average, etc.
When estimating capital cost and valuating a company, a distinction should be made
systematic (market) risk;
security-specific risk negotiated on the market.
Systematic or market risk is determined by unforeseeable events with an impact on
all securities, such as a military conflict.
Specific risk is determined by events that only influence the considered security, such
as the failure of a publicity campaign. Specific risk can be discarded by diversification. If an
investor has a sufficiently diversified securities portfolio, a compensation appears between
the earnings obtained for some securities and the losses in other securities. The more
securities we add starting from a certain number of securities, i.e. 15 20, total risk will be
reduced very little or will not be reduced at all.
Investors only face systematic risk and, hence, they are entitled to a risk
premium for compensation.
The risk premium, in turn, includes:
operating risk premium;
financial risk premium.
The risk coefficient can be expressed as follows:
S=a 1 (1 T)
a = the component of systematic risk determined by the operating return and the
influence of the financing policy.
Replacing risk coefficient in (1), the equity cost rate becomes:
Rc = RF+a(RM-RF)+a(1-T) (RM-RF) (5)
a ( RM - RF ) = operating risk premium;

a(1-T) (RM-RF) = financial risk premium.
Thus, the two components of the risk premium of a security can be outlined, and it
can be analysed which of them has a more significant share.

6.2. Medium and long-term debt costs

6.2.1.The cost of medium and long-term bank loans

Let us suppose that a company contracts a medium and long-term bank loan for a
value D and agrees (promises) to reimburse to the creditor (the bank) the annuities Ai,
i 1, n .
The cost of loans (debt) can be measured through the discounted cost, used both in
choosing out of several loan possibilities, and in determining the weighted average cost of
As it has been said, the discounted cost of loans is given by that discount rate rd that
allows for a relation of equality between the sum of contracted debt (i.e. D) and the annuities
(instalments to be repaid and interests) discounted by this rate, as follows:
n Ai
D= (1)
i 1 1 r
In the following, annuities will be separated considering or not considering taxation
and whether repayment is made in full at the end of the n years, proportionally in time or, in
more delicate situations, it is not uniform across time.
a) without taxation
with the repayment of the entire amount at the end of the n years:
n Dd D
D= (2)
i 1 1 r
i n
d 1 rd

with repayment that is not uniform across time:

n D d R
D= i i
i 1 1 r
d = the nominal interest rate (in percent);
Ri = the amortization of year i (instalment to be annually repaid);
Di = the amount of the loan remaining to be repaid at the beginning of year i.
The following formulae are valid between Ri and Di:
D 1 D
2 1 1 1

D 3 D 2 R 2 D ( R 1 R 2 )

D n D n 1 R n 1 D (R 1 R 2 R n 1 )
with proportional repayment in time:
In this case, R1=R2= ... =Rn=R= , and formula (3) becomes:

n Di d R
D= (4)
i 1 (1 r )

b) with taxation
In this situation, interests are deductible from the taxable profit and the
companys actual burden is lower, i.e. if the company in debt is profitable the interest it will
pay to its creditor on an annual basis allows it to perform tax savings.
Thus, considering T = profit income tax rate, formulae (2), (3) and (4) become:
with the repayment of the entire amount at the end of the n years:
n D d (1 T) D
D= (5)
i 1 1 r
i n
d 1 rd

with repayment that is not uniform across time:

n D d (1 T ) R
D= i i
i 1 1 rd i

with proportional repayment in time:

n D d (1 T ) R
D= i (7)
i 1 (1 rd ) i

In the above formulae, Did and Did(1-T) represent the interest paid and respectively
incurred by the company.

A remark to be remembered, especially in the current situation of our country, is that,

as long as the interest rate may be fixed or variable, it has a significant impact on interest
flows. In the former case, interest flows are known from the beginning; in the latter case, they
can only be estimated with a certain probability.
Moreover, given the appearance of a range of expenses related to loan management,
the debtor incurs both the annuities to be repaid and the loan-management expenses (if they
have to be paid after the loan has been granted), or the loan it will receive shall be decreased
with the amount corresponding to such expenses (if they have to be paid when the loan is
granted). Even though such expenses are not actually incurred from the loan concerned, they
are directly related to it, and they must be taken into account (sometimes they may even reach
considerable values), in order to be accurately aware of the cost of a loan.

6.2.2. The cost of bonds

As for the cost of bonds, the previously presented formulae for medium and long-
term bank loans are also valid here and can be applied with no difficulties. The only
delicate issue arises when bonds are issued with an issue premium33.
Let us consider a company issuing N bonds, with a nominal value VN and an issue
price PE, where PE < VN. The actually collected amount is NPE. However, the company may
decrease its taxable profits by the difference between the nominal value and the issue price,
as the issued bonds are repaid at their nominal value. If the company repays the amount
related to Ni bonds during year i, it may decrease taxable profit by an amount which is

I. Stancu, Finane, Editura Economic, Bucharest, 1996, p. 260

equal to the issue premium paid for such bonds, i.e. Ni(VN - PE). If the company is profitable,
this decrease will allow it to achieve tax savings equal to Ni(VN - PE)T.
Thus, the cost rd of bond loans, issued with a premium, is obtained by solving the
following formula:
n A N (V P ) T
NPE = i i N E
i 1 (1 rd ) i
where Ai is the annuity to be repaid, calculated according to the methods presented for
medium and long-term loan costs.

6.2.3. The cost of leasing

As previously shown, leasing is a particular financing method which may be analysed

as a loan and, hence, its cost can be analysed as an actuarial rate.
The fundamental equation for determining the cost of leasing is:

Discounted inf lows Discounted outflows

i (1)

Inflows i Outflows i
(1 a L )

(1 a L ) i

The discount rate aL as a solution of formula (2), is the explicit cost of leasing.
Thus, the inflows and outflows implied by the performance of a leasing operation
directly determine its cost incurred by the company. We are dealing with the following
inflows or outflows:34
the value of the leased good, indirectly representing the loan received by the
company from the leasing company. Starting from this value, the interest (for financial
leasing) or benefit (for operational leasing) to be paid to the lessor will be calculated:
the net paid lease. The tax savings obtained by the company by deducting the lease
from the taxable income shall also be taken into account.
the residual value of the leased good. It arises in financial lease contracts, when
they provide for an ownership transfer to the user. Such value is established in the contract or
will be determined depending on the prices negotiated at that time for the leased good,
considering accumulated depreciation.
Besides these obvious elements, we appreciate that for a proper determination of the
cost of leasing for the lessee, as an output, one should also consider the tax savings related
to amortization, since the part representing the amortization of the leased good no longer is a
deductible expense and no longer generates tax savings for the leasing user. Therefore, the
leasing user, who is not the owner of the good, incurs an opportunity cost generated by the
loss of tax savings for the amortization of the leased good.35
Hence, all lease contracts should be assessed both by the lessee and the lessor. The
lessee must determine whether leasing is less expensive than a bank loan or bonds, while the
lessor must decide what lease is required in order to obtain a reasonable rate of return.
Since our attention is mainly focused on corporate financing methods and their
cost, it is normal that we should be primarily interested in the users viewpoint, which does
not mean that the lessors viewpoint is less interesting.

A. Ciobanu, article "Costul leasingului- analiz comparativ ntre leasingul operaional i cel financiar",
ANEVAR Newsletter, issue 2-3/2002, p. 26
I. Stancu, Finane, Ediia a treia, Editura Economic, Bucharest, 2002, p. 651.

Therefore, from the lessees viewpoint (the person who borrows), the situation can be
systemically presented as follows:


Thus, s/he receives the good of a value I at moment 0 (as we have stated, without
being the owner of the good).
Therefore, s/he commits to pay in the future the net leases CHi(1-T), the residual
value (VR) and, since s/he is not the owner of the good, the loss in tax savings for
amortization is also recorded as an outflow (TAi).
So, in this case, formula (2) becomes:
n CH (1 T) T A VR
I i i
i 1 1 a L i
1 a L n
Therefore, if the lessee determines the discount rate establishing an equity between
immediate inflows and future outflows, s/he establishes the actuarial cost of lease
This would be, if we might say so, a general case. However, carefully studying the
regulation of leasing in our country, focusing on the structure of lease instalments for the two
types of lease provided for in Romanian legislation, it can be seen that formula (3) is valid, at
most, when estimating the cost of operational lease.
Considering that, for financial lease, the paid lease (a share of the input value of the
good plus the lease instalment) do not amount to the expenses deducted by the company (the
amortization of the good, plus the lease interest), since the latter are higher in the first years
of operation, we consider that the formula used for determining the cost of leasing should be
detailed, with separate consideration for the annual tax savings obtained by the company due
to the deductibility of the lease instalment (rent) from the taxable profit. Moreover, one
should not overlook that the uncertainty associated to the amounts of such tax savings differs
from the one specific to the values of contract-established lease instalments. It is obvious that
we can only talk of tax savings when the company is profitable. Therefore, a high risk
associated to the companys profits will imply a higher risk associated to tax savings and, as
such, the discount rate thereof may be increased by a risk premium.
Therefore, the formula reflecting the previously mentioned issues is:
n CH T A VR n EIch i
I i i
i 1 1 a L i
1 a L i1 1 a EI i

EIchi = the tax savings of year i obtained by the company due to the deductibility of the
lease instalment (rent);
aEI = the discount rate for tax savings, considering the uncertainty regarding the
achievement thereof.
This formula can also be used when estimating operational lease costs, especially
since, in this case as well, one can deal with uncertainties in terms of tax savings.
As it has been mentioned, the cost of leasing is the solution of the formulae above,
which are calculated according to the methodology of the internal rate of return. In fact, the
cost of leasing for the lessee is the counterparty of the rate of return for the lessor.

The cost of each financing source, be it equity or borrowed capital, is compared to the
alternative sources available to the company and, obviously, the cheapest source will be
* *
As it has already been said, in general, fixed assets are procured based on permanent
capital (medium and long-term debt and equity), and current assets are financed from short-
term debt.
Considering the interdependence between investment decisions and financing
decisions, it is obvious that, in order to calculate the weighted average cost of capital (the
global cost of financing), a medium and long-term policy should be adopted, since
investments will be financed from short-term debt and current assets from permanent capital
only on an exceptional basis.
This is the reason for which short-term debt is not included in the calculation of the
weighted average cost of capital, which will be reflected in the next chapter.

6.3. Corporate capital costs

Capital costs are a highly important issue in business, for three major reasons:36
in order to maximize the market value of the company they work for, managers
should minimize the costs of all inputs (the cost of capital included) and, in order to minimize
the cost of capital, they should first be able to measure it;
the managers of financial departments need an estimation of capital cost, that may
help them make correct investment decisions;
many other decisions made by the managers of financial departments, including
those regarding leasing, buyback of bonds, working capital policies, etc., are based on capital
cost estimates.
Corporate capital includes several sources (components), each with a cost of its own.
The basic idea in an economy like Romanian economy, undergoing restructuring and
technological upgrades, is to provide the required capital at a minimum cost. This is why
managers should understand and then use modern methods for determining the cost of
Capital is a highly necessary production factor and, as any other factor, it bears a cost.
The cost of each component is referred to as the cost of the component represented by that
type of capital. Therefore, when we want to determine a companys capital cost we should
consider two parameters: the cost of each source of financing and the share of each in total
invested capitals. Thus, the companys total capital cost appears as a weighted average
cost corresponding to the cost of the sources available to the company.
The weighted average cost of capital or the composite cost of capital is determined
as follows:
WACC = Rc + rd (1)
Rc = the cost rate of equity, determined according to the previous chapters;
rd = the cost rate of borrowed capital (debt), determined according to the probable cost
of debt after corporate taxation; when referring to a single loan, this cost is the interest
rate for the obtained loan, r, from which tax savings (r.T) are deducted; such tax

P. Halpern, J.F. Weston, E.F. Brigham, Finane manageriale, Editura Economic, Bucharest, 1998, p. 586-

savings are due to the fact that an interest is a deductible expense for taxation
C = the sum of internal and external equity.
D = total debt;
Two remarks should be made regarding formula (1):
both the specific costs of each source of financing and their shares are historical
and the adoption of new investments does not significantly alter such variables;37
both total equity and total debt should be expressed in market values. Moreover, if
the company is listed on the stock exchange, stock capitalisation is considered for equity and,
if the debt result from bonds, D is the product between the number of issued bonds and the
current price of the bond. However, unfortunately, the instability and unavailability of
information on market values most frequently results in the use of accounting values.
The cost of capital for a certain investment represents the economic cost of attracting
and maintaining capital in a competitive environment, where investors carefully analyse and
compare all investment opportunities.
When a company needs new capitals to finance the new investment projects
(development financing) and wants to keep a balance of its capital structure, it should obtain
new funds, partially from borrowed capital and partially from its own capital, according to
the companys capital structure. However, one thing is clear. Even if the company wants it, it
is very hard to achieve. Usually, financing is made in discrete amounts, so that a certain
project is financed by the companys capital structure to different extents, which implies that
the next project is financed to other extents, so that the companys targeted capital structure is
maintained in the long run.
Moreover, WACC is the marginal cost of capital, since it refers to the incremental or
marginal cost of the funds required to finance an investment project.
The approach of the cost of capital as both a weighted average cost and a marginal
cost can be explained as follows: the weighted average cost of capital reflects the opportunity
cost or the marginal cost of each specific source of funds used by the company. From this
point of view, it is a marginal concept. However, since the company uses these funds to
certain extents, which are valid in the long term in order to finance investments, the weighted
average cost of capital is calculated by determining the weighted average of the specific
marginal costs to be used. Since the weighted average cost of capital is a weighted average of
the marginal costs of each source of financing, it represents a marginal cost as well.
The marginal cost of capital (MCC) is defined as the cost having to be incurred in
order to obtain an additional currency unit of capital and it increases with the increase of the
capital needs.
It has to be said that a company can obtain limited amounts of new funds at a constant
cost rate. This happens because, as the company wants to obtain higher and higher amounts
in a certain period, the costs for the various sources begin to increase and, implicitly, WACC
will increase for every newly obtained currency unit. Thus, capital cannot be obtained in
unlimited amounts at a constant cost. After a certain threshold, the cost of each additional
currency unit will increase.

I. Stancu, Finane, Ediia a treia, Editura Economic, Bucharest, 2002, p. 665

6.4. Corporate capital structure

Corporate capital structure is one of the major issues of financial management. The
choice of a corporate capital structure is an old and also controversial issue.38 Its difficulty
stems from the fact that a unanimous answer has not yet been provided to the question
whether a company is too much in debt or enough. A wide range of theories and opinions are
available on this question, which complicate the issue even more.
The necessity to choose a targeted capital structure is a priority within the financial
policy of any modern company. This policy should meet the guidelines of the companys
general strategy, depending on the conjunctural realities and the scope of activities, with a
view to achieving the desired goals.
According to the basic goal of the companys financial function, the managers
concern refers to a continuous increase in the companys value, so as to maximize it
compared to the structure of composing assets. If the goal of maximising the companys
value is pursued for each investment project intended to be achieved, by obtaining a
discounted value as high as possible, the company considered as a sum of investment projects
will increase in value. However, the net present value is higher, either due to the achievement
of higher cash flows, or due to a low weighted average cost of invested capital, which
represents the discount rate of the investment cash flows.
Therefore, the achievement of an optimal capital structure will help minimize the
weighted average cost of capital and, implicitly, maximize the companys value.
Hence, an interdependence can be remarked between the cost of capital and capital
structure; this is why capital structure optimization is an issue of strategic financial
management, differentiating competitors with similar financial efforts in terms of efficiency.
The capital structure reflects the division of the companys financial resources
between equity and debt. It is frequently mistaken with the debt/equity ratio referred to as
financial leverage.
The optimisation of capital structure implies finding a combination between equity
and debt defined in terms of return and risk, likely to maximize the value of the companys
shares. Hence, the choice of an optimal capital structure is critical for any company, as it will
directly determine its return and risk.
The following aspects should be underlined regarding capital structure:
companies which are profitable and viable, due to their products, may be nave to
any significant cash flow difficulties, due to high indebtedness;
companies which are not profitable and are not viable in the long run because of
the quality of their products will face significant cash flow issues, irrespective of their capital
The adoption of a certain capital structure is the result of a corporate decision making
process which cannot be done without considering the constraints resulting from the
operation of the capital market, since any form of capital implies a cost.39 Thus, capital
structure is a variable that does not depend only on the company, on its economic growth
goals, on the return or risks it consents to undertake. It is frequently influenced and
determined by shareholders, banks or other borrowers, by the state, and by the economic and
financial conjuncture.40

M. Albouy, Financement et cot du capital des entreprises, Eyrolles, Paris, 1991, p. 1.
H. Cristea, I. Talpo, D. Cosma, Gestiunea financiar a ntreprinderilor, Mirton, Timioara, 1998, p. 189
N. Hoan, Finanele firmei, Continent, Sibiu, 1996, p. 232.

The optimisation of capital structure and of the optimal financing ratios between
equity and debt can be done in two ways:
analysis of capital structure ratios;
the Miller and Modigliani theory.



7.1. General considerations on dividends

The direct purpose of any business is to obtain as high as possible earnings, ensuring
the involvement of all participants in this activity. However, irrespective of the employees
involvement, the arbitrage between dividend allocation and profit retention is an essential
element of any financial decision.
According to our legislation in force41, a dividend represents any allocation in money
or in kind, performed by a legal entity to a participant in the legal entity, as the consequence
of holding securities in such legal entity, except for the following:
an allocation of additional securities, which does not change the securities
ownership percentage for any participant in the legal entity;
an allocation in money or in kind, performed in connection to the buyback of
securities in the legal entity, other than the buyback included in a buyback plan, which does
not alter the securities ownership percentage for any participant in the legal entity;
an allocation in money or in kind, performed in connection to the liquidation of a
legal entity;
an allocation in money or in kind, performed in connection to the decrease in the
registered capital actually set up by participants.
If the amount paid by a legal entity for the goods or services provided to a participant
in the legal entity exceeds the market price for such goods or services, the difference will be
treated as a dividend.
A highly synthetic definition is the following:42 the profit share payable to each
associate is the dividend.
An accurate, clear and concise definition is the following: a dividend is any
allocation performed by a legal entity, in money and/or in kind, to its shareholders or
associates, from the net profits established based on the annual financial statements,
proportionally to their involvement in the paid registered capital, if not otherwise stipulated in
the articles of incorporation.
The allocation quota should be established by the general assembly of shareholders.
The latter also is the one to establish their due date, unless otherwise provided through
special laws, but no later than 6 months from the approval of the annual financial statements
for the concluded financial exercise. Otherwise, the company will pay a penalty for the late
payment, at the legal rate of interest.
It should also be mentioned that dividends will only be allocated from the actual
profits determined according to the law. Any dividend paid contrarily to the law is
reimbursed, provided that the company distributing them proves that the shareholders or
associates were unaware or should have been unaware of the irregularity of such distribution

Law no.571/2003 on the Tax Code, art.7.12
Law no.31/1990 on companies, as republished and amended, art.67

in the given circumstances. The entitlement to dividend reimbursement is prescribed within
three years from their distribution. The dividends payable after the date when the shares were
sent belong to the assignor, unless otherwise agreed by the parties.
Dividends are the core element of dividend decisions, resulting in the compensation
of shareholders or associates. However, companies may or may not have other monetary
forms allowing their shareholders to benefit from the net earnings, as a compensation for the
capital contributed to the company.
Dividend decisions represent all the actions and techniques used to determine the
level of dividends that may be distributed to shareholders. The question arises whether to
allocate dividends or capitalize net profits as much as possible.
Self-financing created by capitalizing profits creates advantages for all the companys
for the companys shareholders, it increases the value of shares, since capital
earnings are less taxed than dividends in most tax systems;
for the companys managers, since it increases their autonomy and freedom of
movement given the decrease in indebtedness;
for the companys creditors, as it favours debt repayment.
However, self-financing decisions are indisputably connected to dividend
allocation decisions. The decision to distribute more or less of the net profits to shareholders
under the form of dividends determines the amount of the net profits that is to be
capitalised. This is why determining the profit allocation ratio (dividend per share / net
profit per share) 100) is a fundamental issue for the company, since, logically, net profits
are a compensation of the shareholders risk.
The dividend allocation decision is considered to be low when the allocation ratio is
less than 20% and strong when it exceeds 60%.
Optimal dividend decision making implies ensuring an optimal ratio between the part
of the net profits that is allocated as dividends and the part remaining for self-financing, that
will ensure the companys future growth and, hence, the premises for increasing the price of
When the general assembly of shareholders decides not to fully allocate net profits,
some of the shareholders are deprived from their right of achieving immediate revenues, in
exchange for the hope of achieving future revenues. This consideration is critical when
selecting the companys shareholders.
The companys creditors, especially its bond holders, are also directly interested in
the allocation ratio, so that a wealth transfer from them to shareholders does not occur. Since
their compensation is mostly on a fixed basis (the interest is fixed), if the risk level
considered when establishing the interest is lower than the actually borne interest, the value
of their bonds will decrease, resulting in such transfer.
If we also take into account the companys managers, who are interested in attracting
self-financing, so as to have a direct source with a cost that is equal to the cost of equity, but
which improves the companys capital structure, it is obvious that the company has an
interest in applying an optimal dividend decision, likely to reconcile the contradictory
interests of its main stakeholders.
From the very beginning, one should remember that the issue of dividends has been
dealt with by several theoretical approaches and empirical studies where such theories and
proposals have been tested, but no common viewpoints were achieved. This is why one
cannot talk of a unitary dividend decision, but rather of methods and practices determining
dividend allocation decisions.

Moreover, the theories in this field are most underdeveloped and incomplete.
Dividend decisions also are most controversial, since the turning point both for investment
decisions and financing decisions is the very dividend43.
However, the theoretical efforts and practical remarks regarding dividends have
allowed to outline several aspects, of which the most important are:
the investors appreciation of companies, depending on higher or lower allocation
the signals conveyed to investors by companies which, though profitable, do not
allocate dividends, regarding investment opportunities. Do future investments procure more
wealth than the dividend they were supposed to allocate in the present time?;
whether allocated dividends are a signal to investors regarding the anticipation of
the companys profitability;
the way how dividends adjust conflicts of interest between the active participants
in a companys life.
All these emphasize the role of the informational contents of dividends for the capital
market. We consider that this will also be seen in Romanian economy, as the legislation
regarding the capital market and tax legislation becomes stabilized, as companies operate
normally and proper relations are established to the capital market, which are not influenced
by group interests.

7.2. Forms of dividend allocation applied by companies

The net earnings obtained after deducting the companys income tax, which are an
entitlement of shareholders as a cost of the equity contributed to the company, can be mainly
distributed thereto under the following forms:
A. payment of dividends in cash or in kind;
B. allocation by means of capital operations;
C. payment of dividends in shares;
D. collateral forms of allocation.
A. Dividends are generally paid in cash, after the financial exercise ends and the
annual financial statements are approved by the general assembly of shareholders or
associates. Upon actual allocation, the company has to deduct dividend tax and pay it to the
state budget.
According to the law, as of January 1, 2007, a single dividend tax ratio of 16% is
applicable to both resident and non-resident citizens, natural persons or legal entities.44
The obligation to calculate and deduct dividend tax is incurred by legal entities
simultaneously with the payment of dividends to shareholders or associates. The tax is paid
by the 25th day of the month following the month of payment. 45 For the dividends which are
allocated, but have not paid to the shareholders or associates by the end of the year when the
financial statements were approved, the dividend tax is paid by December 31 of such year.
In Western countries, in general, dividend taxation is performed on a global basis,
along with the other size-based revenues.

S. Lumby, Investment Appraisal and Financing Decision. A first course in financial management, Fourth
Edition, Chapman & Hall, London, 1991, p. 470
See Law no.343/01.08.2006 amending and supplementing Law no.571/2003, art.I, pt.46
The amendment of the deadline from the 20 th day of the following month to the 25th day of the following
month for companies was applied to the Tax Code by means of Government Ordinance no. 83/19.08.2004 and is
applicable as of January 1, 2005.

If the companys articles of incorporation include this method and especially when the
company manufactures products of interest for shareholders, dividends can also be paid in
kind, obviously after the tax-related obligations are met. This form of payment is only
possible if allowed by the specificities of the activity, i.e. shareholders can receive a full
number of goods.
Irrespective of their payment methods, dividends can take two forms: basic dividends
and special dividends.
Basic dividends, also referred to as statutory dividends, are established under the
form of a guaranteed minimum (a percentage of the net profits) included in the companys
articles of incorporation and must be paid when so allowed by net profits. In general, they
cannot be cumulated, i.e. the dividend of the current year cannot be supplemented with the
statutory dividends which have not been paid, in part or in full, for various reasons, in the
previous years.
If so allowed by net results, the general assembly of shareholders may decide to pay
special dividends, additionally to statutory dividends.
The legislation in some countries includes the obligation of allocating a certain
percentage of net profits.
B. Allocations by means of capital operations mainly take three forms: decreasing
the registered capital, depreciating the registered capital and allocation of free shares.
The decrease of registered capital can be a purely accounting operation if motivated
by the companys losses. However, registered capital may be decreased through the buyback
and cancellation of a number of shares. This operation is assimilated to the payment of
dividends in cash, provided that it entails a fund transfer to the companys shareholders.
However, it differs from the payment of dividend in cash given its facultative character and
the shareholders freedom to fully or partially decline such an offer. At the same time, this
operation is a method to select shareholders. The registered capital can only be decreased
with the vote of the majority of the shareholders reunited in an extraordinary general
assembly and results in changes to the companys articles of incorporation. The purchase
offer is simultaneously presented to all shareholders. If the number of securities provided by
shareholders is higher than the number of those the company wants to buy back, all the offers
are reduced, to the same extent, depending on the ratio between the number of bought back
securities and the number of provided securities.
Capital depreciation is legally different from, but financially similar to the decrease
of registered capital and actually does not imply a reduction of registered capital, but a
decrease of reserves. The depreciated shares are qualified as profit shares, since they no
longer provide entitlement to statutory dividends.
The two types of capital operations are forbidden if the company has issued
convertible bonds or share subscriptions.
These operations are quite frequent in the United States, but rather rare in other
Western countries, because of the legal procedures involved.
The distribution of free-of-charge shares is frequently assimilated to the
distribution of dividends as securities. Such an operation allows the company to provide its
shareholders with new shares, pursuant to the increase of registered capital by integrating
reserves or by dividing shares.
The increase of registered capital by integrating reserves only implies a change in the
equity structure (the increase of the registered capital and the corresponding reduction of
reserves) and the number of shares to be increased.
Share division consists of an increase in their number and a reduction of their nominal
value, with a constant amount of registered capital.

Both categories of operations imply the issue of new shares, but they are different
from a legal and accounting point of view.
C. The payment of dividends in shares can be performed by companies for the full or
partial amount of dividends, the share payment ratio being established by the general
assembly of shareholders, provided that this possibility is included in the articles of
incorporation. The offer of payment in cash or in shares is provided to all shareholders, who
must notify their choice by an established deadline. This form of distribution aims at
developing investments and protecting peoples savings and it is rather frequent in the United
States. An issue that arises refers to the price of corresponding shares, which must not be
lower than the nominal value of securities.
The increase in registered capital pursuant to a request to pay dividends in shares
exempts the company from a cash outflow, also helping improve capital structure by
increasing the equity ratio. This method of distribution is legally assimilated to an increase of
capital in cash.
Since the two options are different, and some shareholders prefer cash, while others
prefer shares, this payment procedure entails a wealth transfer between shareholders. This
effect has been outlined by establishing a ratio between the price of the security after making
a dividend payment decision and the price prior to this decision, as follows:
P1= V
P D (1 c) (1)
1 n

P1 = the price after detaching the dividend payment coupon;
PV = the prior sale price;
D = dividend per share;
c = the ratio between actual subscriptions and the maximum number of theoretical
n = the number of parts to hold in order to be entitled to a free share.
The shareholders who prefer dividend payment in cash will have (P 1+D) after
allocation, while those who prefer payment in shares will have P1(1+ ).
Therefore, a wealth transfer shall take place to those who prefer dividend payment in
shares, to the detriment of those who prefer cash, when:
P1(1+ ) > (P1+D) (2)
or replacing n by PE/D (PE as the issue price of the new shares in order to cover dividend
payment to this purpose) and P1 by its value of formula (1), when:
PV > PE+D (3)
Thus, shareholders who prefer dividends in money are affected if the price prior to the
distribution decision is higher than the price for issuing new shares, increased by the dividend
value. Obviously, in the opposite situation, the wealth transfer is favourable to them.
D. Collateral forms of distribution
Besides the different legal forms of earnings allocation, some of the shareholders, i.e.
majority shareholders may benefit from various advantages: salaries higher than those
achieved by managing employees with the same competences, various advantages in kind,
higher leases for buildings rented to the company by real estate companies controlled by
major shareholders, etc. These advantages in money or in kind can be financially assimilated
to actual dividends, but they mostly infringe the legal and moral principles of equality
between shareholders. The existence of these fake dividends is specific to small and medium

enterprises; statistical remarks also certify a lower dividend distribution ratio precisely
because of these different compensations they benefit from. Moreover, these fake
dividends are a source of conflicts between the shareholders of involved companies.
Dividend allocation by companies is subject to the following requirements:
the existence of actual profits, determined according to the developed activities, as
recognized by beneficiaries, by meeting accounting and taxation rules;
the results in the profit and loss statements should be approved by the general
assembly of shareholders, after they have been submitted to the managing board and the
auditors committee;
the value of dividends should be established according to the proposals of the
managing board, by the general assembly of shareholders.

7.3. Dividend decision practices

It can be seen that the share of net profits that is distributed as dividends significantly
differs from one company to another. A companys capacity to pay dividends is closely
related both to its profitability and to its liquidities.46
Moreover, dividend allocation is imposed both by shareholders, and by the necessity
of maintaining the companys favourable position on the financial market.
Thus, dividend allocation is firstly a liquidity issue, since it involves the payment of
sometimes significant amounts, within a short period. Especially given the current conditions
of large Romanian companies, which have been partially privatised and where we can see an
obvious imbalance between their profitability (sometimes very good) and the acute lack of
cash (which results in issues even for the regular payment of salaries and related obligations),
dividend payment is conditioned by the creation of the required cash.
Secondly, the dividend allocation proportion also depends on the leaders
capacity interested in capitalizing their development profit of convincing their
shareholders of the utility to reinvest profit in the companys investment projects. To this
purpose, they should ensure proper and convincing information regarding the expected
profitability through the accomplishment of internal development projects or the envisaged
deposits, to the benefit of the companys external development interest.
Thirdly, when drawing up and implementing dividend decisions able to ensure
mediation between the interests of managers and shareholders, the tax conditions of
revenues from state-applied dividends should also be considered, compared to the extent
of taxation of other revenues or to the facilities related to the reinvestment of the companys
Two elements seem to characterise dividend decision practices: the distribution
ratio and the distributed amount.
Provided that dividend is an allocation of the net earnings of an exercise, the relation
between the net profits per share (NPS) and dividend per share (D) should be studied.
The distribution ratio characteristic for some dividend decision practices is:
Rd = 100 (1)
However, other practices of this decision, though considering distribution ratio as a
significant element, emphasize the stability and perhaps progressiveness of the distributed
amounts. The elements considered by potential investors when deciding whether to become
shareholders of one company or another also include the prior evolution of amounts
J.M. Samuels, F.M. Wilkes, R.E. Brayshaw, Management of Company Finance, 6th Edition, Chapman & Hall,
London, 1995, p. 610

distributed as dividends. For this reason, the importance of the past evolution of dividends
imposes a certain stability of such amounts for the company. In fact, an irregular distribution
results in the shareholders uncertainty on the size of future dividends. Companies having a
regular dividend distribution, even when they undergo a difficult time, have significant
advantages in terms of image, compared to the companies which suspend, even
temporarily, dividend allocation in some periods. In fact, the constant allocation of dividends
aims at increasing the investors confidence in the company and, implicitly, increasing the
companys market value.
The stability and, perhaps, the progressiveness of the allocated amounts result in
regular dividend decisions. However, any dividend decision should also be reliable, i.e. be
based on real profits and a profit allocation decision aimed at the shareholders medium and
long-term interest.
Considering the previously presented elements, four major types of dividend decision
practices have been established:
A. the constant payout ratio policy;
B. the residual dividend policy;
C. the stable and increasing dividend policy;
D. the stable dividends per share policy.
I. A. The constant payout ratio policy
According to this policy, dividends strictly comply with the fluctuation of the
achieved net profits. It can be mathematically described as follows:
Dt = R d NPSt (2)
Dt = dividend in year t;
Rd = constant allocation ratio;
NPS t = net profits in year t
This type of policy is characterised by significant dividend fluctuation (dividends
directly follow the evolution of net profits per share). This generates a negative impact on the
stock exchange price in the years when profits are lower than in the previous years and,
implicitly, on the maximized market value of the concerned company.
B. The residual dividend policy
According to this policy, dividends fluctuate according to the companys investment
opportunities. It can be mathematically described as follows:
Dt = f ( It ) (3)
It = proposed investments for year t.
In this case, the amount of dividends depends on the available profit after the
financing requirements of investment projects are met. To this purpose, the most profitable
projects are chosen, which prove that reinvestment has been made with a higher yield than
other placements on the financial market or the market of goods and services.
The essence of this decision is that new investment projects will result in an enhanced
company value and shareholders will be compensated through capital earnings. This type of
policy is especially suitable for small and closed companies, with a quick growth.
C. The stable and increasing dividend policy
This type of policy is characterised by the fact that dividends evolve regularly in time,
also with a slight increase, irrespectively of the variations in profits. It can be mathematically
described as follows:
Dt = f ( Dt-1 ) (4)

Even though, in some years, profits decrease, the stability of dividend decisions and
even the slight increase in dividends makes shareholders not sell their shares. In the long run,
the success of this decision refers to an increasing trend of dividend per share, which will
result in an increase in the companys value, provided that the equity cost rate is smaller,
precisely because the company ensures such stability. In the United States, such a policy is
usually implemented by large public utility companies.
According to statistical observations of the companies practice, it could be seen that
dividends increase more slowly than profits, but, exceptionally, it could also be seen that
dividends decrease to a lower rate than if the annual profit achievement ratio decreases. At
the same time, the point is to maintain a constant allocation ratio for as much time as
possible, and the increase should occur only when there is a conviction that this increased
level can be maintained in the following years.
There are some clearly determined reasons supporting the payment of stable and
predictable dividends, instead of following residual dividend policies or constant payout
fluctuating dividends are more risky than stable dividends and, hence, the investors
award a more significant value to the dividends they are certain to receive;
many shareholders use dividends for their current consumption and, in case they
cannot obtain cash in other ways, they have to sell some of their shares. This is actually quite
stable dividends allow management companies to use dividends as a signal
regarding the present and prospective intrinsic profitability of a company.
With a view to maintaining this dividend stability, it is preferable to find the related
means, even when the company does not have enough resources. The following methods can
be used: postponing certain investment projects; deviating from the target capital structure for
a certain period; issuing and selling new shares.
A corollary of this decision would be the following rule: never reduce annual
D. The stable dividends per share policy
According to this policy, the company aims at maintaining a stable level of dividends
per share for a long time. It can be mathematically described as follows:
Dt = Dt-1 = Dt-2 = ... (5)
In general, this policy is suitable for companies whose net profits per share do not
fluctuate significantly from one year to another.
It is our belief that, in our country, it cannot be yet said that companies apply a certain
practice. This happens because, as long as the economic situation does not prove to be stable,
the obtained results are mostly conjunctural. Dividend decision practices will only be clear
when the economic situation is rather stable.

References (selection)
1. Berceanu, Dorel Corporate financial policies, Course book for the English-
taught Bachelor s Programme in Finance and Banking, 2015;
2. Berceanu, Dorel Politica financiar a firmei, Editura Universitaria, Craiova,
3. Berceanu, Dorel Management financiar strategic. Aplicaii practice, Editura
Universitaria, Craiova, 2007;
4. Berceanu, Dorel Deciziile financiare ale firmei, Ediia a doua, Editura
Universitaria, Craiova, 2006.

P. Halpern, J.F. Weston, E. Brigham, Finane manageriale, Editura Economic, Bucharest, 1998, p. 687




lect. univ. dr. Alina MANTA


lect. univ. dr. Mihai NIOI



Chapter 1. Overview of the Financial System

1.1. Function of the financial markets

Financial markets perform the essential economic function of channelling funds from
households, firms, and governments that have saved surplus funds by spending less
than their income to those that have a shortage of funds because they wish to spend more
than their income. This function is shown schematically in Figure l.
Those who have saved and are lending funds, the lender-savers, are at the left, and
those who must borrow funds to finance their spending, the borrower-spenders, are at the
right. The principal lender-savers are households, bur business enterprises and the
government (particularly stale and local government), as well as foreigners and their
governments, sometimes also find themselves with excess funds and so lend them out.
The most important borrower-spenders are businesses and the government (particularly
the federal government). But households and foreigners also borrow to finance their
purchases of cars, furniture and houses. The arrows show that funds flow from lender-savers
to borrower-spenders via two routes.
In direct finance (the route at the bottom of Figure 1), borrowers borrow funds
directly from lenders in financial markets by selling them securities (also called financial
instruments) which are claims on the borrowers future income or assets. Securities are assets
for the person who buys them but liabilities for the individual or firm that sells (issues) them.

Figure 1: Flow of funds

1.2. Structure of the financial markets

Financial markets are like the "central nervous system" of the economy, says
Cecchetti's textbook. Stock, bond, and other financial markets respond to a host of factors
that others in the economy might easily overlook. And their reactions are easily readable in
the form of price movements, e.g., of individual stocks and the stock-market averages,
interest rates on Treasury and corporate bonds, mortgage rates.
Financial markets are also vitally important to an economy's development, because of
the role they play in allocating resources to their most profitable and productive uses. In a
well-developed financial market, financial instruments become streamlined and standardized
in their characteristics, making it a lot easier for potential buyers to know what they're
getting. When this happens, more people will want to purchase financial assets, and firms
can finance their investment more easily. This is good for household portfolios and for the
economy's long-term growth.
Financial instruments are bought and sold in both primary and secondary markets.
- primary financial market: where newly issued financial assets are bought and sold
(likely to finance investment in new physical capital, i.e., plant and equipment)
- secondary financial market: where previously issued financial assets are bought and
sold. The stock market is by and large a secondary financial market, with new issues
accounting for less than 1% of total shares outstanding. (Although not directly connected
with new investment, having a secondary financial market surely raises the level of
investment, and hence raises the stock of physical capital, because it makes stocks and bonds
a lot more liquid, since you can resell them any time you want.)
A financial institution is a business whose primary activity is buying, selling, or holding
financial assets. Financial institutions are sometimes called financial intermediaries
(businesses that connect savers with borrowers), since they serve as middlemen, or mediate,
between individuals, firms, and financial markets.
Financial intermediation or indirect finance is the process of obtaining funds or
investing funds through third-party institutions like banks and mutual funds. As a source of
funds for American businesses, indirect finance is far more common than direct finance. For
every dollar that firms raise by borrowing directly from households or selling stocks directly
to households, they raise about $20 through indirect finance - bank loans, selling bonds and
stocks to mutual funds, pension funds, insurance companies, etc. In future units we'll
examine the reasons why in detail. For now, the short answer is that lending your money to a
business firm is generally cheaper and safer with a financial institution serving as middleman
than if you do it on your own.

Types of financial institutions:

1. Depository institutions (banks, credit unions, savings & loan associations). Their
main liabilities (sources of funds) are deposits, and their main assets are loans.
2. Insurance companies. They collect premiums (regular payments) from policy-
holders, and pay compensation to policy-holders if certain events occur (e.g., fire, theft,
sickness). They invest the premiums in securities and real estate, and these are their main
3. Pension funds. They collect contributions from current workers and make payments
to retired workers. Like insurance companies, they invest the contributions in securities and
real estate, and these are their main assets.
4. Securities firms (provide firms and individuals with access to financial markets).
This category covers a wide array of financial institutions:

-investment banks: sell new securities for companies. Unlike regular banks, they don't
hold deposits, or make loans. (They hold zero assets/liabilities.). Closely related are
underwriters, which not only sell the new securities but pledge to purchase some or all of any
unsold shares.
-brokers: buy/sell old securities on behalf of individuals.
-mutual-fund companies: pool the money of small savers (individuals), who buy shares
in the fund, and invest that money in stocks, bonds, and/or other assets. These are popular
because they allow small savers relatively easy and cheap access and also enable them to
reduce risk by holding a diversified portfolio.
5. Finance companies. Like banks, they use people's savings to make loans to
businesses and households, but instead of holding deposits, they raise the cash to make these
loans by selling bonds and commercial paper. They tend to specialize in certain types of
loans, e.g., automobile (GMAC) or mortgage loans.
6. Government-sponsored enterprises (federal credit agencies). Some of these provide
loans directly, such as to farmers and home buyers. Some, such as the Federal National
Mortgage Association (FNMA), guarantee or buy up private loans, notably mortgage and
student loans. Some, such as the Social Security Administration, administer social insurance

1.3. Financial markets instruments

A financial instrument is a financial asset for the person who buys or holds one, and it
is a financial liability for the company or institution that issues it. Financial asset: any
financial claim or piece of property that can be owned. Financial assets usually have no
intrinsic value of its own, but they entitle the bearer to a stream of income or a share of assets
from the issuer of the asset. Financial liability: the obligation that the issuer of an asset has to
the owner/buyer of that asset. A security is a tradable financial instrument, like a bond or
a share of stock.
The payments promised to the holder of a financial instrument (or financial asset)
are more valuable if they are: larger; sooner to be made; more likely to be made (less
risky); made when they are needed most (e.g., when the holder is poor, retired, or otherwise
in need of money. This last one applies most directly to insurance policies).
Financial assets have two main uses: store of value - Financial assets like stocks and
bonds are mainly valued for their high rate of return; trading risk - Financial assets like
insurance policies allow you to transfer certain financial risks (arising from accidents, theft,
illness, early death, etc.) to another party (in this case, the insurance company).
On the flip side, financial liabilities are useful as a means of raising money and, for
issuers like insurance companies which charge premiums, as a means of income.
"Regular" financial instruments are called underlying financial instruments (or debt and
equity instruments), which are the type we've discussed so far and involve basic transfers of
money or assets from one party to another.
A more complicated type of financial instruments are derivative financial instruments,
which are more complicated and are based on an underlying financial instrument.
In the case of debt securities (tradable financial instruments that pay interest), we can
break them down into two categories according to their maturity length:
A) Money market instruments ("short-term," defined as maturing in < 1 year)
Prominent examples include:
- commercial paper - short-term corporate debt. Commercial paper is similar to
bonds, in the sense of being formal, short-term IOUs promising that a certain sum of money

plus interest will be paid back. Unlike bonds, the holding period is very short, and
corporation agrees to pay the money bank even earlier ("on demand"), if asked.
- treasury bills - short-term debt issued by the federal government to help finance its
current and past deficits;
- short-term "municipal" (state and local government) debt.
Less prominent examples include some other types of borrowed money, like
repurchase agreements (money borrowed using a Treasury bill as collateral) and eurodollars
(dollars borrowed from foreign entities).
B) bonds ("long-term," defined as maturing in >= 1 year). A bond is a formal debt
with a maturity length of one year or more.
- corporate bonds;
- treasury bonds, issued by the federal government to finance the national debt;
- municipal bonds, issued by state and local governments to finance large, long-term
capital projects (e.g., hospitals, highways, schools).
Bonds are also counted in another category of financial instruments, called capital-
market instruments, which also is for long-term instruments but which also includes non-
interest-bearing assets like stocks, as well as debts that are not publicly traded, like mortgage
loans, consumer loans, and business loans.
C) derivative instruments (which derive their value from the behavior of an
underlying financial instrument) are a different animal altogether, and their time horizons
can be very short or quite long.
Perhaps the oldest type of derivatives are futures contracts, whereby one party agrees to
sell another party a certain amount of a good at a definite price at a future date. For
commodities whose prices often fluctuate (e.g., crops, oil), these contracts are important ways
of reducing risk. More recently, these kinds of contracts have been used with financial
instruments. Some examples from the world of stocks:
Futures contracts specify that a sale of a set number of shares of a particular stock will
be sold from one party to another at a particular date. A person might purchase such a
contract so as to avoid risks due to price fluctuations, or a person might purchase the contract
as a way of making a bet that the stock's price will rise (or fall) in the meantime.
Options contracts (call options to buy a set number of shares at a set price at a set date,
put options to sell) are also common, and less risky to purchase, because you have the option
of not making that future trade if the prices have not moved in your favor.

Chapter 2. What Is Money?

2.1. Meaning of money

The dictionary has several definitions of money. In ordinary conversation we

commonly use the word money to mean income ("he makes a lot of money") or wealth ("she
has a lot of money"). In this course (and in macroeconomics courses in general), we use a
different definition, namely: money is anything that is generally accepted as payment.
This is the (macro) economists usage of the term money. MONEY is not the same
thing as INCOME or WEALTH.
When economists talk about the "money supply," we mean something very different
from national income (~GDP) or national wealth. The money supply is a lot smaller than
national income or national wealth. Generally speaking, money supply = cash in
circulation + bank account deposits.
There are several measures of the money supply, or "monetary aggregates." The
narrowest, and simplest, is "M1," or "transactions money," which corresponds closely to the

things that are most generally accepted as payment, namely cash (in circulation) and checking
deposits. M2, which used to be called "broad money," includes most other bank account
deposits as well as money-market funds.

2.2. Functions of money

Three main functions, or uses, of money:

1. Means of payment (medium of exchange). Because money is a generally accepted
form of payment, you can use it to buy things.
2. Unit of measurement (unit of account). You can use it to price things, e.g., in
dollars and cents. Ex.: new textbook is $120, Wall St. Journal (WSJ) subscription is $20,
phone call on Sprint is 10 cents a minute. Quoting prices in terms of dollars, the American
unit of account, is a lot easier than quoting prices in terms of other goods -- e.g., money &
banking textbook = 6 WSJ subscriptions or 1,200 minutes of long-distance calling; WSJ
subscription = 1/6 textbook = 200 long-distance minutes; 1 long-distance minute = 1/1200
textbook = 1/200 WSJ subscription. That's six barter prices to deal with, as compared with
just three dollar prices. (The number of barter prices goes up exponentially as the number of
goods and services increases. If we added a fourth commodity, say, pizza -- to the mix, there
would be twelve barter prices.)
3. Store of value -- an asset in its own right, and not a bad one, while cash earns no
interest, it's perfectly liquid (convertible into cash) and has no default risk. Money in bank
accounts earns some interest and is guaranteed against default by Federal Deposit Insurance.

2.3. Measuring money

2.3.1. The evolution of money and the payments system

The nature of money has changed over time and continues to evolve. Money came into
being thousands of years ago as a superior alternative to barter (trading goods and services
directly for other goods and services). The old type of money was commodity money -
money made up from precious metals or other commodities that have intrinsic value
(are valuable in their own right). Examples of commodity money could include gold, cows,
and pretty shells.
More recently, governments have developed fiat money - currency, usually paper
currency, which by government decree (i.e., "by fiat") is legal tender and which is not
officially convertible into gold or other precious metal.
Fiat money is the type of money we have today. Although our dollar bills have great
value and are accepted all over the world, they do not have intrinsic value, because they are
not really useful other than as money. Take away their monetary value (imagine, for example,
that the government says they're no longer legal tender, or that people lose their faith in U.S.
dollars), and they become mere pieces of paper.
A rapidly increasing share of our transactions in recent decades are electronic
transactions, such as credit-card transactions. Lately there has been the rise of e-money
(payment arrangements that exist only in electronic form and involve transfers of money).
Some forms of e-money: debit card: works like a credit card but transfers funds from
your personal bank account; automatic bill-paying: whereby money is transferred straight
from your bank account to the phone company, the power company, the local tax collector,
according to prior arrangements you have made. Pay-by-phone works similarly; e-cash: (like
Paypal;) arrangement by which you set up an account on the Internet that is linked to your

bank account. When you buy things on the Internet through this arrangement, your bank
account is debited by the amount spent.
Therefore, the evolution of the payment system is as follows: precious metals like gold
and silver (commodity money); paper currency (fiat money); checks; electronic means of
payment; electronic money: Debit cards, Stored-value cards, Smart cards, E-cash.

2.3.2. The money supply

The money supply (Ms) matters because it affects three very important things: the
price level, inflation, and economic recessions:
(1) Price level: higher levels of the Ms are a direct cause of higher price levels.
Likewise, increases in the money supply tend to cause the general price level to increase.
Inflation (an increase in the price level) is often described as "too much money chasing too
few goods." When the money supply increases faster than the productive capacity of the
economy, inflation is the usual result.
(2) Inflation: faster Ms growth rates tend to cause higher rates of inflation. From
international comparisons we see a tight relationship between money (M2) growth rates and
inflation rates. A hyperinflation (explosive growth of prices, inflation rates of over 50% per
month, or well over 1000% per year) is impossible without extremely rapid money-supply
(3) Recessions may be caused by steep declines in the Ms growth rate. In the past
50 years, there have been eight recessions, and every single one of them was preceded by a
notable decline in the money (M2) growth rate. Then again, not every decline in the M2
growth rate was followed by a recession. Thus the old joke that "economists have predicted
twelve of the last eight recessions."
The "monetary aggregates" are measures of the money supply. The main ones are M1
and M2. The Fed used to keep track of a broader monetary aggregate, M3, which included
everything in M1 and M2 plus large CD's, institutionally-held money-market funds, and two
key sources of borrowed funds for banks, term repurchase agreements (repos) and term
Eurodollars. The Fed stopped keeping track of M3 in late 2005, after deciding that it
contained no relevant economic information that was not already in M2.
M1 is the narrowest measure of the money supply, including only cash, checking
account deposits, and travelers checks and money orders. M2, which used to be called "broad
money," includes everything that is in M1 and also includes savings and money-market
deposit accounts, small-denomination certificates of deposit (CD's or time deposits), and
money-market mutual fund shares held by individuals.
The three monetary aggregates contain the following types of money and money-
market instruments:

M1 M2
Cash in circulation Cash in circulation
+ Checking deposits + Checking deposits
(+ Traveler's checks+money (+ Traveler's checks+money orders)
orders) + Savings accounts
+ Money-market mutual fund shares (MMF's) held by
+ Money-market deposit accounts (MMDA's)
+ Small CD's (time deposits)
+ Small repurchase agreements

Note well: A money-market mutual fund, which holds only money-market assets like
T-bills and commercial paper, is very different from a regular mutual fund, which typically
holds mostly capital-market assets like stocks and bonds. Newspaper listings of regular
mutual funds normally list each fund's share price (or "Net Asset Value"), the change in its
price in the previous day, and the fund's rate of return since the year began. Newspaper
listings of money-market mutual funds are much less frequent --not even the Wall St. Journal
lists them every day -- and normally include little more than each fund's approximate interest
rate, expressed as an average of its interest rates over the past seven days ("7-day yield").
Regular mutual fund shares, then, are a lot like stocks in the way they are bought and sold
and reported; money-market funds are a lot more like bank accounts (especially money-
market deposit accounts).
M1 is by far the most volatile of the monetary aggregates, in large part because people
can now easily transfer money from checking accounts to savings accounts, money-market
deposit accounts, and money-market funds. In fact, M1 was falling in the late 1990s, even
though the other monetary aggregates, M2 and M3, were rising.

2.3.3. Prices and inflation

Inflation is one of the "chronic aches and pains" of most modern economies. It erodes
many people's savings and leaves many more people worried that their incomes won't keep
up with rising prices. Since low inflation is one of the two main policy goals (along with
avoiding recessions) of the Federal Reserve, we'll be hearing a lot about it in this course. Let
us turn our attention to defining inflation and seeing how the inflation rate is calculated.
Aggregate price level: an index of the average prices of goods and services in the
economy. Two of the most important measures of the price level are:
- Consumer Price Index (CPI), which measures the average price of a
representative "basket" of consumer goods and services;
- GDP Price Deflator, which deals with the prices of goods and services in all the
different components of GDP (consumption, business investment, government purchases,
net exports) and is used to adjust measured GDP for inflation (i.e., to convert nominal
GDP into real GDP; P = (nominal GDP)/(real GDP), i.e. PY/Y; GDP deflator = 100 *
Nominal GDP/Real GDP).
The price level is an index, which has been set equal to 100 for a chosen base year,
which we use as a basis for comparisons. Comparisons with a base of 100 are easy because
the percent change calculation reduces to simple subtraction -- just subtract 100 from the
current price level, and you've got the total percent change in prices since the base year. Ex.:
Currently the base year for the CPI is the average of three years, 1982-84. The CPI was
about 196 in December 2005, which means that consumer prices on average were 196% as
high, or 96% higher, in December 2005 than they were in 1982-84.

Chapter 3. Fundamentals of Credit Activity

3.1. Basic concepts

Loan means immediate possession of resources in exchange of a future payment

promised involving also an interest payment that rewards the lender (Basno and Dardac,
The word credit comes from the Latin "creditum-creditare", which means "to trust".
This points out a physiologic factor of the credit activity which is the trust.

The role of the credit is carried out by the results obtained in the economy through the
credit relations or by the contribution of the credit to the achievement of some objectives of
economic policy. This role may be seen from the following perspectives:
1. Its contribution to the equalization of the profit ratio, in the sense that being a
mean of the redistribution among the sectors of the available capitals, it participates also in
this process;
2. The contribution of the credit to the intensification of the capital's concentration
process, in the sense that the process of accumulating the capital is encouraged by the credit,
provided that it has investment objectives;
3. The contribution of the credit to the raise of the population's standard of living, in
the sense that by means of a credit one can purchase real estate and goods with high value
and long useful life.
The main functions of the credit. In order to define the credit, there are three
The credit as trust;
The credit as an expression of redistribution relationships;
The credit as a form of exchange relationships (Dardac, 2004).
The complete definition of the credit can be given by taking into account and
correlating these three approaches: the credit represents an economic category that expresses
relationships of distributing part of the GDP or of the national income, through which the
available funds of the economy are mobilized and distributed and new payment means are
created, aiming at satisfying some capital needs and achieving some objectives of the
economic policy.
In essence, the credit represents the exchange of a present monetary value with a
future monetary value (Dima, 2003).
The elements and features of a credit. The elements included in the credit
relationships are:
the parties of the credit relation;
the promise of repayment;
the guarantee of the credit;
the maturity date;
the interest (the price of the credit).
The parties of the credit relation, the creditor and the debtor, are called in the
literature "the subjects of the credit relation". The creditors and the debtors can be grouped
into three major categories: the population, the state and the economic agents.
The promise of repayment represents the creditor's commitment to repay, at the
maturity date, the amount of the borrowed capital, plus the interest, as price of the credit.
Due to an unfavorable circumstance, internal or external, the debtor may be in
incapacity of payment or he may delay the payment of the due amounts. For this reason it is
necessary that the creditor takes the appropriate measures for preventing and eliminating the
risk of non-repayment, by a careful analysis of the credit solicitor from several points of
view: the position on the internal market and in the field of activity, the financial situation,
the leverage degree, the juridical form, the relation with other participants on the market and
the past/ projected cash flow. Tightly connected and deriving from the promise of repayment
appears the guarantee of the credit.
The security/guarantee of the credits represents a characteristic related to their
According to the nature of the elements that constitute the object of the guarantee,
one can make the distinction between the real guarantee and the personal guarantee.

The real guarantee is based on the guaranteeing or "mortgaging" the credit with
material valuables through the valorization of which can be obtained the necessary amounts
for repaying the credit.
A distinct form of real guarantee is the mortgage, the act through which the debtor
concedes the right over a real estate to the creditor, without dispossession.
Usually, a mortgage is accompanied by various interdictions: sale, another mortgage,
rent, split-off, joint, demolition, construction, rehabilitation, design, without the lender's
explicit approval.
The most appropriate form of guarantee is the financial guarantee which is possible by
the assurance in the future of some revenue flows enough to cover the expenses related to the
repayment of the credit and the related interest. For this purpose, the credit is guaranteed with
the patrimonial elements of the debtor (fixed and current assets).
In practice it is used the method of guaranteeing the credit with the portfolio
of accounts receivable held by the economic agent that requested the credit.
The personal guarantee represents the commitment taken by a third party to pay the
amount become due in case the debtor is not capable to pay it.
Many lenders are happy to lend money to a business provided that an individual
personally guarantees the loan. If you personally guarantee a debt, you will be personally
liable for any judgment resulting from a default. This is a common requirement for many
commercial loans.
The maturity date or the repayment term provided in the contract differs according to
the features of the field of activity and the efficiency level of the credit beneficiaries' activity.
Thus, there is a variety of maturity dates, from 24 hours (in the case of interbank
market) to medium and long periods (20 or 30 years) in the case of mortgage loans.
Between the maturity date and the repayment method a correlation can be settled as
follows: the short-term credits are to be repaid entirely at the maturity date, while the medium
and long-term credits imply the gradual repayment.
The interest represents a characteristic of the credit and it is the price of the used
capital or the "rent" that the debtor pays for the right conceded to him, that of using the
borrowed capital. The quantification of the interest is acquired by using the interest rate
which becomes a tool for influencing the demand and the supply of credits.
A low level of the interest rate implies a big demand for credits which determines
favorable effects on the production and the economy, as well as a high cost of credits, a high
interest rate respectively, generates the diminution of the demand for credits. Taking into
account the inflation rate, in comparison with the interest rate provided in the credit contract,
leads to ascertaining the fact that in the periods with a high inflation, the credits are a perfect
financing method for the debtors.
According to the same element, the inflation, the credit relations use two types of
interest: fixed and floating.
The fixed interest is provided in the credit contract and it is valid for the entire period
of the credit.
The floating interest is modified periodically according to the inflationary pressures and
the evolution of the interest level on the market. The interest rates are usually linked to
ROBOR/ EURIBOR/ LIBOR, according to the currency of the facility, as they are computed
as: variable margin (ROBOR/ EURIBOR/ LIBOR) and fixed margin (the fixed margin
integrates the risk of country, the risks of the bank, the risks of the debtor, the liquidity
adjustments due to credit maturity).

3.2. Types of credit

There are various types of credits:

A. According to the economic nature and the parties of the crediting relation
The commercial credit
Sometimes referred to as business credit or commercial lending, commercial credit
refers to the ability of a business to obtain goods and services from a supplier. The borrowing
is done in the form of merchandise (the goods and services are paid at a later date and not in
the moment of the sale). Business credit is extended with the understanding that the business
promises to pay the supplier according to the terms and conditions that the buyer agreed to at
the time of acquisition.
The banking credit
Banking credit represent the amounts lend by the bank to an individual or to a
company. The borrowing capacity may vary from the banking credit, as sometimes
companies/ individuals decide to borrow below the maximum amount the banks are willing
to provide.
The main credits granted by the banks are (according to the way of using them):
o Advances in current account or treasury credits - satisfy the current needs by
covering the unexpected production expenses and temporary financing gaps; they can or
cannot be formally guaranteed and do not have pre-established repayment terms. In general,
this type of credit is granted on some compensation deposits, which can be redistributed by
the bank in the current account of the company.
o Credit lines - are credits in which the bank gives the company a temporary loan,
up to a pre-established maximum amount, in order for the company to cover its current
The consumer credit
The consumer credit is a credit offered to natural persons/individuals who work based
on a working contract and have the salary as a main income source (there also can be
considered as income sources the following: dividends, rents etc). The most known
consumption credits are: personal needs credit; credits for durables goods acquisition; auto
credits; holiday credits; study credits; medical credits.
The bond credit
In finance, a bond is a debt security, in which the authorized issuer owes the holders a
debt and, depending on the terms of the bond, is obliged to pay interest (the coupon) and/or to
repay the principal at a later date, term maturity. A bond is a formal contract to repay
borrowed money with interest at fixed intervals. Bonds are issued by public authorities, credit
institutions, companies and supranational institutions in the primary markets and provide the
borrower with external funds to finance long-term investments, or, in the case of government
bonds, to finance current expenditure.
The mortgage credit
A debt instrument that is secured by the collateral of specified real estate property and
that the borrower is obliged to pay back following a pre-established reimbursement schedule.
Mortgages are used by individuals and businesses to make large purchases of real
estate without paying the entire value of the acquisition up front. In a residential
mortgage, a home buyer mortgages his or her house to the bank. The bank has a claim on the
house should the borrower default on paying the installments. In the case of a foreclosure, the
bank may evict the home's tenants and sell the house, using the income from the sale to offset

B. According to the debtor's position
The credit granted to natural persons
This form of credit is granted to individuals and can have many forms:
Treasury credit - when the payments done through the current account are higher
than the cash existing in the account;
Consumption credit - for acquiring goods that will be paid by installments;
Personal credit - free utilization of the money received; Home acquisition credit;
Personal loans, as a type of loans offered to individuals (natural persons) can have the
following forms:
o Fixed rate loans - generally used to provide finance for purchases for covering
temporary gaps in cash flows. They are made on short term (6 months-3 years) and can be
secured or not; the payments are generally done monthly.
o Budget accounts provide personal customers with the means of spreading their
household and other regular expenses through the year. The customer makes a regular
monthly payment into a budget account (one twelfth of the agreed estimated annual
expenses) and draws on that account to settled specified bills.
o Mortgage loans - loans secured by means of a legal charge over a property
o Bridging loans are short term loans that provide a customer with funds to purchase
a new home while the sale proceeds of their former home are awaited.
o Credit cards - provide a revolving credit facility, up to a predetermined maximum,
and a period of interest-free credit if the balance on the statement is paid off in full
within a stated period.
The credit granted to legal persons.
This form of credit is granted to companies and can have many forms:
Working capital credit - covering the merchandise and production expenses;
Pre-financing credit - for the expenses with goods produced in one period and sold
in another future period;
Equipment/investments credit;
Inventory financing
Warehousing financing
International finance credits - for exports
Factoring; etc
o Factoring - is a method of financing where a bank or other specialized company
purchases a company's trade receivables. The consideration for this receivables acquisition
may be immediate or deferred for a fixed period of time. The amount paid for the debts
depends on the additional services offered, which may include: protection against bad
debts (non-recourse factoring - the factoring bank bears the risk of loss if the debtor is
unable to pay and therefore takes a greater discount on the face value of the invoice);
receivables collection; invoices & collections administration.
o Inventory financing loan that is secured by inventory and is scheduled to be
repaid from the sale of that inventory. All the borrower's inventories can be used as security
on a loan. However, the seller is not constrained from selling inventories, so that the bank
cannot control specific inventory items.
o Warehousing financing facilitates inventory lending by providing controls on the
disposition of a borrower's inventories. An independent third party receives and stores the
inventories and provides the bank with warehouse receipts. The bank then creates a deposit
for the borrower at an advance rate, typically in the range of 50 to 80 % of the value of the
receipted goods. As the borrower's customers submit orders for the goods the bank releases

goods to make the sales and the proceeds of the sales are remitted directly to the bank to
repay the loan.
C. According to the debtor's and the creditor's nature
The private credit
This type of credit is the one offered to companies and individuals in order to perform
their activity and achieve certain goals.
The public credit
The public credit is the ensemble of relations of utilization and mobilization of
resources with temporary and redeemable character in order to cover the public expenses of
the state. Usually it is done through bond emissions (state bonds) and it can be done in two
ways: the state is financed directly by the natural and legal persons who want to offer support
for the state or the credit is contracted through specialized institutions (banks, social
insurance companies, pension institutions, etc) who collect the money from the market and
put them at the state's disposal.
D. According to the purpose of granting the credit
Credits for production
These credits are offered in order to support the companies in their production
process. They can have the following forms: operating credits, investments credits,
speculative credits.
Credits for circulation
The circulation credit is granted for covering the expenses with the transportation and
storing of goods, being viewed as an advanced payment for the goods sold and not cashed in
Credits for consumption
The credit for consumption is granted for the procurement of goods for personal use.
E. According to the nature of the guarantees
Real credits - based on a material security (real guarantee) which can have the
following forms:
the retention right - the creditor has the right to restrain an asset of the debtor if the
credit was not entirely paid;
the mortgage - the act through which the debtor gives to the creditor an asset as
guarantee for the credit received;
the privilege - the right given by the law to certain creditors to have priority in
being paid by the debtor, when they have a guarantee over a part or all the assets of the
Personal credits - based on personal moral guarantees (is the pledge of a third party
to pay the credit if the borrower cannot do it). The guarantees have the following forms:
o simple guarantee - the third party has the right to negotiate its obligations
and, if there are more than one persons guaranteeing for the borrower, it will be held
responsible only for its part;
o solidarity guarantee - the third party can be liable to pay the debt in the same time
or even before the borrower.
F. According to the extent of the creditor's rights
Credits that can be declared exigible before their maturity date
These credits are characterized by the fact that the creditor has the right to ask for the
reimbursement of the loan any time before the maturity date, with or without previous notice
to the debtor.
Credits that cannot be declared exigible before their maturity date
These credits are characterized by the fact that they can be reimbursed only at the
maturity date or according to the reimbursement schedule, and not before that date.

Mixed credits
They are a mix between the two described above and the reimbursement of the loan is
made before the maturity date only in special situations on which the parties agreed when
concluded the contract.
G. According to the way of paying off the obligations of payment
Redeemable credits. The redeemable credit is a credit which involves installments,
equal or not, and can be with or without interest.
Non-redeemable credits ("Balloon" credits). For these credits, the reimbursement
of the loan is done entirely at the maturity date.
H. According to the maturity date of the credit:
Short-term credits: granted for short periods of time (from 1 to 6 months).
They can have the following forms (however not limited to those categories):
o Warehouse certificates: titles for 3 or 6 months issued by the government in
order to cover the money deficit of the current year. They have a fixed interest rate and the
nominal value is equal with the issue value.
o Treasury certificates: they are issued for 1, 3 or 6 months in order to cover the
temporary resource need which resulted because the public income was not collected
properly and in time.
o Tax certificates: titles that are used by the population for tax payments to the state.
The amount borrowed is not reimbursed but compensation is made between the state
debt/duty to the creditor, who holds the certificate, and the creditor debt/duty to the state,
represented by the income tax.
Medium-term credit: they are granted for periods between 1 and 3 years
Long-term credits: granted for long period of times
The long and medium term credits can be represented by bonds, mortgages, leasing
contracts, investment facilities etc.

3.2.1. The Interest Rate
The interest is a fee, paid on borrowed capital. The interest is calculated upon the value
of the assets.
The amount lent, or the value of the assets lent, is called the principal. This principal
value is held by the borrower on credit. Interest is therefore the price of credit, not the price
of money as it is commonly - and mistakenly - believed to be.
The percentage of the principal that is paid as a fee (the interest), over a certain period
of time, is called the interest rate.
The fee is also a compensation to the lender for foregoing other useful investments that
could have been made with the loaned money. These foregone investments are known as the
opportunity cost.
Interest rate is a rate which is charged or paid for the use of money. An interest rate is
often expressed as an annual percentage of the principal. It is calculated by dividing the
amount of interest by the amount of principal.
For example, if a lender (such as a bank) charges a customer $90 in a year on a loan of
$1000, then the interest rate would be:
90/1000 = 9%.
Interest rates are typically noted on an annual basis, known as the annual percentage
rate (APR).
The assets borrowed could include, cash, consumer goods, large assets, such as a
vehicle or building.
Interest is essentially a rental, or leasing charge to the borrower, for the asset's use.
There are two main types of interest rate: simple and compound.

The simple interest rate is calculated on the original principal only. Simple interest
pays a fixed amount over time. Accumulated interest from prior periods is not used in
calculations for the following periods.
Simple interest is normally used for a single period of less than a year, such as 30 or 60
days and it is calculated as follows:
Is = p x i x n
Is - simple interest;
p - principal (original amount borrowed or loaned);
i - interest rate for one period;
n - number of periods.
Simple interest is useful when:
- The interest earnings create something that cannot grow more. Its like the corporate
bond paying money that cannot be reinvested;
- The investor wants simple, predictable, non-exponential results.
In practice, simple interest is fairly rare because most types of earnings can be

Example 1: For a loan of $100 for 3 years at 50% interest rate, the simple interest will

Is = p x i x n = 100 x 0.5 x 3 = 150 $

Example 2: For a loan of $100 for 60 days at 50% simple interest rate per year (assume
a 365 day year) will be:

Is = p x i x n = 100 x 0.5 x (60/365) = 8.22 $

Compound interest is calculated each period on the original principal and all interest
accumulated during past periods.
The interest earned in each period is added to the principal of the previous period to
become the principal for the next period. In general, there will be (1+i) times more amounts
each year. After n years, this becomes:

Ic = p (1+ i) n

Compound growth is useful when:

- interest can be reinvested, which is the case for most savings accounts;
- it can be predicted a future value based on a growth trend.
The power of compounding can have a great effect on the accumulation of wealth.

Example: For a loan of 100$, for 3 years and at 50% interest rate:

at first year: Ic1 = 100 (1 +0.5) = 150 $

in the second year: Ic2 = 100 (1+0.5)2 = 225$
in the third year: Ic3 = 100 (1+0.5)3 = 337.5 $

If the compounding periods are yearly, semiannually, quarterly or continuous, the

principal and the interest rate will be:

Ic = p(1 + i/t) nt
Ic = principal and interest rate;
p = initial deposit;
i = interest rate;
t = number of times per year interest is compounded;
n = number of years invested.

The following table shows the final principal (Ic), after n = 1 year, of an account initially
p = $10000, at 6% interest rate (i) at the given compounding (t): Ic = p(1 + i/t) nt

t Ic

1 (yearly) $ 10600.00

2 (semi-anually) $ 10609.00

4 (quarterly) $ 10613.64

12 (monthly) $ 10616.78

52 (weekly) $ 10618.00

365 (daily) $ 10618.31

1. John Smith made a deposit at a bank of 2,500 USD, for 4 years with a simple interest
rate of 15%. How many money would have lost John at the end of the 4 years if his
deposit had the compound interest rate?
For the loan of $2,500 for 4 years at 15% interest rate, the simple interest: Is = p x i x n =
2,500 x 0.15 x 4 = 1500 $
For the loan of $2,500 for 4 years at 15% interest rate, the compound interest: Ic = 2,500
x (1+0.15)4 = 4372.5 $
He would have lost: 4372.5 $ - 1500 $ = 2872.5 $;
2. What will be the interest rate for a loan of 12,500 USD for 30 days at 50% simple
interest rate per year?
For a loan of $12,500 for 30 days at 50% simple interest rate per year: Is = p x i x n =
12,500 x 0.5 x (30/365) = 513.7 $
3. Made the comparison (principal plus interest rate) for using the simple and
compound interest rate for one investment of 20,000 USD during a period of 10 years
using 17% interest.
For the loan of $20,000 for 10 years at 17% interest rate, the simple interest: Is = p x i x n
= 20,000 x 0.17 x 10 = 34,000 $
For the loan of $20,000 for 10 years at 17% interest rate, the compound interest: Ic =
20,000 x (1+0.17)10 = 20,000 x 4,806828 = 96,136.56 $
4. What is the compound interest rate for a loan of 5000 USD, for 2 years, using a 20%
interest rate compounded yearly, semi-annually and quarterly?
For the loan p = 5,000 $, after n = 2 year, at 20% interest rate (i) at the given

compounding (t=1), the compound interest:
Ic = p(1 + i/t) nt = 5,000(1+0,2)2 =7,200$
For the loan p = 5,000 $, after n = 2 year, at 20% interest rate (i) at the given
compounding (t=2), the compound interest:
Ic = p(1 + i/t) nt = 5,000(1+0,2/2)4 = 7,320$
For the loan p = 5,000 $, after n = 2 year, at 20% interest rate (i) at the given
compounding (t=4), the compound interest:
Ic = p(1 + i/t) nt = 5,000(1+0,2/4)8 = 7,387.28$

In finance, an individual who lends money for repayment at a later point in time
expects to be compensated for the time value of money, and to be compensated for the risks
of having less purchasing power when the loan is repaid.
These risks are:
systematic risks which includes the possibility that the borrower will be unable to
pay on the originally agreed terms, or that collateral backing the loan will prove to be less
valuable than estimated;
regulatory risks which includes taxation and changes in the law which would
prevent the lender from collecting on a loan or having to pay more in taxes on the amount
repaid than originally estimated;
inflation risks takes into account that the money repaid may not have as much
buying power from the perspective of the lender as the money originally lent that is inflation,
and may include fluctuations in the value of the currencies involved.

Nominal interest rates include all three risk factors, plus the time value of the money
Real interest rates include only the systematic and regulatory risks and are meant to
measure the time value of money.
Therefore the difference between the nominal interest rate and the real interest rate is
given by the inflation rate. In finance and economics, nominal interest rate refers to the rate
of interest before adjustment for inflation.
The real interest rate is the interest rate adjusted for expected changes in the price
levels so that it more accurately reflects the true cost of borrowing. So, the real interest rate
includes compensation for the lender's lost value due to inflation.
The real interest rate is defined by the Fisher equation which states that the nominal
interest rate (i) equals the real interest rate (r) plus the expected rate of inflation ():
Rearranging terms, the real interest rate equals the nominal interest rate minus the
expected inflation rate:
Example: For a one-year simple loan with a 10% nominal interest rate (i) and an
expected inflation rate of 6% over the course of the year, the real interest rate will be:
r = 10% - 6% = 4%
The lender is anxious to make a loan in the case of increasing inflation rate, because in
terms of real goods and services, he will actually earn a lower interest rate.
On the other hand, the borrower fares quite well because at the end of the year, the
amount paid back will be less in terms of goods and services. Therefore, when the real
interest rate is low, there are greater incentives to borrow and less to lend. The distinction
between real and nominal interest rates is important because the real interest rate, which
reflects the real cost of borrowing, is likely to be a better indicator of the incentives to
borrow and lend.
It appears to be a better guide to how people will be affected by what is happening in
credit markets.
The real interest rate is used in various economic theories to explain such phenomena
as the business cycle, capital flight and economic bubbles.
when the real rate of interest is high, that is demand for credit is high, then money
will, all other things being equal, move from consumption to savings;
conversely, when the real rate of interest is low, demand will move from savings, to
investment and consumption.
A low level of the interest rate implies a big demand for credits which determines
favorable effects on the production and the economy, as well as a high cost of credits, a high
interest rate respectively, generates the diminution of the demand for credits.
Taking into account the inflation rate, in comparison with the interest rate provided in
the credit contract, leads to ascertaining the fact that in the periods with a high inflation, the
credits are a perfect financing method for the debtors.
According to the same element, the inflation, the credit relations use two types of
interest: fixed and floating.
The fixed interest is provided in the credit contract and it is valid for the entire period
of the credit.
The floating interest is modified periodically according to the inflationary pressures
and the evolution of the interest level on the market.
The interest rates are usually linked to ROBOR/ EURIBOR/ LIBOR.
EURIBOR is short for Euro Interbank Offered Rate. The Euribor rates are based on

the average interest rates at which a large panel of European banks borrow funds from one
another. There are different maturities, ranging from one week to one year. The Euribor rates
are considered to be the most important reference rates in the European money market.
LIBOR is the average interbank interest rate at which a selection of banks on the
London money market are prepared to lend to one another. LIBOR is watched closely by
both professionals and private individuals because the LIBOR interest rate is used as a base
rate (benchmark) by banks and other financial institutions. Rises and falls in the LIBOR
interest rates can therefore have consequences for the interest rates on all sorts of banking
products such as savings accounts, mortgages and loans.
ROBOR (Romanian Interbank Offered Rate) is the average interest rate for RON-
denominated loans in the interbank market and is set by the National Bank of Romania.

3.3. The Romanian legal framework related to credit activity

The legal framework of the credit is represented by the Banking Law - Law no.
58/1998 with the subsequent modifications provided by Law no. 485/2003. According to
Law no. 58/1998, art. 3, the credit represents any payment engagement of an amount of
money in exchange of the right to repay the amount paid and to pay interest or any expenses
related to this amount or any prolongation of a debt's maturity as well as any engagement of
acquiring a title that includes a debt or any other right to pay an amount of money.
When granting credits, the banks pursue that the solicitors present credibility for their
repayment at maturity. For this purpose the banks require the solicitors the guarantee of the
credits in the conditions set by their lending policies. The banks must obey some prudential
requirements when provided by the regulations of the National Bank of Romania, including
the following:
the minimum level of solvency, determined as a ratio between own funds and the
total of assets and elements outside the balance sheet, weighed according to their risk degree;
the maximum exposure to a single debtor, expressed as percentage, as a ratio
between its total value and the level of bank's own funds or as a maximum amount;
the maximum aggregate exposure, expressed as percentage, as a ratio between the
total value of great exposures and the level of own funds;
the minimum level of liquidity, determined according to the maturities ofthe debts
and bank's obligations;
the classification of the granted credits and the interests not cashed-in related to
them and the setting up of the specific risk provisions;
the currency position, expressed as percentage according to the level of own funds;
the management of the bank's resources and securities;
the extension of subsidies network and other secondary bank centers.
Banks have to report monthly to the National Bank of Romania every large loan
granted to their customers. The loan is considered to be large when the amount of all loans
granted to a single debtor, including guarantees and other commitments assumed on behalf of
him, exceeds 10% of the own funds of the bank. The amount of one large loans granted to the
debtor shall not exceed 20% from the own funds of the bank and the total amount of all large
loans granted by a bank shall not exceed 8 times the level of the own funds of the bank
(National Bank of Romania-Norms no. 8/1999 concerning the minimizing of the credit risk of
banks, published in OM no 245 on 06.01.1999; Art. No. 6).
The banks are bond to provide for an adequate level of solvency. The minimum
solvency ratio calculated as the report between their own funds and total assets should be
12% and the minimum solvency ratio computed as the report between the equity and total
assets should be 8%

According to the Norm no 8/1999 concerning the minimizing of the credit risk,
published in OM no. 245 on 06.01.1999 issued by the National Bank of Romania, the banks
can grant loans to the persons who are in special relations with it, only under certain
conditions provided by the special rules.

Chapter 4. The Credit Analysis

4.1. Basic Concepts

The past decade has seen dramatic losses in the banking industry. Companies that had
been performing well suddenly announced large losses due to credit exposures that turned
sour, interest rate positions taken, or derivative exposures that may or may not have been
assumed to hedge balance sheet risk. In response to this, commercial banks have almost
universally embarked upon an upgrading of their risk management and control systems.
The major purpose of credit analysis is to identify risks in lending situations,
draw conclusion regarding the likelihood of payment and make recommendations as to the
proper type and structure of the loan in the light of the perceived financing needs and risks.
Credit analysis is the quantitative and qualitative analysis of a company, which help to
determine the company's debt service capacity, or how capable it is to pay back its principal
payments to the bank or other creditors. Credit analysis is concerned with identifying,
evaluating and mitigating those risks which may result in a company not being able to meet
its creditors' claims.
Credit analysis involves the examination of the link between management,
performance or capacity and the working relationship of a company's assets, liabilities and
equity as shown on its balance sheet, the result of its operations as reflected in its income
statement and cash flow. The evaluation of the company's financial statements and the ratios
that indicate the efficiency of the company's performance will thus provide an indicator of the
probability of success of the ability to service its debt in the future.

4.1.1. The ''five C's"- the basic components of a credit analysis

Character is the general impression the customer makes on the prospective lender or
investor. The lender will form a subjective opinion as to whether or not the company is
sufficiently trustworthy to repay the loan or generate a return on funds invested in the
company. The background and experience in business and in the industry will be considered.
The quality of the references and the background and experience levels of employees will
also be reviewed.
Capacity to repay is the most critical of the five factors; it is the primary source of
repayment - cash inflows and cash generated by the company. The prospective lender will
want to know exactly how the borrower intends to repay the loan. The lender will consider
the cash flow from the business, the timing of the repayment, and the probability of
successful repayment of the loan. Payment history on existing credit relationships - personal
or commercial - is considered an indicator of future payment performance. Potential lenders
will also want to know about other possible sources of repayment.
Capital is the money personally invested in the business by the shareholder borrower
and is an indicator of how much the shareholder has at risk should the business fail.
Interested lenders and investors will expect a contribution from borrower's own assets and to
have undertaken personal financial risk to establish the business before asking them to
commit any funding. The capital investment is seen also as a proof for shareholder's
commitment in the business.

Collateral (or guarantees) are additional forms of security the customer can provide
the lender. Giving a lender collateral means that an own asset is mortgaged, such as a
property, to the lender with the agreement that it will be the repayment source in case the loan
is not repaid from the established sources as per terms and conditions agreed for the
financing. A guarantee, on the other hand, is just that - someone else signs a guarantee
document promising to repay the loan if the initial lender cannot. Some lenders may require
such a guarantee in addition to collateral as security for a loan. A collateral is considered "the
second way out" by the lender in case the credit goes wrong.
Conditions describe the intended purpose of the loan and the conditions under which
the credit is being granted. Will the money be used for working capital, additional equipment,
and inventory or for a long term investment? The lender will also consider local and
macroeconomic conditions and the overall climate, both within the industry and in other
industries that could affect the business.

4.1.2. The importance of risk analysis in credit evaluation

The nature of the business and the competitive environment in which the company
operates determine to a large extent the asset investment, financial decisions and profit
dynamics of the company. Risk analysis is performed to understand the company's
competitive position, its strategy, and its effect on financing needs. The bank expects the
principal and the interest to be paid. The risk that the bank takes is that the company will not
be able to pay back whole or parts of the total sum so all the credit applications should
thoroughly be analyzed.
The following steps should be followed:
1. Identify the risks
Define and document all risks inherent in the management, product, company,
industry and economy that could possibly affect the company's operations, and thus its ability
to service its debt. This is done through information gathering - the more relevant
information, the better.
2. Evaluate the risks
It should be evaluated how and to what extent the risks might affect the operations of
the business. Generally the business risk regards the quality and efficiency of the assets,
performance risk is determined through income statement analysis and financial risk is
determined by how liabilities are funded by the assets. Management risk is determined by
how well management controls the above three major risks.
3. Mitigate the risks
After a thorough understanding of the risks has been made, it is in the bank's
best interest that the risks are minimized and even fully mitigated. Once the interrelationship
of all the risks has been defined, a balance must be found between the risks and return, which
is done through the structure of the loan agreement, collateral, as well as appropriate
covenants and established pricing.
The main factors that mitigate interest rate risks are: established limits on mismatch
positions, hedging with financial futures or other instruments; management monitoring

4.2. Main elements of the credit analysis

Before looking at the types of loans available from commercial banks, it is important
to understand the perspective of the typical commercial loan officer when he or she
analyzes a loan proposal. There is often a lot of confusion and resentment about the

relationship between bankers and entrepreneurs. The entrepreneur believes the banker does
not understand and appreciate his or her business requirements, while the loan officer may
have had bad experiences with entrepreneurs who expect to borrow more than a million
dollars (collateralized only by a dream), the loan officer has had to foreclose on a default
by a small business or certain internal norms or regulations impose the lender to follow
a more restrictive policy. Banks are in the business of selling money and capital is the
principal product in their inventory. Bankers, however, are often personally risk averse and
have internal controls and regulatory restrictions affecting their risk tolerance.
The bank's shareholders and board of directors expect loan officers to take all steps
necessary to minimize the bank's risk in each transaction and obtain the maximum protection
against default. As a result, the types of loans available to growing companies, the terms and
conditions, and the steps the bank takes to protect its interest all have a direct relationship to
the proper assessment of risk. The management team assigned to obtain debt financing from a
commercial bank must embark on an immediate risk-mitigation and risk-management
program to prepare for negotiating the loan documentation.

4.2.1. Loan proposal characteristics

Although the exact elements of a loan package will vary depending on a company's
size, industry, and stage of development, most lenders will want the following fundamental
questions answered:
a) Who is the customer?
b) How much capital do they need and when?
c) How will the capital be allocated and for what specific purposes?
d) How will the borrower service the debt obligations (application and
processing fees, interest, principal, or balloon payments)?
e) What protection (collateral) can the borrower provide the bank in the event that he
is unable to meet the agreed obligations?
f) What are the key business matrices and how well are they measured, monitored
and understood (the diagnostic "dashboard")?
These questions are all designed to help the loan officer assess the risk factors in the
proposed transaction. They are also designed to provide the loan officer with the information
necessary to persuade the loan committee to approve the transaction. It must be understood
that the loan officer (once convinced of the company's creditworthiness) will serve as an
advocate on clients' behalf in presenting the proposal to the bank's loan committee and
shepherding it through the bank's internal processing procedures. The loan documentation,
terms, rates, and covenants that the loan committee will specify as conditions to making the
loan will be directly related to how the company can demonstrate its ability to mitigate and
manage risk as described in the business plan and formal loan proposal.
The loan proposal should include the following categories of information, many of
which might be included under the business plan:

Summary of the request. An overview of the history of the company, the amount of
capital needed, the proposed repayment terms, the intended use of the capital, and the
collateral available to secure the loan. Also the proposed pricing is included under this
Borrower's history. A brief background of your company; its capital structure; its
founders; its stage of development and plans for growth; a list of customers, suppliers,
and service providers; management structure and philosophy; main products and services;
and an overview of any intellectual property owned developed; group structure and support
offered by the parent are also to be considered.
Market data. An overview of trends in the industry; the size of the market; the market
share of the company; an assessment of the competition; the sustainable competitive
advantages; marketing, public relations, and advertising strategies; market research
studies; and relevant future trends in the industry as well as expectations for the future.
Financial information. Multi-scenario financial statements (best case/ expected
case/worst case), federal and state tax returns, company valuations or appraisals of key assets,
current balance sheet, credit references, and the income statement. The role of the capital
requested in the plans for growth, an allocation of the loan proceeds, and the ability to
repay must be carefully explained.
Schedules and exhibits. As part of the loan proposal, there should also be attached
certain key documents, such as agreements with strategic vendors or customers, insurance
policies, leases, and employment agreements.

4.2.2. Structure of the credit analysis

Every bank has a specific format of the credit analysis, but they include most of the
issues that will be further discussed. Generally, the analysis of the credit should include the
following elements:

A. Description of the loan - There are a
number of types of loans available from a B. Description of the Company-
commercial bank, one or more of which could The description of the company
be tailored to meet specific requirements. including the name, industry,
Loans are usually categorized by the maturity description of the activity, the legal
of the loan, the expected use of proceeds, and form, ownership, holding or
the amount of money to be borrowed. The mother company, group structure
availability of various loans will depend on should be made. It should also be
both the nature of the industry and the bank's mentioned the market share of the
assessment of company's creditworthiness. company, the products or services
it provides and the major suppliers,
major clients and major
competitors and also the suppliers
and clients.
C. Credit History - Any lender would want
to know whether the client has paid past
credit accounts on time. However, late D. Analysis of the Market/Industry -
payments are not an automatic reason for The Bank should identify and evaluate the
not granting the loan. At the same time, vulnerability of the company to external
having no late payments in the credit report factors and its ability to protect against
does not mean granting the loan. them.

- Financial analysis using business or financial ratios

provides a mean of assessing a company's strengths and
weaknesses. Using data from the balance sheet and
income statement, various ratios can be computed which
can then be compared directly to those of competing
E. Financial companies of varying sizes.
analysis of the - Generally, financial ratios are calculated for the purpose
borrower of evaluating aspects of a company's operations and fall
into the following categories: liquidity ratios, solvency
ratios, profitability ratios, efficiency ratios.

Once the loan proposal has been submitted,

the process thereafter should not be a
mystery or an indefinite process.
decision Negotiating the Loan Documents: interest
rates, collateral, restrictive convenants,
prepayment rights, hidden costs and fees.

G. Additional conditions

4.3. Credit Scoring

4.3.1. Credit assessment methods in the Romanian banks

Credit scoring is a scientific method that uses statistical models to assess an

individual's credit worthiness based on their credit history and current credit accounts. In
Romania, credit scoring is mostly used to determine in which of the 5 classes, the credit will
be included. According to their own norms the banks decide to which category of clients they
grant the loan, but most of the Romanian banks base their decision on credit analysis report.
The criteria and indicators used might vary from one bank to another; however the principles
considered should be the same.
The credit scoring (for legal persons) is generally based on qualitative and quantitative
criteria such as:
A) Qualitative criteria. Management quality, business strategy and environment,
collateral received, customer transparency and quality of financial statements presented,
buyers/ suppliers' diversification, technology used, age/size of the company and track record,
quality and evolution of the competition, are considered the most useful tools for
evaluating the quality of business and management.
The evaluation of the qualitative factors is achieved so that the bank can form its
convictions regarding the moral and professional values of the managers of the credit
applicant economic agents, of the main shareholders/associates and collaborators, and also of
the reputation of the firm seen by means of the products, services quality and the manner of
fulfilment of the obligations assumed in the relations with the business partners.
The non-financial analysis contributes to the most real evaluation of the crediting
risk and it supposes taking into account two categories of non-financial factors: internal and
Table no. 1.
Internal non-financial factors
1. Management of the activity professional training, prestige and experience in
the field;
experience and reputation of the managerial team;
morality and capacity of the management to pay
their obligations;
quality of the informational system.
2. Clients activity evolution and profile of the activity;
activity area and activity character;
products and services;
marketing, competition and marketing;
clients and suppliers;
human resources.
3. Strategy the existence of a strategy for the next 5 years;
ways of achieving the proposed strategy;
the existence or nonexistence of the financial
restructuring or improvement.
External non-financial factors

1. Activity field: characteristics of the activity field

2. Impact of the legislation on the clients activity

3. Dependence on the supply sources and the sale markets, etc.

Source: Spulbr, C., Nioi, M. - Enterprise Lending, Sitech Publishing House, Craiova,

The result obtained upon the algebra addition of the points awarded to each evaluation
indicator establishes the clients economical-financial and non-financial performance and,
thus, is at the basis of the crediting decision.
B. Quantitative criteria refer to main ratios calculated based on the financial
documents of the company.
The number and exact type of financial indicators used to assess the creditworthiness
of the firm differs from one bank to another, but a representative set of indicators includes:
- level and structure indicators: turnover, equity, return of the year (profit or loss),
working capital, working capital requirements, net treasury, liquidity, solvency, leverage,
assets turnover;
- indicators of profitability and return;
- indicators of risk: interest coverage ratio.

4.3.2. The setting up of the financial performance of the borrower

The determination of the quality of the borrower is assessed by including the

customers in one of the five categories and it is based upon a classification system:
Table no. 2

Classification of borrowers according to the financial performance

Category Credit with

of the credit Current credit deferred payment Due credit

Credits under

B Performing
Credit undercredits
supervision supervision
Credit under standard Due creditCredit
C Substandard credit Doubtful Credit Credit with losses
D Doubtful Credit Credit with losses Credit with losses
E Loss Credit with losses Credit with losses
Source: Dima, M. (coord.) Banking for Business Administration, ASE Publishing House,
Bucureti, 2012;

A) borrowers with a profitable activity and a solid financial standing having

ensured the proper conditions of supply and marketing, technology, administration and
human resources which safely provide the reimbursement of the due installments and the
related interests at maturity.
B) borrowers with a good economic and financial standing at present, with good
creditworthiness ratios, but for the next period there are low chances to maintain these
performances at the same level, due to either technological or administrative
problems, related to the nature and the object of the activity.
C) borrowers have at present a satisfactory economic and financial standing,
but with a trend of worsening of their production ratios, efficiency of the activity etc.

D) the economic and financial standing of the borrowers is characterized by
inferior ratios, with fluctuations on short-term between a satisfactory and unsatisfactory
E) borrowers have an unprofitable activity, with losses, involving uncertainty
regarding the capacity of the reimbursement of the credit and related interests.
According to their quality, the credits could be classified as follows:
Performing credits (with low risk) - no risk placements which enables the
reimbursement of the debt according to the contract clauses;
Credits under supervision - granted to customers with very good economic and
financial records but who for short periods of time they faced difficulties in reimbursing the
installments and the related interests. This category also includes credits that are not at
maturity or reimbursed in due time, but which have been granted to some customers with a
trend of diminishing their turnover in the future according to the bank forecasting (due to
problems related to their performance, their competitiveness, depreciation of the equipment
Credits substandard - risky placements, which could affect the reimbursement of
the debt. They are not sustained by the net capital value or by the reimbursement capacity of
the borrower. The losses implied by this kind of credits are undertaken by the banks if the
reimbursement is made only partially;
Doubtful credits (with major risk) - the reimbursement or their liquidation is very
difficult as they are not or partially covered;
Credits with losses - they cannot be reimbursed.
The points afferent to each category of presented indicators can differ from one bank to
another, in accordance to the crediting rules and the analysis procedure.

Chapter 5. Banks and Bank Management

5.1. Bank balance sheets

Balance sheets are the standard accounting tool for listing a bank's assets and liabilities,
which is all that a bank's balance sheet is. Drawing one up is fairly simple:
- Step one: Draw a big lower-case "t."
- Assets (how the bank uses its funds) go on the left side.
- Liabilities (sources of funds, or how the bank gets its funds) go on the right side.
You may have seen a similar table in introductory macro. The numbers in parentheses
are the proportions of the total.


Reserves (cash on hand or stored with DEPOSITS (checking 8% + savings & CDs 57%
Fed) (1%) = 65%)

Cash items in the process of collection Borrowings (loans from other banks and
(3%) nonbanks) (20%)

Securities (Treasury bonds, etc.) (24%) Other liabilities (incl. borrowings from foreign
sources) (6%)

LOANS to firms, individuals, etc.


Other assets (8%) Bank capital ( = Total assets - Total liabilities)


-------------------------------------------------- --------------------------------------------------------


in April 2007) (100%; $9.8 T)

For the balance sheet to "balance," the two sides must add up to the same amount.
However, a healthy bank will not have equal amounts of assets and liabilities, but will instead
have more assets than liabilities.

Assets - Liabilities = Bank capital (or Net worth)

What we do to make the two sides equal is to add Bank capital to the Liabilities side.
(Note that it now bears the heading "Liabilities + Bank Capital." Bank capital could be either
equity (shares of stock in the bank) or retained earnings.
We normally list the most liquid items first. (The general rule is to list items in
descending order of liquidity.)
On the asset side, then, the first item on a bank's balance sheet is reserves, which banks
keep to meet deposit outflows (withdrawals, checks drawn on the bank, etc.) and because
they're required to do so by the Fed. Banks are required by the Fed to hold a certain
proportion of their deposits as reserves, mainly to guard against "runs on the bank" and to
allow the Fed to manipulate the money supply. Reserves can be held either as cash or in
accounts at the Fed. Currently, the required reserve ratio (RRR) is 10% on checking
accounts and zero on savings and money-market accounts.
The difference between a bank's total reserves and its required reserves is its excess
excess reserves (ER) = actual reserves - required reserves = actual reserves 10 % *
checking deposits.
Excess reserves are mainly kept by banks as a precaution. In good times, banks
generally try to keep as few excess reserves as possible, since they earn no interest on them.
The Fed's reserve requirements are typically much higher than what banks actually need in
order to be able to handle deposit outflows.
Example of Balance Sheet of a Commercial Bank:

Checkable Deposits. Checkable deposits are bank accounts that allow the owner of the
account to write checks to third parties. Checkable deposits include all accounts on which
checks can be drawn: non-interest-bearing checking accounts (demand deposits), interest-
bearing NOW (negotiable order of withdrawal) accounts, and money market deposit accounts
Nontransaction deposits. are the primary source of bank funds (53% of bank liabilities
in Table 1). Owners cannot write checks on nontransaction deposits, but the interest rates
paid on these deposits are usually higher than those on checkable deposits. There are two
basic types of nontransaction deposits: savings accounts and time deposits (also called
certificates of deposit, or CDs).
Borrowings. Banks also obtain funds by borrowing from the Federal Reserve System,
the Federal Home Loan banks, other banks, and corporations. Borrowings from the Fed are
called discount loans (also known as advances). Banks also borrow reserves overnight in the
federal (fed) funds market from other U.S. banks and financial institutions.
Bank Capital. The final category on the liabilities side of the balance sheet is bank
capital, the bank's net worth, which equals the difference between total assets and liabilities
(10% of total bank assets in Table 1). Bank capital is raised by selling new equity (stock) or
from retained earnings. Bank capital is a cushion against a drop in the value of its assets,
which could force the bank into insolvency (having liabilities in excess of assets, meaning
that the bank can be forced into liquidation).
Reserves. All banks hold some of the funds they acquire as deposits in an account at
the Fed. Reserves are these deposits plus currency that is physically held by banks (called
vault cash because it is stored in bank vaults overnight). Although reserves earn a low interest
rate, banks hold them for two reasons. First, some reserves, called required reserves, are held
because of reserve requirements, the regulation that for every dollar of checkable deposits at
a bank, a certain fraction (10 cents, for example) must be kept as reserves. This fraction (10
% in the example) is called the required reserve ratio. Banks hold additional reserves, called
excess reserves, because they are the most liquid of all bank assets and a bank can use them

to meet its obligations when funds are withdrawn, either directly by a depositor or indirectly
when a check is written on an account.
Cash Items in Process of Collection. Suppose that a check written on an account at
another bank is deposited in your bank and the funds for this check have not yet been
received (collected) from the other bank. The check is classified as a cash item in process of
collection, and it is an asset for your bank because it is a claim on another bank for funds that
will be paid within a few days.
Deposits at Other Banks. Many small banks hold deposits in larger banks in exchange
for a variety of services, including check collection, foreign exchange transactions, and help
with securities purchases. This is an aspect of a system called correspondent banking.
Collectively, reserves, cash items in process of collection, and deposits at other banks are
referred to as cash items. In Table 1, they constitute only 8% of total assets, and their
importance has been shrinking over Lime. In 1960, for example, they accounted for 20% of
total assets.
Securities. A bank's holdings of securities are an important income-earning asset:
Securities (made up entirely of debt instruments for commercial banks, because banks are not
allowed to hold stock) account for 22% of bank assets in Table 1, and they provide
commercial banks with about 10% of their revenue. These securities can be classified into
three categories: U.S. government and agency securities, state and local government
securities, and other securities. The U.S. government and agency securities are the most
liquid because they can be easily traded and convened into cash with low transaction costs.
Because of their high liquidity, short-term U.S. government securities are called secondary
Loans. Banks make their profits primarily by issuing loans. In Table 1, some 61 % of
bank assets are in the form of loans, and in recent years they have generally produced more
than half of bank revenues. A loan is a liability for the individual or corporation receiving it,
but an asset for a bank, because it provides income to the bank. Loans are typically less liquid
than other assets, because they cannot be turned into cash until the loan matures. If the bank
makes a one-year loan, for example, it cannot get its funds back until the loan comes due in
one year. Loans also have a higher probability of default than other assets. Because of the
lack of liquidity and higher default risk, the bank earns its highest return on loans. As you
saw in Table 1, the largest categories of loans for commercial banks are commercial and
industrial loans made to businesses and real estate loans. Commercial banks also make
consumer loans and lend to each other. The bulk of these interbank loans are overnight loans
lent in the federal funds market. The major difference in the balance sheets of the various
depository institutions is primarily in the type of loan in which they specialize. Savings and
loans and mutual savings banks, for example, specialize in residential mortgages, while credit
unions tend to make consumer loans.
Other Assets The physical capital (bank buildings, computers, and other equipment)
owned by the banks is included in this category.

5.2. T-accounts

Bank balance sheets are a modified form of balance sheets, useful for examining how
a bank reacts to changes. Instead of laboriously listing all of the bank's assets and liabilities,
T-accounts list only the changes in the bank's assets and liabilities.

- Basic BankingCash Deposit:

Opening of a checking account leads to an increase in the banks reserves equal to the
increase in checkable deposits.

- Basic BankingCheck Deposit

- Basic BankingMaking a Profit

Asset transformation-selling liabilities with one set of characteristics and using the
proceeds to buy assets with a different set of characteristics. The bank borrows short and
lends long

For example, suppose I won the NCAA basketball pool and get paid with a check for
$100, drawn on Prof. Spizman's account at the Key Bank, and deposit it into my checking
account at Pathfinder Bank. The initial change, before the check clears, to my bank's balance
sheet will be as follows:

Pathfinder Bank, BEFORE Check Clears

Cash items in the process of collection + $100 Checking deposits + $100

At Key Bank, before the check clears there is no change on Key's balance sheet,
because Key has no way of knowing that someone has written a check on a Key account.
They don't find out about that until the check has gone to the New York Fed to be cleared.
After the check clears, the change in Pathfinder Bank's balance sheet is just a bit
different, and Key's balance sheet will be a lot different:

Pathfinder Bank, AFTER Check Clears

Reserves at Fed + $100 Checking deposits + $100
If the reserve requirement is 10%, the bank has an increase in excess reserves of --?
(Change in) excess reserves = total reserves - required reserves
= $100 - (10%) ($100)
= $100 - $10 = $90
It will probably loan out those excess reserves, so as to earn interest on them.

Key Bank, AFTER check clears

Reserves at Fed - $100 Checking deposits - $100
The change in Key's excess reserves is negative, since only $10 had to be held as
reserves against those $100 in checking deposits yet $100 cash is now gone. So if the bank
had zero excess reserves before, it would now have excess reserves of -$90 (= -$100 - (-
$10)), or a reserve deficiency of $90. To obtain that $90, the bank would have to borrow
some funds from the Fed or another bank, borrow from a corporation (repo), sell off some of
its assets (e.g., T-bills), issue commercial paper, or call in some of its loans. Of those options,
calling in some of its loans (usually accomplished by simply not renewing short-term loans)
is the one the bank likes least, because its loans are its most profitable business - a bank, after
all, makes a profit by obtaining funds at a relatively low interest rate (zero on basic checking
accounts) and loaning them out at much higher interest rates. Also, the customer whose loan
is called in will have to take his business elsewhere, and might do so permanently; since
banks hate to lose good customers, they generally avoid calling in loans early.

5.3. Areas of bank management

Going down a typical balance sheet, we can note four different areas of primary
concern to a profit-maximizing, risk-averse bank management team. A bank's managers have
to keep track of four different primary areas:
(1) LIQUIDITY MANAGEMENT: make sure the bank has just enough cash
reserves and liquid assets to meet (net) deposit outflows and its reserve requirements at the
Fed. Here we see the usual risk-return relationship. Reserves don't pay interest, so keeping
too much in the way of reserves reduces the bank's overall profitability. But holding just the
bare minimum of reserves exposes the bank to liquidity risk, i.e., the risk of failing to meet its
Fed reserve requirements or being unable to meet an unexpectedly large deposit outflow.
(2) ASSET MANAGEMENT: acquire assets (loans, securities) with acceptably
low risk and high return. Several types of risk come into play here. First, there is credit
risk, or default risk - the possibility that some of the loans owed to the bank won't be repaid.
To manage credit risk, financial intermediaries can do the following activities: screening and
information collection, specialization in lending, monitoring and enforcement of restrictive

covenants, long-term customer relationships, loan commitments, collateral and compensating
balances, credit rationing.
Bank loans and bond holdings are also subject to interest-rate risk - the possibility that
market interest rates might go up, causing the bank's fixed-rate loans to lose value. Because
interest-rate risk is particularly severe on household mortgages, which typically have a length
of 30 years, banks tend to sell their mortgages off as quickly as possible, to government
agencies like the Federal National Mortgage Association (which buy them up and repackage
them as securities to sell to the public). (In addition, especially for banks that are active in
financial derivatives markets, there is trading risk, or market risk, if, say, a derivatives
contract ends up obliging the bank to sell a financial instrument for less than it paid for it.).
As with household investors, banks can reduce some of their risk through diversification, e.g.,
by making different kinds of loans and holding securities of varying maturity lengths.

If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will
reduce bank profits and a decline in interest rates will raise bank profits.

Basic Gap Analysis:

(rate-sensitive assets rate sensitive liabilities)

interest rates = in bank profits

Maturity Bucket Approach

measures the gap for several maturity subintervals
Standardized Gap Analysis
accounts for differing degrees of rate sensitivity

(3) LIABILITY MANAGEMENT: acquire funds (deposits, borrowings) at low

cost. A good combined yardstick of asset and liability management together is the bank's
interest-rate spread: the difference between the average interest rate at which the bank loans
(earns) money and the interest rate at which the bank borrows (pays) money. Interest-rate
risk comes into play here as well. Higher interest rates can deal a bank a double-blow, the
PDV of the bank's long-term fixed-rate loans and bonds takes a beating, while the bank has to
pay higher interest rates to its depositors in order to be competitive.
(4) CAPITAL ADEQUACY MANAGEMENT: decide how much capital (net
worth) the bank should have and acquire it. Capital adequacy management is similar to
liquidity management. Just as a bank may hold excess reserves to guard against unexpected
deposit outflows, it needs to have a decent cushion of funds -- specifically, a large enough
excess of assets compared with its liabilities -- to protect it from an unexpected drop in the

value of its assets, since virtually all of its loans carry at least some risk of default. Banks are
required by federal authorities to meet certain minimum capital requirements. The level of
bank capital can be either too high or too low: too much bank capital dilutes the shareholders'
equity, thus reducing their returns (i.e., their return on equity), whereas too little puts the
bank at risk of insolvency.

Return on Assets: net profit after taxes per dollar of assets

net profit after taxes
Return on Equity: net profit after taxes per dollar of equity capital
net profit after taxes
equity capital
Relationship between ROA and ROE is expressed by the
Equity Multiplier: the amount of assets per dollar of equity capital
EM =
Equity Capital
net profit after taxes net profit after taxes assets

equity capital assets equity capital
A simple way to memorize the four areas of bank management: just remember the
acronym "LALC" for Liquidity management, Asset management, Liability management,
and Capital adequacy management.
The Off-Balance-Sheet Activities are: Loan sales (secondary loan participation),
Generation of fee income, Trading activities and risk management techniques - Futures,
options, interest-rate swaps, foreign exchange, Speculation, Principal-agent problem, Internal
Controls (Separation of trading activities and bookkeeping, Limits on exposure, Value-at-
risk, Stress testing).

Chapter 6. Central Banks and Tools of Monetary Policy

6.1. Introducing the Federal Reserve

Virtually every country has a central bank of some kind, to be the government's banker
and to regulate the supply of money and credit. The U.S. central bank is the Federal
Reserve System, or the Fed. It is a network of 12 regional Federal Reserve banks in major
U.S. cities, with additional branches in a couple dozen other cities. The Fed's greatest power
is concentrated in Washington, DC, where the Federal Reserve Board of Governors, headed
by the Fed Chairman (now Ben Bernanke), is located. Today the Fed is the most
powerful economic policy-making institution, and its decisions on monetary policy and
interest rates are watched intently by businesses, banks, and financial markets.
The Fed has been around since 1914, one year after Congress passed the Federal
Reserve Act. The act was prompted by the severe financial panic of 1907, which led many to
conclude that the private banking system needed an outside organization to help avert future
panics. Congress gave the Fed a permanent charter, with the understanding that it would be a
"lender of last resort" that could provide liquidity and credit in troubled times. Although the
Fed was created by the federal government, and despite the similarity of the words "Fed" and
"feds," the Fed is technically not part of the government. It is an independent, self-financing
agency. The presidents of the twelve regional Federal Reserve Banks are appointed by the

banks' shareholders, not by politicians. The seven members of the Fed's board of governors
are appointed by the President of the United States and confirmed by the Senate, but they
have 14-year terms, long enough to make them basically independent of the political process.
Still, the Fed's independence from politics is far from complete. The chairman of the Fed has
only a 4-year term, which means that every U.S. president gets to appoint a Fed chair to his
liking. On the other hand, presidents of both parties tend to appoint the same sort of people
to the Fed - respected academic or business economists who are dedicated to keeping
inflation low.
The Fed has become considerably more powerful over the course of this century. It
became especially powerful in the 1980s, as Paul Volcker (who served as Fed Chairman
from 1979-87) brought down double-digit inflation nearly single-handedly. Also, rising
federal budget deficits in the 1980s, and concern that they were unacceptably large, meant
that fiscal policy (changing the levels of government spending and taxes so as to stimulate or
slow down the economy) was no longer much of an option. Alan Greenspan, who served as
Fed Chairman from 1987-2006 and presided over low inflation and tremendous prosperity,
was even more revered the Volcker. People now look first to the Fed, rather than to Congress
or the White House, for action on the economy.
The Fed influences the supply of credit, the money supply, and interest rates
mainly by manipulating the supply of bank reserves.
The Fed's mission has evolved over the years to the point where the Fed is basically
expected to keep the economy strong and stable. In particular, the Fed's two main goals
are: (1)low and stable inflation (around 1-3%); (2) low unemployment (around 4-5%).

6.2. Structure of the Fed

The Fed is a bank, with assets and liabilities to manage, but it is totally unlike any other
U.S. bank. It does not accept deposits, aside from commercial banks' reserve accounts and
government deposits; instead, the vast majority of the Fed's liabilities are dollar bills,
a.k.a. "Federal Reserve Notes" or "Currency in circulation." U.S. currency is the Fed's
liability because the Fed is responsible for maintaining the value of that currency by keeping
inflation low.
On the asset side, unlike commercial banks, the Fed makes almost no loans, except
emergency discount loans to banks facing cash shortages. The vast majority of the Fed's
assets are government securities, which the Fed buys and sells in order to affect the supply
of bank reserves and the money supply.
The Fed's holdings of government securities are also important in that they provide the
Fed with substantial interest income, more than enough to finance the Fed's operations. The
Fed's interest expenses on the liability side are about zero, because it does not pay interest on
U.S. currency or on banks' reserve accounts. Put that two facts together, and you get an
enormously profitable bank; the Fed's charter, however, requires it to turn over all of its
profits to the federal government. In terms of total assets, the Fed is larger than all but a few
U.S. banks. (It was the largest as recently as the late 1990s.)
The Federal Reserve System is composed of the following:
- the seven members of the Federal Reserve Board of Governors in Washington,
DC. These are the central figures of the Fed. All seven Fed governors sit on the Fed's official
policy-making group, the Federal Open Market Committee (FOMC), which has 12 members
altogether. Each is appointed by the President of the United States (and confirmed by the
Senate) to a 14-year term. They cannot be reappointed, but most return to academia or
business before their term is up, anyway. The Chairman (now Ben Bernanke; was Alan

Greenspan, 1987-2006) is the exception: his term as Chairman is only 4 years and is
- 12 regional Federal Reserve Banks in major financial centers of the U.S. such as
New York, Boston, and Chicago. Of the regional Feds, the Federal Reserve Bank of New
York is by far the most powerful. It conducts the Fed's open-market operations (buying and
selling of securities so as to influence the money supply and interest rates) and its foreign-
exchange transactions (designed to influence the dollar's exchange rate). Its president is the
permanent Vice-Chairman of the FOMC.
- several thousand commercial banks, some of which belong to the Federal Reserve
System but all of which are subject to the Fed's reserve requirements and are able to borrow
money from the Fed (at its "discount window").
The Federal Open Market Committee (FOMC) is the Fed's policy-making group.
- it meets every six weeks to plot the course of monetary policy
- it decides what it wants the federal funds rate to be. Open-market operations (OMO)
is its tool for reaching that target.
- it has 12 members -- the seven Fed Governors, the NY Fed President, and four
other regional Fed Bank Presidents.
- it sets targets for the federal funds rate, which are implemented by the NY Fed as
OMO decisions.
6.3. Tools of monetary policy

The Fed has three main policy tools, which it uses to influence the level of bank
reserves and the monetary base, and through them the money supply and interest rates and the
(1) changes in banks' required reserve ratio (currently 10% of checking deposits
must be kept as reserves). The Fed rarely changes these requirements, because it's too blunt a
policy instrument, in that it could lead to excessive changes in the money supply and liquidity
crunches at many banks.
(2) discount loans / changes in the discount rate. These loans to banks fulfill the
Fed's "lender of last resort" function. While not many banks take out such loans, in a period
of financial crisis or recession the Fed may encourage banks to do so. The discount rate is the
interest rate the Fed charges on its loans to banks. (Historically it was slightly lower than the
federal funds rate, the overnight lending rate between banks, but that's no longer the case.
For example, in 2004 the discount rate was a point higher than the federal funds rate.)
(3) OPEN MARKET OPERATIONS (OMO; buying and selling Treasury bonds
from banks). When the Fed buys a T bond from a bank or lends money to a bank, it
increases the total of bank reserves, thereby increasing the monetary base. When the Fed sells
a T bond to a bank, the bank pays the Fed by allowing the Fed to debit its reserve account,
thereby decreasing the total of bank reserves and the monetary base. OMO is by far the Fed's
most commonly used policy tool, and is what the Fed uses to control the much-watched
federal funds rate (the interest rate at which banks loan reserves to each other).


1. Dima, M. (coord.) Banking for Business Administration, ASE Publishing House,

Bucureti, 2012;
2. Mishkin F., Matthews K., Giuliodori M. - The Economics of Money, Banking and
Financial Markets, European Edition, Pearson, 2013;
3. Spulbr, C., Nioi, M. - Enterprise Lending, Sitech Publishing House, Craiova,


The material is extracted from The Economics of Money, Banking, and

Financial Markets, by Frederic Mishkin

Chapter 7. Banking and the Management of Financial Institutions

Because banking plays such a major role in channelling funds to borrowers with
productive investment opportunities, this financial activity is important in ensuring that the
financial system and the economy run smoothly and efficiently. Banks provide loans to
businesses, help us finance our college educations or the purchase of a new car or home, and
provide us with services such as checking and savings accounts.

7.1. The bank balance sheet

To understand how banking works, we start by looking at the bank balance sheet, a
list of the banks assets and liabilities. As the name implies, this list balances; that is, it has
the characteristic that:

Total assets = total liabilities + capital

A banks balance sheet is also a list of its sources of bank funds (liabilities) and uses
to which the funds are put (assets). Banks obtain funds by borrowing and by issuing other
liabilities such as deposits. They then use these funds to acquire assets such as securities and
loans. Banks make profits by charging an interest rate on their asset holdings of securities and
loans that is higher than the interest and other expenses on their liabilities.


A bank acquires funds by issuing (selling) liabilities, such as deposits, which are the
sources of funds the bank uses. The funds obtained from issuing liabilities are used to
purchase income-earning assets. Briefly, we will describe the important sources of funds for
Sight deposits. Sight deposits are bank accounts that allow the owner of the account
to write cheques to third parties or to draw cash out of ATMs without loss of interest. Sight
deposits include all accounts on which cheques can be drawn: non-interest-bearing accounts
(demand deposits) and interest-bearing cheque accounts. Sight deposits are payable on
demand, hence they are sometimes known as demand deposits; that is, if a depositor shows
up at the bank and requests payment by making a withdrawal, the bank must pay the
depositor immediately. Similarly, if a person who receives a cheque written on an account
from a bank presents that cheque at the bank, it must pay the funds out immediately (or credit
them to that persons account). A sight deposit is an asset for the depositor because it is part
of his or her wealth. Because the depositor can withdraw funds and the bank is obliged to
pay, sight deposits are a liability for the bank. They are usually the lowest-cost source of bank
funds because banks pay no interest or a very small amount of interest on these deposits and
depositors are willing to forgo some interest to have access to a liquid asset that they can use

to make purchases. The banks costs of maintaining cheque deposits include interest
payments and the costs incurred in servicing these accounts processing, preparing and
sending out monthly statements, providing efficient tellers (human or otherwise), maintaining
an impressive head office and conveniently located branches, and advertising and marketing
to entice customers to deposit their funds with a given bank.
Time deposits. Time deposits cannot be withdrawn on demand like sight deposits.
They have a fixed term to maturity which means that the funds have to be kept in the account
for a minimum period to earn interest. Depositors cannot write cheques on time deposits, but
the interest rates paid on these deposits are usually higher than those on sight deposits. Time
deposits also include savings accounts. Time deposits have a fixed maturity length, ranging
from several months to over five years, and assess substantial penalties for early withdrawal
(the forfeiture of several months interest).
Banks deposits and other funding. Banks borrow and lend to each other through
the interbank market. These interbank deposits can be the same as demand deposits or they
can have fixed maturities of one month, three months or even several years. The function of
the interbank market is to distribute funds between banks that have surplus funds and banks
that have shortages of funds. So a loan from one bank to another is not like a loan from a
bank to a customer. Banks deposit funds (lend) in the interbank market and other banks bid
(borrow) funds. The process of bid and offer produces a market rate of interest at which
banks are willing to lend to each other or borrow from each other. A bank can also borrow
from the central bank at times.
Debt and other securities. Banks also obtain funds by borrowing from the financial
market. They do this by issuing bonds and certificates of deposits (CDs). CDs are negotiable;
like bonds, they can be resold in a secondary market before they mature. For this reason,
negotiable CDs are held by corporations, money market mutual funds, and other financial
institutions as alternative assets to Treasury bills and other short-term bonds.
Foreign currency deposits. An international bank also borrows and lends in foreign
currency. Certain foreign currency deposits like US dollars can be held by domestic residents
and foreigners can also deposit funds in their own currency. Holding foreign currency
deposits exposes the banks to foreign currency risk.
Bank capital. The final category on the liabilities side of the balance sheet is bank
capital, the banks net worth, which equals the difference between total assets and liabilities.
Bank capital is raised by selling new equity (stock) or from retained earnings. Bank capital is
a cushion against a drop in the value of its assets, which could force the bank into insolvency
(having liabilities in excess of assets, meaning that the bank can be forced into liquidation).


A bank uses the funds that it has acquired by issuing liabilities to purchase income-
earning assets. Bank assets are thus naturally referred to as uses of funds, and the interest
payments earned on them are what enable banks to make profits.
Reserves. All banks hold some of the funds they acquire as deposits in an account at
the central bank. Reserves are these deposits plus currency that is physically held by banks
(called vault cash because it is stored in bank vaults overnight). Although reserves earn a low
interest rate, banks hold them for two reasons. First, some reserves, called required reserves,
are held because of reserve requirements, the regulation that for every euro of sight deposits
at a bank, a certain fraction must be kept as reserves. This fraction is called the required
reserve ratio. Banks hold additional reserves, called excess reserves, because they are the
most liquid of all bank assets and a bank can use them to meet its obligations when funds are

withdrawn, either directly by a depositor or indirectly when a cheque is written on an
Securities. A banks holdings of securities are an important income-earning asset.
These securities can be classified into three categories: government and agency securities
such as Treasury bills and short-term government bonds, commercial paper and private-sector
bonds, and other securities. Treasury bills and other short-term government debt are the most
liquid because they can be easily traded and converted into cash with low transaction costs.
Because of their high liquidity, short-term government securities are called secondary
reserves. Banks also hold commercial paper and other short-term securities of the non-
financial company sector for two reasons. First, companies are more likely to do business
with banks that hold their securities. And second, short-term company securities are liquid,
but less liquid and riskier than equivalent maturity government securities, primarily because
of default risk: there is some possibility that the issuer of the securities may not be able to
make its interest payments or pay back the face value of the securities when they mature.
Therefore the interest rate on commercial paper is normally higher than that on Treasury
Loans. Banks make their profits primarily by issuing loans. A loan is a liability for
the individual or corporation receiving it, but an asset for a bank, because it provides income
to the bank. Loans are typically less liquid than other assets, because they cannot be turned
into cash until the loan matures. If the bank makes a one-year loan, for example, it cannot get
its funds back until the loan comes due in one year. Loans also have a higher probability of
default than other assets. Because of the lack of liquidity and higher default risk, the bank
earns its highest return on loans. Commercial banks also make consumer loans and lend to
each other. The bulk of these interbank loans are short-term loans lent in the interbank
market. The major difference in the balance sheets of the various depository institutions is
primarily in the type of loan in which they specialize. Savings banks and UK-type building
societies, for example, specialize in mortgages, while credit banks tend to make consumer
Net trading assets. Trading assets are government securities, asset-backed securities
or commercial securities such as derivatives that the bank holds for the purpose of selling
them for a profit. They are valued at the existing market price (known as mark-to-market) and
are bought at a low price and sold at a high price. These assets are held for a short period so
as to gain from a profit in trade. The bank also holds trading liabilities where they might
guarantee or sell asset-backed securities and derivatives. The subtraction of these from its
assets gives its net trading assets.
Other assets. The physical capital (bank buildings, computers and other equipment)
owned by the banks is included in this category.

7.2. Basic banking

In general terms, banks make profits by selling liabilities with one set of
characteristics (a particular combination of liquidity, risk, size and return) and using the
proceeds to buy assets with a different set of characteristics. This process is often referred to
as asset transformation. For example, a savings deposit held by one person can provide the
funds that enable the bank to make a mortgage loan to another person. The bank has, in
effect, transformed the savings deposit (an asset held by the depositor) into a mortgage loan
(an asset held by the bank). Another way this process of asset transformation is described is
to say that the bank borrows short and lends long because it makes long-term loans and
funds them by issuing short-dated deposits. How does a bank get away with lending out
long its deposits that can be withdrawn on demand on short notice? It does this by

applying the law of large numbers to liability management. Normally, depositors do not
withdraw their deposits at the same time as other customers. Recognizing that depositors
withdraw their funds at different times means that banks only need to hold a certain amount
as reserves to meet day-to-day withdrawals and lend the rest in long-term loans. This process
is known as maturity transformation. This is the process by which banks accept short
maturity deposits and convert them into long maturity loans.
The process of transforming assets and providing a set of services (cheque clearing,
record keeping, credit analysis and so forth) is like any other production process in a firm. If
the bank produces desirable services at low cost and earns substantial income on its assets, it
earns profits; if not, the bank suffers losses. Interest income comes from interest received on
loans to households and firms, interest from fixed-income securities such as government bills
and commercial paper, and receivables from equity-related securities and variable-income
securities. Interest expenses are interest paid to depositors and to loans taken from other
banks through the interbank market.
Commission income is the fees the bank charges for its various financial services and
investment activities and net commission is the net income after subtracting the costs
associated with these services.
Other operating income is income derived from leasing activity or sale of assets that
are not on the trading account and net trading income is net revenue obtained from the buying
and selling of financial securities.
Administrative expenses are largely costs of labour and other expenses related to all
other variable costs such as running premises, computers, security etc. Loan loss provisions
are special reserves held on anticipation of defaults of loans and write-downs are loans that
have gone bad and are unrecoverable.

7.3.General principles of bank management

Now that you have some idea of how a bank operates, lets look at how a bank
manages its assets and liabilities to earn the highest possible profit. The bank manager has
four primary concerns. The first is to make sure that the bank has enough ready cash to pay
its depositors when there are deposit outflows that is, when deposits are lost because
depositors make withdrawals and demand payment. To keep enough cash on hand, the bank
must engage in liquidity management, the acquisition of sufficiently liquid assets to meet the
banks obligations to depositors. Second, the bank manager must pursue an acceptably low
level of risk by acquiring assets that have a low rate of default and by diversifying asset
holdings (asset management). The third concern is to acquire funds at low cost (liability
management). Finally, the manager must decide the amount of capital the bank should
maintain and then acquire the needed capital (capital adequacy management).

7.3.1.Asset management

To maximize its profits, a bank must simultaneously seek the highest returns possible
on loans and securities, reduce risk, and make adequate provisions for liquidity by holding
liquid assets. Banks try to accomplish these three goals in four basic ways. First, banks try to
find borrowers who will pay high interest rates and are unlikely to default on their loans.
They seek out loan business by advertising their borrowing rates and by approaching
corporations directly to solicit loans. It is up to the banks loan officer to decide if potential
borrowers are good credit risks who will make interest and principal payments on time (i.e.
engage in screening to reduce the adverse selection problem). Typically, banks are
conservative in their loan policies; the default rate is usually less than 1%. It is important,

however, that banks not be so conservative that they miss out on attractive lending
opportunities that earn high interest rates. Second, banks try to purchase securities with high
returns and low risk. Third, in managing their assets, banks must attempt to lower risk by
diversifying. They accomplish this by purchasing many different types of assets (short- and
long-term, government bonds and highly rated commercial bonds) and approving many types
of loans to a number of customers. Banks that have not sufficiently sought the benefits of
diversification often come to regret it later.
Finally, the bank must manage the liquidity of its assets so that it can satisfy its
reserve requirements without bearing huge costs. This means that it will hold liquid securities
even if they earn a somewhat lower return than other assets. The bank must decide, for
example, how much in excess reserves must be held to avoid costs from a deposit outflow. In
addition, it will want to hold Treasury bills or other government securities as secondary
reserves so that even if a deposit outflow forces some costs on the bank, these will not be
terribly high. Again, it is not wise for a bank to be too conservative. If it avoids all costs
associated with deposit outflows by holding only excess reserves, the bank suffers losses
because reserves earn low interest, while the banks liabilities are costly to maintain. The
bank must balance its desire for liquidity against the increased earnings that can be obtained
from less liquid assets such as loans.

7.3.2.Liability management

Before the 1960s, liability management was a staid affair: for the most part, banks
took their liabilities as fixed and spent their time trying to achieve an optimal mix of assets.
There were two main reasons for the emphasis on asset management. First, the majority of
the sources of bank funds were obtained through sight (demand) deposits that by law could
not pay any interest. Thus banks could not actively compete with one another for these
deposits by paying interest on them, and so their amount was effectively a given for an
individual bank. Second, because the interbank market was not well developed, banks rarely
borrowed from other banks to meet their reserve needs. Starting in the 1960s, however, large
banks in London and New York began to explore ways in which the liabilities on their
balance sheets could provide them with reserves and liquidity. This led to the development of
the interbank market, and the development of new financial instruments such as negotiable
certificates of deposits (CDs) which enabled banks with surplus funds to lend to banks in
need of funds through the interbank market. This new flexibility in liability management
meant that banks could take a different approach to bank management. They no longer
needed to depend on sight deposits as the primary source of bank funds and as a result no
longer treated their sources of funds (liabilities) as given. Instead, they aggressively set target
goals for their asset growth and tried to acquire funds (by issuing liabilities) as they were
For example, today, when a bank finds an attractive loan opportunity, it can acquire
funds by selling a negotiable CD. Or, if it has a reserve shortfall, it can borrow funds from
another bank in the interbank market without incurring high transaction costs. The interbank
market can also be used to finance loans. Because of the increased importance of liability
management, most banks now manage both sides of the balance sheet together in an asset
liability management (ALM) committee.
The greater emphasis on liability management explains some of the important changes
over the past three decades in the composition of banks balance sheets. While negotiable
CDs and bank borrowings have greatly increased in importance as a source of bank funds in
recent years, sight deposits have decreased in importance.

7.3.3.Capital adequacy management

Banks have to make decisions about the amount of capital they need to hold for three
reasons. First, bank capital helps prevent bank failure, a situation in which the bank cannot
satisfy its obligations to pay its depositors and other creditors and so goes out of business.
Second, the amount of capital affects returns for the owners (equity holders) of the bank.
Third, a minimum amount of bank capital (bank capital requirements) is required by
regulatory authorities.
How the amount of bank capital affects returns to equity holders. Because owners
of a bank must know whether their bank is being managed well, they need good measures of
bank profitability. A basic measure of bank profitability is the return on assets (ROA), the net
profit after taxes per euro of assets:

The return on assets provides information on how efficiently a bank is being run,
because it indicates how much profits are generated on average by each euro of assets.
However, what the banks owners (equity holders) care about most is how much the bank is
earning on their equity investment. This information is provided by the other basic measure
of bank profitability, the return on equity (ROE), the net profit after taxes per euro of equity
(bank) capital:

There is a direct relationship between the return on assets (which measures how
efficiently the bank is run) and the return on equity (which measures how well the owners are
doing on their investment). This relationship is determined by the equity multiplier (EM), the
amount of assets per euro of equity capital:

To see this, we note that:

which, using our definitions, yields:

Trade-off between safety and returns to equity holders. We now see that bank
capital has both benefits and costs. Bank capital benefits the owners of a bank in that it makes
their investment safer by reducing the likelihood of bankruptcy. But bank capital is costly
because the higher it is, the lower will be the return on equity for a given return on assets. In
determining the amount of bank capital, managers must decide how much of the increased
safety that comes with higher capital (the benefit) they are willing to trade off against the

lower return on equity that comes with higher capital (the cost). In more uncertain times,
when the possibility of large losses on loans increases, bank managers might want to hold
more capital to protect the equity holders. Conversely, if they have confidence that loan
losses wont occur, they might want to reduce the amount of bank capital, have a high equity
multiplier, and thereby increase the return on equity.
Bank capital requirements. Banks also hold capital because they are required to do
so by regulatory authorities. Because of the high costs of holding capital for the reasons just
described, bank managers often want to hold less bank capital relative to assets than is
required by the regulatory authorities. In this case, the amount of bank capital is determined
by the bank capital requirements.

7.4.Managing credit risk

As seen in the earlier discussion of general principles of asset management, banks and
other financial institutions must make successful loans that are paid back in full (and so
subject the institution to little credit risk) if they are to earn high profits. The economic
concepts of adverse selection and moral hazard provide a framework for understanding the
principles that financial institutions have to follow to reduce credit risk and make successful
Adverse selection in loan markets occurs because bad credit risks (those most likely
to default on their loans) are the ones who usually line up for loans; in other words, those
who are most likely to produce an adverse outcome are the most likely to be selected.
Borrowers with very risky investment projects have much to gain if their projects are
successful, so they are the most eager to obtain loans. Clearly, however, they are the least
desirable borrowers because of the greater possibility that they will be unable to pay back
their loans. Moral hazard exists in loan markets because borrowers may have incentives to
engage in activities that are undesirable from the lenders point of view. In such situations, it
is more likely that the lender will be subjected to the hazard of default. Once borrowers have
obtained a loan, they are more likely to invest in high-risk investment projects projects that
pay high returns to the borrowers if successful. The high risk, however, makes it less likely
that they will be able to pay the loan back.
To be profitable, financial institutions must overcome the adverse selection and moral
hazard problems that make loan defaults more likely. The attempts of financial institutions to
solve these problems help explain a number of principles for managing credit risk: screening
and monitoring, establishment of long-term customer relationships, loan commitments,
collateral and compensating balance requirements, and credit rationing.

7.4.1.Screening and monitoring

Asymmetric information is present in loan markets because lenders have less

information about the investment opportunities and activities of borrowers than borrowers do.
This situation leads to two information-producing activities by banks and other financial
institutions screening and monitoring.
Screening. Adverse selection in loan markets requires that lenders screen out the bad
credit risks from the good ones so that loans are profitable to them. To accomplish effective
screening, lenders must collect reliable information from prospective borrowers. Effective
screening and information collection together form an important principle of credit risk
management. When you apply for a consumer loan (such as a car loan or a mortgage to
purchase a house), the first thing you are asked to do is fill out forms that elicit a great deal of
information about your personal finances. You are asked about your salary, your bank

accounts and other assets (such as cars, insurance policies and furnishings), and your
outstanding loans; your record of loan, credit card and charge account repayments; the
number of years youve worked and who your employers have been. You also are asked
personal questions such as your age, marital status and number of children. The lender uses
this information to evaluate how good a credit risk you are by calculating your credit score, a
statistical measure derived from your answers that predicts whether you are likely to have
trouble making your loan payments. Deciding on how good a risk you are cannot be entirely
scientific, so the lender must also use judgement. The loan officer, whose job is to decide
whether you should be given the loan, might call your employer or talk to some of the
personal references you supplied. The officer might even make a judgement based on your
demeanour or your appearance. (This is why most people dress neatly and conservatively
when they go to a bank to apply for a loan.) The process of screening and collecting
information is similar when a financial institution makes a business loan. It collects
information about the companys profits and losses (income) and about its assets and
liabilities. The lender also has to evaluate the likely future success of the business. So in
addition to obtaining information on such items as sales figures, a loan officer might ask
questions about the companys future plans, the purpose of the loan, and the competition in
the industry. The officer may even visit the company to obtain a first-hand look at its
operations. The bottom line is that, whether for personal or business loans, bankers and other
financial institutions need to be nosy.
Specialization in lending. One puzzling feature of bank lending is that a bank often
specializes in lending to local firms or to firms in particular industries, such as energy. In one
sense, this behaviour seems surprising, because it means that the bank is not diversifying its
portfolio of loans and thus is exposing itself to more risk. But from another perspective, such
specialization makes perfect sense. The adverse selection problem requires that the bank
screen out bad credit risks. It is easier for the bank to collect information about local firms
and determine their creditworthiness than to collect comparable information on firms that are
far away. Similarly, by concentrating its lending on firms in specific industries, the bank
becomes more knowledgeable about these industries and is therefore better able to predict
which firms will be able to make timely payments on their debt.
Monitoring and enforcement of restrictive covenants. Once a loan has been made,
the borrower has an incentive to engage in risky activities that make it less likely that the loan
will be paid off. To reduce this moral hazard, financial institutions must adhere to the
principle for managing credit risk that a lender should write provisions (restrictive covenants)
into loan contracts that restrict borrowers from engaging in risky activities. By monitoring
borrowers activities to see whether they are complying with the restrictive covenants and by
enforcing the covenants if they are not, lenders can make sure that borrowers are not taking
on risks at their expense. The need for banks and other financial institutions to engage in
screening and monitoring explains why they spend so much money on auditing and
information-collecting activities.

7.4.2.Long-term customer relationships

An additional way for banks and other financial institutions to obtain information
about their borrowers is through long-term customer relationships, another important
principle of credit risk management. If a prospective borrower has had a transactions
(cheque) or savings account or other loans with a bank over a long period of time, a loan
officer can look at past activity on the accounts and learn quite a bit about the borrower. The
balances in the transaction and savings accounts tell the banker how liquid the potential
borrower is and at what time of year the borrower has a strong need for cash. A review of the

transactions the borrower has written reveals the borrowers suppliers. If the borrower has
borrowed previously from the bank, the bank has a record of the loan payments. Thus long-
term customer relationships reduce the costs of information collection and make it easier to
screen out bad credit risks.
The need for monitoring by lenders adds to the importance of long-term customer
relationships. If the borrower has borrowed from the bank before, the bank has already
established procedures for monitoring that customer. Therefore, the costs of monitoring long-
term customers are lower than those for new customers. Long-term relationships benefit the
customers as well as the bank. A firm with a previous relationship will find it easier to obtain
a loan at a low interest rate because the bank has an easier time determining if the prospective
borrower is a good credit risk and incurs fewer costs in monitoring the borrower.
A long-term customer relationship has another advantage for the bank. No bank can
think of every contingency when it writes a restrictive covenant into a loan contract; there
will always be risky borrower activities that are not ruled out. However, what if a borrower
wants to preserve a long-term relationship with a bank because it will be easier to get future
loans at low interest rates? The borrower then has the incentive to avoid risky activities that
would upset the bank, even if restrictions on these risky activities are not specified in the loan
contract. Indeed, if a bank doesnt like what a borrower is doing even when the borrower isnt
violating any restrictive covenants, it has some power to discourage the borrower from such
activity: the bank can threaten not to let the borrower have new loans in the future. Long-term
customer relationships therefore enable banks to deal with even unanticipated moral hazard

7.4.3.Loan commitments

Banks also create long-term relationships and gather information by issuing loan
commitments to commercial customers. A loan commitment is a banks commitment (for a
specified future period of time) to provide a firm with loans up to a given amount at an
interest rate that is tied to some market interest rate. The majority of commercial and
industrial loans are made under the loan commitment arrangement. The advantage for the
firm is that it has a source of credit when it needs it. The advantage for the bank is that the
loan commitment promotes a long-term relationship, which in turn facilitates information
collection. In addition, provisions in the loan commitment agreement require that the firm
continually supply the bank with information about the firms income, asset and liability
position, business activities and so on. A loan commitment arrangement is a powerful method
for reducing the banks costs for screening and information collection.

7.4.4.Collateral and compensating balances

Collateral requirements for loans are important credit risk management tools.
Collateral, which is property promised to the lender as compensation if the borrower defaults,
lessens the consequences of adverse selection because it reduces the lenders losses in the
case of a loan default. It also reduces moral hazard because the borrower has more to lose
from a default. If a borrower defaults on a loan, the lender can sell the collateral and use the
proceeds to make up for its losses on the loan. One particular form of collateral required
when a bank makes commercial loans is called compensating balances: a firm receiving a
loan must keep a required minimum amount of funds in a cheque account at the bank. For
example, a business getting a 10 million loan may be required to keep compensating
balances of at least 1 million in its cheque account at the bank. This 1 million in
compensating balances can then be taken by the bank to make up some of the losses on the

loan if the borrower defaults. Besides serving as collateral, compensating balances help
increase the likelihood that a loan will be paid off. They do this by helping the bank monitor
the borrower and consequently reduce moral hazard. Specifically, by requiring the borrower
to use a cheque account at the bank, the bank can observe the firms cheque payment
practices, which may yield a great deal of information about the borrowers financial
condition. For example, a sustained drop in the borrowers cheque account balance may
signal that the borrower is having financial trouble, or account activity may suggest that the
borrower is engaging in risky activities; perhaps a change in suppliers means that the
borrower is pursuing new lines of business. Any significant change in the borrowers
payment procedures is a signal to the bank that it should make inquiries. Compensating
balances therefore make it easier for banks to monitor borrowers more effectively and are
another important credit risk management tool.

7.4.5.Credit rationing

Another way in which financial institutions deal with adverse selection and moral
hazard is through credit rationing: refusing to make loans even though borrowers are willing
to pay the stated interest rate or even a higher rate. Credit rationing takes two forms. The first
occurs when a lender refuses to make a loan of any amount to a borrower, even if the
borrower is willing to pay a higher interest rate. The second occurs when a lender is willing
to make a loan but restricts the size of the loan to less than the borrower would like. At first
you might be puzzled by the first type of credit rationing. After all, even if the potential
borrower is a credit risk, why doesnt the lender just extend the loan but at a higher interest
rate? The answer is that adverse selection prevents this solution. Individuals and firms with
the riskiest investment projects are exactly those that are willing to pay the highest interest
rates. If a borrower took on a high-risk investment and succeeded, the borrower would
become extremely rich. But a lender wouldnt want to make such a loan precisely because the
credit risk is high; the likely outcome is that the borrower will not succeed and the lender will
not be paid back. Charging a higher interest rate just makes adverse selection worse for the
lender; that is, it increases the likelihood that the lender is lending to a bad credit risk. The
lender would therefore rather not make any loans at a higher interest rate; instead, it would
engage in the first type of credit rationing and would turn down loans.
Financial institutions engage in the second type of credit rationing to guard against
moral hazard: they grant loans to borrowers, but not loans as large as the borrowers want.
Such credit rationing is necessary because the larger the loan, the greater the benefits from
moral hazard. If a bank gives you a 1,000 loan, for example, you are likely to take actions
that enable you to pay it back because you dont want to hurt your credit rating for the future.
However, if the bank lends you 10 million, you are more likely to fly to Rio to celebrate.
The larger your loan, the greater your incentives to engage in activities that make it less likely
that you will repay the loan. Because more borrowers repay their loans if the loan amounts
are small, financial institutions ration credit by providing borrowers with smaller loans than
they seek.

Chapter 8. Economic analysis of financial regulation

The financial system is among the most heavily regulated sectors of the economy, and
banks are among the most heavily regulated of financial institutions. In this chapter, we
develop an economic analysis of why regulation of the financial system takes the form it
does. Unfortunately, the regulatory process may not always work very well, as evidenced by
the subprime meltdown and other financial crises, in Europe, the United States and many

other countries throughout the world. Here we also use our economic analysis of financial
regulation to explain the worldwide crises in banking and to consider how the regulatory
system can be reformed to prevent future disasters.

8.1. Asymmetric information and financial regulation

Asymmetric information the fact that different parties in a financial contract do not
have the same information leads to adverse selection and moral hazard problems that have
an important impact on the financial system. The concepts of asymmetric information,
adverse selection and moral hazard are especially useful in understanding why government
has chosen the form of financial regulation. There are eight basic categories of financial
regulation: the government safety net, restrictions on asset holdings, capital requirements,
prompt corrective action, licensing and examination, assessment of risk management,
disclosure requirements, and consumer protection.

8.1.1.Government safety net

Financial intermediaries, like banks, are particularly well suited to solving adverse selection
and moral hazard problems because they make private loans that help avoid the free-rider
problem. However, this solution to the free-rider problem creates another asymmetric
information problem, because depositors lack information about the quality of these private
loans. This asymmetric information problem leads to several reasons why the financial
system might not function well.
Bank panics and the need for deposit insurance. Before the existence of deposit
insurance, a bank failure (in which a bank is unable to meet its obligations to pay its
depositors and other creditors and so must go out of business) meant that depositors would
have to wait to get their deposit funds until the bank was liquidated (until its assets had been
turned into cash); at that time, they would be paid only a fraction of the value of their
deposits. Unable to learn if bank managers were taking on too much risk or were outright
crooks, depositors would be reluctant to put money in the bank, thus making banking
institutions less viable. Second, depositors lack of information about the quality of bank
assets can lead to bank panics, can have serious harmful consequences for the economy. To
see this, consider the following situation. There is no deposit insurance, and an adverse shock
hits the economy. As a result of the shock, 5% of the banks have such large losses on loans
that they become insolvent (have a negative net worth and so are bankrupt). Because of
asymmetric information, depositors are unable to tell whether their bank is a good bank or
one of the 5% that are insolvent.
Depositors at bad and good banks recognize that they may not get back 100 cents on
the euro for their deposits and will want to withdraw them. Indeed, because banks operate on
a sequential service constraint (a first-come, first-served basis), depositors have a very
strong incentive to show up at the bank first, because if they are last in line, the bank may run
out of funds and they will get nothing. Uncertainty about the health of the banking system in
general can lead to runs on banks both good and bad, and the failure of one bank can hasten
the failure of others (referred to as the contagion effect). If nothing is done to restore the
publics confidence, a bank panic can ensue.
Bank panics have existed throughout history and were typically associated with bad
harvests and speculative bubbles such as the Dutch tulip mania (16347) and the British
South Sea bubble (171719). But bank runs were commonplace in the US in the nineteenth
and early twentieth centuries, with major ones occurring every 20 years or so, in 1819, 1837,
1857, 1873, 1884, 1893, 1907 and 19303. Bank failures were a serious problem even during

the boom years of the 1920s, when the number of bank failures averaged around 600 per
year. In September 2007 the British bank Northern Rock faced a bank run that witnessed long
lines of depositors patiently waiting to withdraw their deposits. Other types of runs are the
quiet ones that do not see lines of depositors withdrawing funds but other banks and financial
institutions withdrawing funds from an individual bank. A silent run on the investment bank
Bear-Stearns in March 2008 was only halted when the Federal Reserve Bank of New York
helped JPMorgan Chase acquire it.
A government safety net for depositors can short-circuit runs on banks and bank
panics, and by providing protection for the depositor, it can overcome reluctance to put funds
in the banking system. One form of the safety net is deposit insurance, a guarantee such as
that provided by the central bank or government-backed deposit insurance institutions such as
the Federal Deposit Insurance Corporation (FDIC) in the United States in which depositors
are paid off in full on the first $100,000 they have deposited in a bank if the bank fails. (FDIC
coverage was temporarily raised to $250,000 during the subprime financial crisis in October
2008.) With fully insured deposits, depositors dont need to run to the bank to make
withdrawals even if they are worried about the banks health because in many cases their
deposits will be worth 100 cents on the dollar no matter what. Deposit insurance is an
accepted part of the landscape of government safety net arrangements. In recent years,
government deposit insurance has grown in popularity and has spread to many countries
throughout the world.
Other forms of the government safety net. Deposit insurance is not the only form of
government safety net. Governments have often stood ready to provide support to domestic
banks facing runs even in the absence of explicit deposit insurance. Furthermore, banks are
not the only financial intermediaries that can pose a systemic threat to the financial system.
When financial institutions are very large or highly interconnected with other financial
institutions or markets, their failure has the potential to bring down the entire financial
One way governments provide support is through lending from the central bank to
troubled institutions, as the Federal Reserve did during the subprime financial crisis. This
form of support is often referred to as the lender of last resort role of the central bank. In
other cases, funds are provided directly to troubled institutions, as was done by the Bank of
England in 2008 during a particularly virulent phase of the financial crisis. Governments can
also take over (nationalize) troubled institutions and guarantee that all creditors will be repaid
their loans in full. Following the banking crisis the UK government took a 43% stake in the
Lloyds Banking Group in 2009. In 2008 the Royal Bank of Scotland Group, one of the largest
banks in the world, received a capital injection from the UK government which took a share
of 60% of the company. In 2009 a further capital injection took the government stake in the
bank to 84%. The DEXIA Group is a Franco-Belgian banking group that came under
pressure during the financial crisis of 2008 and received direct capital injections from the
Belgian and French governments totalling 6 billion. Following a 4 billion loss announced
in July 2011 after marking down the value of Greek bond holdings, the Belgian government
announced the purchase of the Belgian arm of the bank for 4 billion. Similarly, in October
2008 the Dutch government purchased a 49% stake in the Dutch operations of Fortis Bank.
Moral hazard and the government safety net. Although a government safety net
can help protect depositors and other creditors and prevent, or ameliorate, financial crises, it
is a mixed blessing. The most serious drawback of the government safety net stems from
moral hazard, the incentives of one party to a transaction to engage in activities detrimental to
the other party. Moral hazard is an important concern in insurance arrangements in general
because the existence of insurance provides increased incentives for taking risks that might
result in an insurance payoff. For example, some drivers with automobile collision insurance

that has a low excess might be more likely to drive recklessly, because if they get into an
accident, the insurance company pays most of the costs for damage and repairs. Moral hazard
is a prominent concern in government arrangements to provide a safety net. With a safety net
depositors and creditors know that they will not suffer losses if a financial institution fails, so
they do not impose the discipline of the marketplace on these institutions by withdrawing
funds when they suspect that the financial institution is taking on too much risk.
Consequently, financial institutions with a government safety net have an incentive to take on
greater risks than they otherwise would, with taxpayers paying the bill if the bank
subsequently goes belly up. Financial institutions have been given the following bet: Heads I
win, tails the taxpayer loses.
Adverse selection and the government safety net. A further problem with a
government safety net like deposit insurance arises because of adverse selection, the fact that
the people who are most likely to produce the adverse outcome insured against (bank failure)
are those who most want to take advantage of the insurance. For example, bad drivers are
more likely than good drivers to take out automobile collision insurance with a low
deductible. Because depositors and creditors protected by a government safety net have little
reason to impose discipline on financial institutions, risk-loving entrepreneurs might find the
financial industry a particularly attractive one to enter they know that they will be able to
engage in highly risky activities. Even worse, because protected depositors and creditors have
so little reason to monitor the financial institutions activities, without government
intervention outright crooks might also find finance an attractive industry for their activities
because it is easy for them to get away with fraud and embezzlement.
Too big to fail. The moral hazard created by a government safety net and the desire
to prevent financial institution failures have presented financial regulators with a particular
quandary. Because the failure of a very large financial institution makes it more likely that a
major financial disruption will occur, financial regulators are naturally reluctant to allow a
big institution to fail and cause losses to its depositors and creditors. The term too big to fail
is now applied to a policy in which the government provides guarantees of repayment of
large uninsured creditors of the largest banks, so that no depositor or creditor suffers a loss,
even when they are not automatically entitled to this guarantee. The deposit insurance
guarantors (typically the central bank) would do this by using the purchase and assumption
method, giving the insolvent bank a large infusion of capital and then finding a willing
merger partner to take over the bank and its deposits. The too-big-to-fail policy was extended
to big banks that were not even among the eleven largest. In fact the term too big to fail is
somewhat misleading because when a financial institution is closed or merged into another
financial institution, the managers are usually fired and the stockholders in the financial
institution lose their investment.
One problem with the too-big-to-fail policy is that it increases the moral hazard
incentives for big banks. If the central bank were willing to close a bank using the payoff
method, paying depositors only up to the 100,000 limit, large depositors with more than
100,000 would suffer losses if the bank failed. Thus they would have an incentive to
monitor the bank by examining the banks activities closely and pulling their money out if the
bank was taking on too much risk. To prevent such a loss of deposits, the bank would be
more likely to engage in less risky activities. However, once large depositors know that a
bank is too big to fail, they have no incentive to monitor the bank and pull out their deposits
when it takes on too much risk: no matter what the bank does, large depositors will not suffer
any losses. The result of the too-big-to-fail policy is that big banks might take on even greater
risks, thereby making bank failures more likely. Similarly, the too-big-to-fail policy increases
the moral hazard incentives for non-bank financial institutions that are extended a
government safety net. Knowing that the financial institution will get bailed out, creditors

have little incentive to monitor the institution and pull their money out when the institution is
taking on excessive risk. As a result, large or interconnected financial institutions will be
more likely to engage in highly risky activities, making it more likely that a financial crisis
will occur.
Too important to fail. The problem of moral hazard could occur even if the safety
net was not provided by the government or a government-sponsored agency. If the central
bank organized a bailout of a financial institution that was in trouble because it thought that
failure would infect the rest of the financial system, even though it may not commit public
funds to the exercise, the intervention alone could create moral hazard.
Financial consolidation and the government safety net. With financial innovation
and the globalization of banking, financial consolidation has been proceeding at a rapid pace,
leading to both larger and more complex financial organizations. Financial consolidation
poses two challenges to financial regulation because of the existence of the government
safety net. First, the increased size of financial institutions as a result of financial
consolidation increases the too-big-to-fail problem, because there will now be more large
institutions whose failure would expose the financial system to systemic (system-wide) risk.
Thus more financial institutions are likely to be treated as too big to fail, and the increased
moral hazard incentives for these large institutions to take on greater risk can then increase
the fragility of the financial system. Second, financial consolidation of banks with other
financial services firms means that the government safety net may be extended to new
activities such as securities underwriting, insurance or real estate activities, as has occurred in
the US with government support for Fannie Mae and Freddie Mac, the two large mortgage
providers, and AIG, the global insurance company, during the subprime financial crisis in
2008. This increases incentives for greater risk taking in these activities that can also weaken
the fabric of the financial system. Limiting the moral hazard incentives for the larger, more
complex financial organizations that have arisen as a result of recent changes in legislation
will be one of the key issues facing banking regulators in the aftermath of the subprime
financial crisis.

8.1.2.Restrictions on asset holdings

As we have seen, the moral hazard associated with a government safety net
encourages too much risk taking on the part of financial institutions. Bank regulations that
restrict asset holdings are directed at minimizing this moral hazard, which can cost the
taxpayers dearly. Even in the absence of a government safety net, financial institutions still
have the incentive to take on too much risk. Risky assets may provide the financial institution
with higher earnings when they pay off; but if they do not pay off and the institution fails,
depositors and creditors are left holding the bag. If depositors and creditors were able to
monitor the bank easily by acquiring information on its risk-taking activities, they would
immediately withdraw their funds if the institution was taking on too much risk. To prevent
such a loss of funds, the institution would be more likely to reduce its risk-taking activities.
Unfortunately, acquiring information on an institutions activities to learn how much risk it is
taking can be a difficult task. Hence most depositors and many creditors are incapable of
imposing discipline that might prevent financial institutions from engaging in risky activities.
A strong rationale for government regulation to reduce risk taking on the part of financial
institutions therefore existed even before the establishment of government safety nets.
Because banks are most prone to panics, they are subjected to strict regulations to
restrict their holding of risky assets such as common stocks. Bank regulations also promote
diversification, which reduces risk by limiting the euro amount of loans in particular
categories or to individual borrowers. For example different countries apply different

maximum loan-to value (mortgage loan relative to the value of the property) regulations to
mortgages from 60% in Germany to 80% in Denmark. With the extension of the government
safety net during the subprime financial crisis, it is likely that non-bank financial institutions
may face greater restrictions on their holdings of risky assets. There is a danger, however,
that these restrictions may become so onerous that the efficiency of the financial system will
be impaired.

8.1.3.Capital requirements

Government-imposed capital requirements are another way of minimizing moral

hazard at financial institutions. When a financial institution is forced to hold a large amount
of equity capital, the institution has more to lose if it fails and is thus more likely to pursue
less risky activities. In addition, capital functions as a cushion when bad shocks occur,
making it less likely that the financial institution will fail, thereby directly adding to the
safety and soundness of financial institutions.
Bank regulators have also become increasingly worried about banks holdings of
risky assets and about the increase in banks off-balance-sheet activities, activities that
involve trading financial instruments and generating income from fees, which do not appear
on bank balance sheets but nevertheless expose banks to risk. An agreement among banking
officials from industrialized nations set up the Basel Committee on Banking Supervision
(because it meets under the auspices of the Bank for International Settlements in Basel,
Switzerland), which has implemented the Basel Accord that deals with a second type of
capital requirements, risk-based capital requirements.
The Basel Accord, which required that banks hold as capital at least 8% of their risk-
weighted assets, has been adopted by all the major economies. Assets and off-balance-sheet
activities were allocated into four categories, each with a different weight to reflect the
degree of credit risk. The first category carries a zero weight and includes items that have
little default risk, such as reserves and government securities issued by the Organisation for
Economic Co-operation and Development (OECD industrialized) countries. The second
category has a 20% weight and includes claims on banks in OECD countries. The third
category has a weight of 50% and includes municipal bonds and residential mortgages. The
fourth category has the maximum weight of 100% and includes loans to consumers and
corporations. Off-balance sheet activities are treated in a similar manner by assigning a
credit-equivalent percentage that converts them to on-balance-sheet items to which the
appropriate risk weight applies.
The 1996 Market Risk Amendment to the Basel Accord set minimum capital
requirements for risks in banks trading accounts. Over time, limitations of the Basel Accord
have become apparent, because the regulatory measure of bank risk as stipulated by the risk
weights can differ substantially from the actual risk the bank faces. This has resulted in
regulatory arbitrage, a practice in which banks keep on their books assets that have the same
risk-based capital requirement but are relatively risky, such as a loan to a company with a
very low credit rating, while taking off their books low-risk assets, such as a loan to a
company with a very high credit rating. The Basel Accord could thus lead to increased risk
taking, the opposite of its intent. Another weakness was that the categories of credit risk were
too crude and insufficiently differentiated. Also Basel 1 led to biases like lending to the
government. To address these limitations, the Basel Committee on Bank Supervision released
proposals for a new capital accord, often referred to as Basel 2.
The Basel Committees work on bank capital requirements is never-ending. Indeed,
with the extension of the government safety net to non-bank financial institutions during the
subprime financial crisis, capital requirements for these other financial institutions will

receive more scrutiny in the future. As the financial industry changes, regulation of capital
must change with it to ensure the safety and soundness of financial institutions. It is
increasingly likely that the Basel Committee will have an even greater role in exploring
capital requirements for a wider range of financial institutions in the future.

8.1.4.Prompt corrective action

If the amount of a financial institutions capital falls to low levels, there are two
serious problems. First, the bank is more likely to fail because it has a smaller capital cushion
if it suffers loan losses or other asset write-downs. Second, with less capital, a financial
institution has less skin in the game and is therefore more likely to take on excessive risks.
In other words, the moral hazard problem becomes more severe, making it more likely that
the institution will fail and the taxpayer will be left holding the bag.

8.1.5.Financial supervision: bank licensing and examination

Overseeing who operates financial institutions and how they are operated, referred to
as financial supervision or prudential supervision, is an important method for reducing
adverse selection and moral hazard in the financial industry. Because financial institutions
can be used by crooks or overambitious entrepreneurs to engage in highly speculative
activities, such undesirable people would be eager to run a financial institution. Licensing
financial institutions is one method for preventing this adverse selection problem; through
chartering, proposals for new institutions are screened to prevent undesirable people from
controlling them. Regular on-site examinations, which allow regulators to monitor whether
the institution is complying with capital requirements and restrictions on asset holdings, also
function to limit moral hazard.
Bank examiners give banks a CAMELS rating. The acronym is based on the six areas
assessed: capital adequacy, asset quality, management, earnings, liquidity and sensitivity to
market risk. With this information about a banks activities, regulators can enforce
regulations by taking such formal actions as cease and desist orders to alter the banks
behaviour or even close a bank if its CAMELS rating is sufficiently low. Actions taken to
reduce moral hazard by restricting banks from taking on too much risk help reduce the
adverse selection problem further, because with less opportunity for risk taking, risk loving
entrepreneurs will be less likely to be attracted to the banking industry. Note that the methods
regulators use to cope with adverse selection and moral hazard have their counterparts in
private financial markets.
Licensing is similar to the screening of potential borrowers, regulations restricting
risky asset holdings are similar to restrictive covenants that prevent borrowing firms from
engaging in risky investment activities, capital requirements act like restrictive covenants that
require minimum amounts of net worth for borrowing firms, and regular examinations are
similar to the monitoring of borrowers by lending institutions.
Once a bank has been licensed, it is required to file periodic reports that reveal the
banks assets and liabilities, income and dividends, ownership, foreign exchange operations
and other details. The bank is also subject to examination by the bank regulatory agencies to
ascertain its financial condition at least once a year. Bank examinations are conducted by
bank examiners, who sometimes make unannounced visits to the bank (so that nothing can be
swept under the rug in anticipation of their examination). The examiners study a banks
books to see whether it is complying with the rules and regulations that apply to its holdings
of assets. If a bank is holding securities or loans that are too risky, the bank examiner can
force the bank to get rid of them. If a bank examiner decides that a loan is unlikely to be

repaid, the examiner can force the bank to declare the loan worthless (to write off the loan,
which reduces the banks capital). If, after examining the bank, the examiner feels that it does
not have sufficient capital or has engaged in dishonest practices, the bank can be declared a
problem bank and will be subject to more frequent examinations.

8.1.6.Assessment of risk management

Traditionally, on-site examinations have focused primarily on assessment of the

quality of a financial institutions balance sheet at a point in time and whether it complies
with capital requirements and restrictions on asset holdings. Although the traditional focus is
important for reducing excessive risk taking by financial institutions, it is no longer felt to be
adequate in todays world, in which financial innovation has produced new markets and
instruments that make it easy for financial institutions and their employees to make huge bets
easily and quickly. In this new financial environment, a financial institution that is healthy at
a particular point in time can be driven into insolvency extremely rapidly from trading losses.
Thus an examination that focuses only on a financial institutions position at a point in time
may not be effective in indicating whether it will, in fact, be taking on excessive risk in the
near future.
This change in the environment for financial institutions has resulted in a major shift
in thinking about the prudential supervisory process throughout the world. Bank examiners,
for example, are now placing far greater emphasis on evaluating the soundness of a banks
management processes with regard to controlling risk. Now bank examiners give a separate
risk management rating from 1 to 5 that feeds into the overall management rating as part of
the CAMELS system. A number of elements of sound risk management are assessed to come
up with the risk management rating: (1) the quality of oversight provided by the board of
directors and senior management, (2) the adequacy of policies and limits for all activities that
present significant risks, (3) the quality of the risk measurement and monitoring systems, (4)
the adequacy of internal controls to prevent fraud or unauthorized activities on the part of
employees and (5) since 2010 a number of regulatory authorities have published guidelines
on bankers remuneration and bonuses that feed into risk-taking behaviour. This shift toward
focusing on management processes has resulted in the adoption of processes to deal with
trading risk and risk based on market movements. These guidelines require the banks board
of directors to establish interest-rate risk limits, appoint officials of the bank to manage this
risk, and monitor the banks risk exposure. The guidelines also require that senior
management of a bank develop formal risk management policies and procedures to ensure
that the board of directors risk limits are not violated and to implement internal controls to
monitor interest-rate risk and compliance with the boards directives.
Particularly important is the implementation of stress testing, which calculates losses
under dire scenarios, or value-at-risk (VaR) calculations, which measure the size of the loss
on a trading portfolio that might happen 1% of the time say, over a two-week period. In
addition to these guidelines, bank examiners will continue to consider interest-rate risk in
deciding the banks capital requirements.

8.1.7.Disclosure requirements

Individual depositors and creditors will not have enough incentive to produce private
information about the quality of a financial institutions assets. To ensure that there is better
information in the marketplace, regulators can require that financial institutions adhere to
certain standard accounting principles and disclose a wide range of information that helps the
market assess the quality of an institutions portfolio and the amount of its exposure to risk.

More public information about the risks incurred by financial institutions and the quality of
their portfolios can better enable stockholders, creditors and depositors to evaluate and
monitor financial institutions and so act as a deterrent to excessive risk taking. Disclosure
requirements are a key element of financial regulation. Basel 2 puts a particular emphasis on
disclosure requirements with one of its three pillars focusing on increasing market discipline
by mandating increased disclosure by banking institutions of their credit exposure, amount of
reserves, and capital. Regulation to increase disclosure is needed to limit incentives to take on
excessive risk and to improve the quality of information in the marketplace so that investors
can make informed decisions, thereby improving the ability of financial markets to allocate
capital to its most productive uses. Particularly controversial in the wake of the subprime
financial crisis is the move to so-called mark-to market accounting, also called fair-value
accounting, in which assets are valued in the balance sheet at what they could sell for in the
market (see the Closer look box, Mark-to market accounting and the subprime financial

8.1.8.Consumer protection

The existence of asymmetric information also suggests that consumers may not have
enough information to protect themselves fully. Consumer protection regulation in the EU
has been sparse and mainly concerned with harmonization of the regulation to enable
consumer credit transactions to occur smoothly across borders. The Consumer Credit
Directive of 1987 was the first of this type of regulation that was applied EU-wide. The rapid
evolution of financial products led to a further consumer credit directive which was brought
into national law in June 2010. The regulation requires all lenders, not just banks, to provide
information to consumers about the cost of borrowing, including a standardized interest rate
(called the annual percentage rate, or APR) and the total finance charges on the loan. Other
regulations relate to the right of withdrawal by the consumer within fourteen days of the
credit contract at no financial penalty and the right to repay a debt contract early and to incur
only reasonable costs.

8.2.The single banking market in Europe

International banking has gone through a process of deregulation and globalization

during the last twenty years of the twentieth century, which has resulted in increased
competitive pressure in banking markets. The creation of a single banking market in the
European Union was designed with the aim of accelerating the process of competition created
by the opening up of banking markets and deregulation. By offering consumers and firms
banking services across national boundaries, the single banking market is supposed to
improve welfare by promoting lower interest rates for loans and mortgages and higher
interest rates for savings and deposits. The objective of the single banking market is that any
banking service provider in the EU can establish an equivalent provision, or acquire another
banking service provider across the EU. Any EU customer can bank with any legally
constituted banking institution across the EU.
The single banking market is based on several directives that addressed the key issues
of barriers to cross-border activity, capital ratios and deposit protection. The process began
with two key banking directives. The First Banking Directive (1977) set the framework for
the integration of the banking market within the EU. It was designed to establish the rules for
banks to establish branches in other member states based on host-country regulations. This
created a platform for cross-border EU bank entrants to behave like domestic banks and
operate under host-country regulations. A level playing field was created but by doing so an

incoming bank could not exploit any competitive advantage it may have had because it had to
operate under host-country regulations for its branches operating cross-border and home-
country regulations in its home market.
The Second Banking Directive (1988), implemented in 1993, had at its core two
elements: first, the principle of home-country control or mutual recognition of regulatory
authorities; and second, the concept of the single banking passport. Home-country control
means that banks are regulated according to the legislative framework of their home country.
If a bank in one EU member state conducts business in another EU state, the regulatory
authority in the host country will recognize the primacy of the home country. The single
passport means that if a bank is licensed to do business in one EU state, it is similarly
entitled to do business in any other EU state. In this way an EU state-based bank can set up a
branch or subsidiary in any other EU state or, perhaps more importantly, take over any bank
in another state. This passport provision is intended to open up the EU banking market,
exposing domestic banks to the threat of foreign acquisition if uncompetitive. States are not
allowed to impose barriers to this external threat for example by imposing an obligation upon
non-domestic but nevertheless EU-based banks to establish separate capital bases for entities
established within their borders, or by requiring the permission from officials prior to the
launching of takeover bids.
Other directives such as the Own Funds Directive (1989, 1991) and the Solvency
Ratio Directive (1989) were intended to set common capital adequacy standards across the
EU market. One of the central objectives was to bring about greater cross-border activity
whilst removing the ability of domestic regulators to obstruct ownership of banks passing
into foreign control. The Financial Service Action Plan (1999) provided a time frame for the
creation of a single market in wholesale financial services, to open retail banking services and
to strengthen the rules on prudential supervision. In the case of the latter objective, the
European Banking Authority was set up in 2011 to act as a European bank regulatory agency
that oversees national regulatory agencies and even overrules national regulatory agencies if
it thinks proper regulatory oversight is not being carried out. The stated objective is to have a
common set of regulations to avoid regulatory arbitrage and regulatory competition. The
principles of the single banking market have been harmonization, national treatment, mutual
recognition and common regulation. The reality has been much more modest. Formidable
obstacles remain to a full integration of EU banking markets. These include language and
culture, home bias in the case of retail banking, branch network, differences in legal systems,
and discriminatory tax treatment. However, the most important obstacle is the acceptance of
the general good principle that opens up the possibility of opt-outs from specific directives.
Other barriers are informal such as implicit government or official interventions to favour
national banks.




conf. univ. dr. Narcis Eduard MITU:


lect. univ. dr. Nicoleta FLOREA



Chapter 1. General Consolidated Budget and Public Treasury

The concept of budget has evolved continuously. The political motivation for its
development (establishing the Parliament control over the Government activity) has been
completed with the financial one (avoidance of waste).
In Romania, the management of public financial resources is done through a unitary
system of budgets. This unitary and correlated system of funds is reunited in terms of what is
called the general consolidated budget that reflects in one year all incomes and expenses of
the state and of all other public entities, by eliminating double registrations (in order to avoid
their double entry) that may occur as a result of the transfers of resources between various
links of the budget system, by the consolidation operation.
Therefore, budget consolidation refers to the operation of eliminating the transfers of
money between the component budgets of the budget system in order to avoid their double
registration. This operation also includes the adjustments determined by the annual entries of
external credits and reimbursements of capital instalments.
According to the current legislation, the general consolidated budget includes several
categories of public budgets, namely: state budget; local budgets; budget of state social
insurances; budgets of special funds; budget of state treasury; budgets of independent public
institutions; the budgets of public institutions fully or partially funded from the state budget,
the budget of state social insurances, local budgets and budgets of special funds, as
applicable; the budgets of public institutions fully funded from own incomes; the budget of
funds resulted from external credits contracted or guaranteed by the state and whose
reimbursement, interests and other costs are provided from public funds; the budget of
external non-reimbursable funds.
These categories of budgets are independent, meaning that they have own incomes
and expenses, are prepared and approved distinctly, and administratively, their owners have
full independence.
The state budget is the main link of our budget system, it is developed and managed
by the Government and approved under the law by the Parliament. In its structure, it includes
over 50 budgets belonging to central institutions and bodies of the state power and
administration (Romanian Presidency, Senate, Chamber of Deputies, General Secretariat of
the Government, the Supreme Court of Justice, ministries, Romanian Academy and other
public institutions that do not have hierarchically superior bodies).
The incomes supplying the state budget are registered by sources, being grouped into
(tax and non-tax) current incomes and incomes from capital. Therein, tax incomes are
predominant (direct and indirect taxes).
Most of the social-cultural, country defence, public order ensuring actions, economic
actions and objectives in branches and fields of strategic importance, scientific research,
environmental protection are mainly funded from the state budget.
Local budgets include the budgets of the administrative-territorial units of legal
personality (townships, cities, municipalities, counties). These budgets are also prepared as
independent budgets, particularly taking into account own incomes, possible to mobilise and
the potential transfers (grants, distributed amounts) from the state budget. Their preparation is
done in each administrative-territorial subunit, with the support of specialised bodies, and

their approval is of the competence of local bodies of the state power (local councils). When
balancing transfers are necessary, the completion of the projects of local budgets is done after
discussing about them with the Ministry of Public Finance.
Most of the own incomes belonging to local budgets are of fiscal feature. Transfers
from the state budget are added to these incomes, in the form of grants received from the state
budget and other budgets or amounts distributed from the income tax and value added tax, in
order to finance the decentralised expenses locally.
The following are mainly financed from local budgets: expenses for the maintenance
of local deliberative and executive authorities; expenses for secondary education48 (preschool
and primary education, secondary school, vocational education, special education); some
health expenses49; most expenses in the field of culture, leisure and religion (activity of
public libraries, museums, houses of culture, music institutions, sports services, etc.); certain
expenses for social insurance and protection (assistance given to elderly people, social
assistance in case of illnesses and disabilities, social assistance for families and children,
housing support, nurseries, prevention of social exclusion by social aid and social canteens);
expenses for communal management (public lighting, sanitation, sewerage, water, gas, heat
supply, etc.); some economic actions of local importance (public transportation, pest and
disease control in agriculture, etc.).The budget of state social insurances is prepared
separately from the state budget and is approved by the Parliament under a separate law. It is
developed, managed and administrated by the Ministry of Labour, Family and Social
The incomes of this type of budget primarily consists of the contribution for state
social insurances, which is paid by economic operators and public institutions; the
contributions of employees and of other policyholders; contributions for the social insurances
payable by private units based on the free initiative; differentiated contributions of employees
and pensioners who go to spas or leisure; other incomes (the amounts obtained from
liquidating the debits of previous years, repaying the grants given in previous years and not
used, increases and penalties applied for the non-payment in due time and in full of
contributions for social insurances, fines applied for the incompliance with the law,
reimbursement of amounts paid by error, unpaid and prescribed pensions, etc.); interests for
availabilities in accounts, etc. The budget of state social insurances is also supplied by the
surplus of the previous year, which is carried forward to the following year.
The expenses of the state social insurance budget primarily covers the pensions (the
pension for the work performed and age limit, invalidity pension, anticipated pension, partial
anticipated pension, survivors benefit); allowances and social insurance aids (allowances to
prevent illnesses and recovery of work capacity, allowance in case of temporary incapacity of
work, maternity allowance, childbirth allowance, allowance for child growth and care up to
the age of two, allowance for the care of ill or disabled children, aid in case of death); the
referrals to spa and leisure; expenses with the payment of postage fees incurred by sending
pensions; capital expenses for investments; expenses with financial operations that include
interest payments and commissions to the credits contracted by the credit release authorities,

In the structure of the operating expenses of the undergraduate education institutions, the expenses with the
salaries of teachers, of technical-administrative staff, maintenance and household expenses, current repairs and
overhauls, postage, phone expenses, students' scholarships, heating, lighting.
By own budgets of townships, cities, municipalities, medical services are financed in the sanitary units with
beds and other sanitary institutions and actions. The expenses on medical services in the sanitary units with beds
are also covered by own budgets of the counties.

The budgets of special funds aim at solving the economic and social problems
emerged in economy and are supplied from resources particularly affected to these purposes.
Currently, the budgets of special funds approved by special laws, which are formed
and managed outside the state budget and the state social insurance budget are: the budget of
the Fund for social health insurances and the budget of the Fund of unemployment
insurances. These budgets are approved as annex to the state budget law and respectively to
the state social insurance budget law. The projects of these budgets are developed by the
Ministry of Public Finance based on the proposals of the main credit release authorities
responsible for managing those budgets.
The state treasury budget is the document by which the incomes and expenses of this
institution are provided and approved every year.
The body authorised by law to develop, manage and execute directly the budget of the
state Treasury is the Ministry of Public Finance fulfilling this task by the General Directorate
of Public Accounting and Settlement System in the Public Sector.
The treasury budget covers both the costs for organising and operating this institution
as well as the deposit interests and availabilities kept in the State Treasury the interests
related to the domestic and external public debt.
This type of budget is drawn up annually and approved by Government decision. It
can be modified by the Government, whenever necessary, upon the justified proposal of the
Ministry of Public Finance, depending on the changes occurred to the items taken into
account when establishing and approving the initial budget. Even though the total expenses
approved by the Treasury budget are maximum limits that cannot be exceeded, the Ministry
of Public Finance may approve, throughout the year, the change of budgetary credits
approved for the interest payments by credit transfers from other budgetary subdivisions, in
relation to the evolution of availabilities and deposits held in the General Current Account of
the Public Treasury and the level of interest rates. The annual surplus resulted from the
implementation of the Treasury budget is carried forward to the following year and is used to
cover the expenses approved by budget for that year.
The importance of organising the public Treasury system in Romania results from the
following considerations:50 (1) it is considered the most suitable system for organising the
public finances, protecting them from all risks; (2) it allows solving some significant financial
problems, by means of specific operations (management of foreign credits received by the
Government to support the reform programs; mobilisation of financial resources from the
economy to cover the budget deficit and for the service of public debt; financing the states
obligations by government agreement with settlement in the clearing accounts, barter and
economic cooperation, in order to balance the imports with the exports); (3) it allows
permanently knowing the public resources and ensures forecasting the needs for loans for
financing the budget deficit.
Public Treasury includes all the resources the state has. However, it is not limited only
to the execution of the state budget. Thus, by Public Treasury, the separation of the public
sector finances from the private resources of the distinct accounts in banks was done. The
policy of financial placements from the temporary availabilities in the treasury accounts is
also achieved, on the one hand ensuring the use of temporary availabilities (surplus of money
collections over payments) and on the other hand, supporting the transition process through
the state's mechanisms.
Therefore, Public Treasury is a unitary and integrated system by which the state
provides the performance of collection and payment operations regarding public funds,

Tatiana Moteanu and collaborators, Buget i trezorerie public, Editura Universitar, Bucharest, 2003, pag.

including those regarding the public debt and other state operations, safely and in accordance
with the legal provisions in force.
The budgets of independent public institutions (e.g.: the National Securities
Commission (CNVM - National Securities Commission), the National Energy Regulatory
Authority (ANRE - Autoritatea Naional de Reglementare n domeniul energiei), the
Authority for State Assets Recovery (AVAS - Autoritatea pentru Valorificarea Activelor
Statului), the Romanian Insurance Supervisory Commission (Insurance Supervisory
Commission in Romania), the State Office for Inventions and Trademarks (OSIM - Oficiul de
Stat pentru Invenii i Mrci), etc.), include income and expenses and, as applicable, only the
annual expenses of the central public institutions are not subordinated to any other entity of
public law.
The budgets of public institutions wholly or partly financed from the state budget,
state social insurance budget, local budgets and budgets of special funds include annual
expenses of public institutions operating only based on the resources received from the state
budget, state social insurance budget, local budgets and budgets of special funds, according to
the financing system and are subordinated to independent public institutions, as well as the
annual incomes and expenses of public institutions that receive subsidies from the state
budget, state social insurance budget, local budgets and budgets of special funds to complete
own funds and are subordinated to independent public institutions.
The budgets of public institutions fully financed from own incomes are the
documents where the incomes and expenses of public institutions subordinated to
independent public institutions are specified and approved, which operate only based on their
own incomes resulting from rents, organisation of cultural and sports events, art contests,
publications, editorials, studies, projects, use of products from their own or related activities,
services and the like.
The budgets of reimbursable external credits, contracted or guaranteed by the state
and whose reimbursement and other costs are provided from public funds. The funds
resulted from external credits are provided and approved as annex to the state budget law.
These budgets only have expenses where the costs authorised to be incurred from the
amounts originating from external credits are specified. It should be noted that they (external
credits) are not budgetary income.
Budgets of non-reimbursable external funds: The non-reimbursable external funds
are provided and approved as annex to the state budget law. By these types of budgets, the
expenses authorised to be incurred from the attracted non-reimbursable external funds are
The budgetary principles are a synthesis of the experience of budgetary practice, as
well as of the requirements and demands posed by the process of establishing and executing
the state budget. The budget legislation is based on these principles and includes them as
legal rules. Their legal coverage cannot be rigid however, but it can also be adapted to the
economic interests and particularities, characterising not only the reference state, but even the
orientation of the state regime, legislative body or governments.
In the states with market economy, the budgetary principles define: the way of
covering the public incomes and expenses in the state budget, meaning its scope; length of
time for which the parliament authorises the government to achieve the budget year; the
relationship that should exist between the budget incomes and expenses; informing the public
opinion on the sources of incomes and their destination.
In our country, according to the Law on Public Finances, the following underlie the
development and execution of the state budget, budget of state social insurances, local
budgets and budgets of special funds: the principle of universality; the principle of publicity;

the principle of budgetary unity; the principle of annuality; the principle of budgetary
specialisation; principle of monetary unit.
According to the principle of universality, the incomes and expenses are included
fully into the budget, in gross amounts. Also, budgetary incomes cannot be affected directly
to a specific budgetary expenditure, except for donations and sponsorships, which have
distinct destinations established.
The Principle of publicity establishes that the budgetary system must be open and
transparent, this being possible by: public debate of the budget projects, on the occasion of
approving them; publishing the laws by which the budgets have been approved, as well as the
annual accounts of their implementation; means of mass information with access to all
information dissemination, regarding the content of the state budget, except for the non-
publishable information and documents stipulated by law.
The principle of budgetary unit. This principle involves the inclusion of all states
incomes and expenses into a single document, called general budget, prohibiting the retention
or separation of certain incomes or parts of incomes in order to finance certain public actions.
Principle of annuality aims at two aspects: the period of time for which the budget is
prepared and approved and the period when the incomes are collected and the expenses
recorded in the authorisation given to the Government by the Parliament are incurred.
In terms of the period for which the budget is drawn up and approved, practices are
observed, which differ from one country to another, meaning that many of them draw up and
approve the public budget during a budget year overlapped on the calendar year (January 1 st -
December 31st), among which Austria, Belgium, Brazil, France, Germany, Greece, Italy,
Netherlands, Norway, Portugal, Romania, etc. However, in other countries, the budget year
starts during a calendar year, and it ends in the following calendar year, such as: (April 1 st -
March 31st) Canada, India, Israel, Japan, Great Britain, etc.; (July 1st - June 30th) Australia,
Cameroon, Egypt, Pakistan, Sweden; (October 1st to September 30th) USA, Thailand, etc.
In terms of budget implementation period duration, it is also known as possible
options either to overlap it with that of the budget year, or to extend this period by another 3-
6 months, over the duration of one year, which involves a deviation from the principle of
budget annuality.
The first variant is called management system and is characterised by the fact that at
the end of the budget year, the budget implementation is closed, regardless of the fact that
some of the expenses or incomes related to the expired year have remained unused. In this
situation, it is accepted that any incomes and expenses (provided, but unrealised) are to be
retrieved and reflected in the budget for the following years and the management of that year
closes in the limit of the achievements recorded by the expiry of the budget year.
The second variant is called implementation system and it implies that at the end of
the budget year, the year does not end, but both the income collection and the incurrence of
expenses continues during the extension period along with the budget implementation for the
new year. This means that during the period of extending the budget implementation for the
expired year two budgets shall work (in the current year), separately recording the incomes
and expenses related to each of the two budget years and following to close the budget year
for the previous year after 15 -18 months instead of 12 months.
In accordance with the principle of budgetary specialisation, the budget incomes
should be budgeted and approved by the by sources and the public expenditures that are to be
incurred by categories, depending on their actual destination and depending on their
economic content.
The implementation of this principle is achieved through budgetary classification,
which is a unitary scheme of grouping the budgetary incomes and expenditures according to
certain criteria (administrative criterion, economic criterion, functional criterion being used

most often). It should be sufficiently simple and clear to be easily understood and applied and
to provide information on the source of the incomes, destination of expenses, public
institutions (ministries, departments, services) by which these are achieved. Its use is
mandatory for all public institutions, both in the budget design and approval phase, and in its
execution and completion phase.
The monetary unit principle requires that all budgetary operations are expressed in
the national currency.
The budget process involves a set of actions and measures undertaken by the specific
institutions of the state in order to implement the financial policies of political parties and of
governments they represent, through the general consolidated budget.
The budgetary process is characterised by certain features: it is a complex process it
aims at a very large number of participants with multiple and diverse issues; it is a cyclic
process they are developed in a well-defined calendar period, after which the process is
resumed; it is a process of decision the competent authorities shall decide on the allocation
of public resources; it is a political process the decisions on allocating the resources are
determined by the doctrinal thinking and political interests of the party / parties in power.
In its generic sense, the budgetary process is defined by all the works and operations
concerning the design (development), approval, execution, completion of the budget,
including the implementation and achievement of the budgetary control over them, as well as
the approval of budget implementation.
In most countries, the initiative on the budgetary matter belongs to the executive (to
the Government), which must prepare the draft budget and submit it to the Parliament. Within
the Government, the Ministry of Public Finances or the Ministry of Budget (in some
countries) is directly responsible for this issue, as a body specialised in the financial field.
When preparing the draft budget, the objectives of the governing program of the
party (coalition of parties) in power are taken into account, as well as the analyses conducted
by the Ministry of Public Finances regarding the evolution of the economy (reunited in the
tax and budgetary Strategy), the budget implementation results during the previous periods,
the conjectural factors that may generate influences on the budgetary indicators in the future.
The examination, debate and approval of the state draft budget is the responsibility
of the Parliament and it usually involves: its analysis in the parliamentary committees;
reconciliation of amendments (changes) proposed in the draft budget; the presentation of the
draft budget in the Parliament by the Chief of the Executive Board or by the Minister of
Finance; the approval of the draft budget in the Parliament; ratification of the budget
approved by the President.
The budget implementation is one of the most important actions within the budgetary
process. As a phase of the budgetary process, the budget implementation is also a
Governments responsibility, fulfilled by the Ministry of Public Finances, which must
organise the work and apply the appropriate procedures. Under this latter aspect, it is worth
noting the use of various tools and procedures in the execution of the expenditure part,
respectively income part, involving a certain structure of the activity and personnels
In the expense part, the budget implementation, within the approved amounts to be
made available to the beneficiaries of budgetary allowances (credits) involves a specific
procedure, with operations corresponding to the following distinct phases: engagement;
liquidation; authorisation; payment.
Engaging a budgetary expenditure may occur as a result of an own decision, taken
independently and expressed by preparing an agreement (contract or order) between that
public institution and the beneficiary of the amount (legal entity or natural person), wherein
the mutual rights and obligations shall be stipulated. It may also result from rules or legal

documents issued by bodies of the state power and administration, and drafted by the public
institutions involved in achieving the actions which those rules or documents refer to. The
decisions, by which the engagement of budgetary expenses occurs, can only be taken by the
people who have the legal competence to employ payments from public financial resources,
within the limits of the given competences and of the amounts approved by the budget. Such
people are usually the heads of public entities (ministers, managers, etc.) or other employees
who usually have managerial positions in that institution, who are also known as credit
release authorities.
The liquidation of budget expenses is the operation by which fulfilment of the legal
requirements or obligations of the beneficiary of the amount (that is to be paid) is observed
by individuals authorised to represent it. This stage is established both based on factual
findings regarding the services provided, goods delivered and received, works performed and
on justifying documents legally prepared and presented to the public institution (that is to
decide and make the payment), such as: reception reports, settlements, invoices, etc.
The authorisation of budgetary expenses is materialised by the public institutions
issuance of an order for the payment of the due amount (the liquidation is admitted),
equivalent to giving a payment order in favour of the natural person or legal entity entitled to
collect it.
The payment is the final stage of the incurrence of expenses by which the public
institution pays its obligations to third parties. This can be done either by transfer into the
beneficiary's account opened at a bank or in cash, via the cashiers office of that public
institution. By their content, the first three types of operations regarding the incurrence of
budgetary expenses (engagement, validation, authorisation) are the competence of the credit
release authorities, represented by the managers of the public bodies or their authorised
representatives. In contrast, the actual payment can be made only by the managers (handlers)
of public money, who have cashier or paying account positions, ensuring a separation of the
competences, necessary to prevent incorrect, fraudulent operations.
In its turn, the implementation of the part of budgetary incomes, starting from the
principle that for these, the provisions of the approved budget are minimum limits of the
money collections and having the tax collection as main component, also involves several
types of works (operations), actions distributed in time, namely: settlement; liquidation;
issuance of securities; actual taxation (collection) of the income.
Settlement, as an operation specific to taxes (the main budgetary income), involves
the identification and assessment of the taxable matter.
Liquidation is the stage where the amount of the tax due by the natural person or legal
entity is established, depending on the taxable matter and legal taxation rates and on other
elements provided by the tax law. By opening the tax records on the determined payment
obligations borne by each taxpayer, aiming to collect the due taxes is ensured, anticipating
next operation of issuing the collection order.
The issuance of the collection (taxation) order borne by the taxpayer aims at certain
budgetary incomes and consists of preparing a document that authorises the collection of that
income to the related budget. The issuance of the taxation order is also called tax roll
opening. This actually implies recording in a register (for some time now, electronically), in
a separate party, of the debt the taxpayer has for the given period. Recording that debt is the
legal basis for monitoring the budgetary incomes by usual or exceptional (enforcement)
Levying is done by actually collecting the tax or fee in the established amount and
deadline, either in cash or by transfer. Performing the collection operations also involves
taxpayers pursuing to meet the payment deadlines, and the tax bodies may apply sanctions or
enforcement measures to those debtors who do not pay their obligations to the state. The

actual collection of tax incomes is an operation of managing public money, which may be
done, in principle, by collector-accountants or tax agents.
The options on organising the cashiers office implementation of the budget, also
financing the deficit varies in time and space, but the budgetary theory and practice have
outlined two representative systems, namely: by means of the banking system; via the
treasury system.
The completion of the budgetary implementation is the stage following the collection
of incomes and the incurrence of budgetary expenses and it results in the preparation of
documents required to complete the budget year. According to the management system in our
country, the effects of ending the budget year are:
a) any income not collected by December 31st shall be charged in the budget account
for the next year, in the results of which it is to be reflected;
b) any expense not incurred shall be paid only into the account of the budget of the
new year, if that budget shall contain of provisions in this regard.
The documents to be prepared when closing the budget implementation by the
Government and forwarded to the Parliament in this regard are:
a) The general account of the state budget implementation is drafted by the Ministry
of Public Finance, under the coordination of the Government based on the accounting reports
submitted by the main credit release authorities and on the accounts regarding the cashiers
office implementation of the budget submitted by the competent bodies. This has the same
structure as the approved budget and, for the incomes it includes data on the initial budgetary
provisions, the final budgetary provisions and collections made, and for expenses it includes
the initially approved budgetary credits, the final budgetary credits and the payments made.
Based on this, the result of the execution is established deficit or surplus and proposals on
covering and placing it are made. The general account of the state budget implementation is
completed by the Government and submitted to the Parliament by July 1 st of the following
year, which must approve it by November 30th of the same year. The general account of state
budget implementation is approved by a law along with the annual accounts of implementing
the budget of state social insurances and budgets of special funds, after the Court of Accounts
verifies them;
b) The result of the implementation highlights the state budget balance as a result of
budgetary implementation of incomes and expenses, which may be a surplus when the
resources exceed the needs or a deficit when the collected incomes do not cover the expenses
c) The general account of public debt is drawn up by the Ministry of Public Finances
and consists of the domestic debt and states direct foreign public debt accounts and the
situation of the governmental guarantees for domestic credits and for foreign credits received
by other legal entities. It shall be submitted to the Parliament as an annex to the account of
state budget implementation.
d) The annual public report drafted by the Court of Accounts within 6 months as of
receiving the accounts of implementing the budgets subject to audit (state budget, budget of
state social insurances, local budgets, budget of special funds, general account of public
debt). It includes the remarks of the Court and provides the legislative power with actual
information on the implementation of the national public budget.
Budgetary Audit. The entire budgetary process and especially the implementation of
the budget involves the exercise of control, starting with verifying the reality of the
information used to substantiate the provisions included in the draft budget and ending with
ensuring the authenticity of the account of budget implementation. In relation to the nature of
the bodies that perform it, the audit may be political, jurisdictional and administrative.

The political audit is exercised by the Parliament both when examining and approving
the draft budget and the account of budget implementation and during the budget
implementation. By the Parliaments vote on the account of budget implementation, the
executive authority is released of the financial management of the ended budget year.
Through its permanent committees or specially established investigation committees, the
Parliament may also perform control actions, hear members of the Government and any other
individuals managing or administrating public funds. This control is focused on the way of
observing the parliamentary authorisation by the executive board, but it may also aim at the
management of funds and the efficiency of their use.
The jurisdictional audit is the competence of a specialised body (the Chamber or the
Court of Accounts) and aims at establishing the legal responsibility for how the public
patrimony is managed and administrated, through the thorough verification of the justifying
documents underlying the operations. It annually provides the management release for
accounting accounts if they are found to be in order and the irregularities observed are
included in the annual report submitted to the Parliament.
The administrative control is exercised by the executive authorities and takes the form
either of internal hierarchical audit exercised within ministries and other government
agencies or of external audit exercised by the competent authorities, particularly the Ministry
of Public Finances. Thus, in each ministry, in the other central and local bodies of state
administration, there are specialised bodies of control over the legality, appropriateness and
efficiency of using budget funds. After exercising it, this audit may be preventive,
concomitant with or a posteriori of performing the budget operations, the preventive audit
being of highest efficiency.

Chapter 2. State Loans and Public Debt

In today's economy, there are frequent instances when the incomes acquired by the
state from taxes and fees and those originating from its undertakings and properties do not
fully cover its expenses. In such cases the budgetary imbalance, focused on deficit,
completing the public incomes is done by financing the deficits with resources from loans,
meaning through public credits. The loan is therefore an exceptional way to acquire public
incomes, a way of anticipating future incomes.
The practice of public loan is based on the confidence in the states solvency and is
done either by directly contracting by the state (and assimilates thereto) the loans from
natural persons or legal entities holding available money, or by means of specialised
institutions (banks, savings banks, insurance funds, etc.) which collect cash from the market,
entrusting it afterwards to the state for a determined period of time. Whatever the form of
employment, the public loan involves creditors acceptance of some credit granting
conditions: guarantee, reimbursement deadline, interest rate, facilities, etc.
The call on public loans involves a number of processes to redistribute the gross
domestic product (GDP), both nationally and internationally.
Internally, the effects of using public loans may occur since the phase of subscription
and can materialise into a redistribution of the GDP between the accumulation fund and the
consumption fund, depending on the destination the amounts borrowed by the state acquire.
Thus, if the amounts acquired through loans are used to finance the pure or unproductive
public expenses (defence, public order, justice, etc.) they generate an additional consumption
demand and an amputation of the capital growth in favour of increasing the consumption
fund. In the situation where the financial resources acquired by loan are used by public
authorities for productive purposes (infrastructure development, achievement of objectives
and economic actions, environmental protection, etc.) we are not in the situation of

redistribution between the accumulation fund and the consumption fund, but only between
the subjects materialising the use of part of the accumulation fund, namely that part
transferred from the private sector into the public by means of state loans.
The process of internal redistribution of GDP continues in the stage of actually using
the amounts borrowed and takes the form of profits which the economic agents achieve by
delivering goods, providing services or performing works for the public sector and which are
paid from the amounts acquired by public loan.
However, regardless of the (productive or unproductive) destination acquired by the
borrowed amounts, a redistribution of GDP occurs nationally, in the form of interests,
earnings and other benefits granted to subscribers on loan and which are borne from the
taxes and duties collected from the whole mass of taxpayers.
The loans contracted on the foreign market have more significant effects, generating a
redistribution of the GDP internationally.
Initially, these loans generate a GDP redistribution and capital transfers from the
creditor to the debtor nation, redistribution that is however temporary, the loan being
reimbursable. Further, by paying the due instalments, interests and related commissions a
reverse redistribution occurs, from the debtor nations to the creditor ones. If the payment of
the capital instalments is (hypothetically) made based on the amounts previously received as
loan, the payment of interests and external commissions is a permanent transfer of GDP from
the debtor nation to the creditor one. The destination the borrowed amounts acquire is
particularly more important in this context. Only their productive and efficient use creates the
premises for the GDP growth and for bearing the interests and commissions based on the
value newly created within the objectives achieved, thus avoiding the tax increase in the
The public loan has the following features:
a) it is of contractual character, expressing the parties agreement. The conditions of
issuance and reimbursement, the form and size of the income it provides, as well as other
possible benefits granted to lenders are however established unilaterally by the decision
making bodies of the state. The potential subscribers may accept or refuse the terms of the
loan, but cannot claim some preferential treatment over other subscribers. In the case of
public credit there is no material guarantee provided, the presumption that the state is solvent
at any time being sufficient. Typically, public loans are based on the principle of optionality,
however also knowing situations of forced loans, when the subscription was of binding
feature. Such loans can be contracted for preparing or carrying out wars, country's
reconstruction after the war, removal of the effects of natural disasters or as a result of severe
economic crisis. In order to succeed in placing such loans the issuance and reimbursement
conditions of which are unattractive, an extensive popularisation action is conducted,
highlighting their importance for the nation and that subscribing for a loan is a patriotic duty
for every citizen. At other times, subscribers are faced with the situation of choosing between
an extraordinary flat tax, of final and non-reimbursable feature, and a reimbursable state loan
but with an interest below the market level.
b) it is of reimbursable feature, being returned on the deadline established for natural
persons or legal entities who granted it. The reimbursement deadline is established by the
state when launching the loan, being correlated with the predictable evolution of public
incomes and expenses. However, there are also perpetual loans, at the issuance of which the
state undertakes only to pay an interest to its creditors, for an indefinite period of time,
without establishing a deadline for repaying the loan. The state can, however, redeem the
public documents on stock exchange, when the operation has economic advantages.
c) it ensures a certain counter-performance to subscribers. This is the "price" of the
loan and may take the form of interest, gain or both, whereto other material or tax benefits are

often added. Sometimes the benefits provided by the state when launching a loan are
subsequently restricted. Thus, the state can proceed with decreasing the interest rate by
converting the public debt; at other times, the initial material advantages provided by the state
are automatically decreased by the depreciation of the currency used to contract the loan.
When launching a public loan, it is necessary to establish some technical elements
that define it legally, namely: the name of the loan, the borrower, lenders, loan amount,
reimbursement deadline, interest, other advantages and facilities for subscribers, etc.
a) The name of the loan may be related to its destination, the exceptional character or
pursued object being specified in the name of the loan. In case of loans contracted to cover
the budget deficits, the contracting year, interest rate, the form the income takes, etc are
specified in the name of the loan.
b) the borrower is the credit requesting public authority, which employs the credit
under the conditions specified in the issuance prospectus. By employing the credit, that
authority becomes subscribed or debtor, but it can also be called issuer of documents bearing
a specific name (treasury certificates, bonds, treasury bills, state rent, etc.), and certifying the
loan subscription, state security amount, interest and / or gain, reimbursement deadline, etc.
c) Lenders (subscribers, creditors or depositors) are natural persons and / or legal
entities holding temporarily available amounts and are willing to lend the state or another
public authority, receiving in exchange state securities (government securities) which
certifies certain rights for them.
d) The loan amount means the total of the borrowed amount and appears as the
amount approved by the legislature or executive body and as the amount achieved on the
completion of the operation of placing the state securities. The approved amount is usually
limited as nominal value of the amount to be borrowed and as period of time when
subscriptions can be done. In practice, unlimited (open) loans can be encountered, both in
terms of the amount and in terms of the subscription period. The amount achieved is the
expression of trust (or mistrust) the loan issuers enjoy from the potential subscribers, also
being dependent on the conditions and benefits provided to subscribers by the issuing
prospect. Contracting the state loans is done by issuing some documents with the form and
content specified by the normative act to launch the loans and which are generically called
public credit securities, state securities, government securities, stocks.
If the loan is contracted from a large number of subscribers, these documents take the
materialised form and are effectively handed over to subscribers. When the number of
creditors is low, the amounts borrowed are recorded in the public debt records without
issuing special documents, taking the form of accounts receivables. Accounts receivables do
not require expenses for issuing and keeping the securities, but they do not provide the
possibility to negotiate at the stock exchange, but only outside thereof, by fulfilling certain
Although they are called stocks, public credit securities have no own (intrinsic) value.
However, they certify the amounts borrowed by the state or by another public authority and,
in this context and conventionally, the terms of nominal value and real value are used.
The nominal value is the amount recorded on the state security and expresses the
claim which the holder is to collect from the state, respectively the states debt to its holder.
The real value is the actual amount a public credit security is sold or purchased at. It
is manifested both in the credit engagement stage and throughout the loan validity period and
is dependent on the rate at which the state securities are quoted.
The rate is the price which 100 nominal value monetary units are bought and sold
at and this can be: at par, meaning equal to 100; below par, meaning lower than 100, or
above par, meaning more than 100. It is influenced by the supply-demand on the loan capital

market, by the interest level and other advantages provided by the state to the holders of
public documents.
In relation to the stage of loan agreement development, one can speak of issue price,
trading price and reimbursement rate (amortisation).
The issue price is the price established by the issuer when launching the loan for one
hundred monetary units of its value. Normally, the issue price is an "at par" price 51. The
situations where, due to the competition on the money capital loan market and to the states
stringent need for resources, the issue price is below par. This equals to a share premium
the subscribers enjoy, as a difference between the nominal value of the loan security and the
amount actually paid to receive it. In an entirely exceptional way, the issue price can be
above par.
If the holder of the public credit security wants to recover their money before the
security due date (in case of credit securities quoted at the stock exchange), they can sold it at
the rate which the security is quoted at, meaning the trading rate, which can be at par,
below par or above par depending on the supply-demand ratio on the capital market.
Finally, at the stage of public loan amortisation, for the redemption of public credit
securities, the state can practice a reimbursement price (amortisation) that can be "at par",
"below par" or "above par". In this context, the subscribers can enjoy a reimbursement
premium, which appears as the difference between the below par price which the loan was
placed at and the at par price which the securities are redeemed at, or as difference between
the at par price which it was placed at and the above par price which the loan is
reimbursed at.
e) The reimbursement deadline indicates the date when the state loan should be
reimbursed. From this point of view, public loans can have precise reimbursement deadlines
or without such deadlines. Those with precise deadlines can be below one year (short-term),
between 1 and 5 years (medium term) and over 5 years (long term).
In the case of short term loans, public credit securities are issued, which are called
treasury bills, debt certificates, tax certificates or bills, treasury policies and for certifying the
medium and long term or term-less loans, bonds and interest bearing securities are issued.
Each one of them has its own features and legal regime.
f) Interest and other forms of remuneration. The price paid by the state to its creditors
to use the borrowed amount takes either the form of interest (fixed income), or the form of
the gain (differentiated income), or a combination of both. For the state loans with interest,
each bond has a number of coupons attached, which is periodically detached (once or twice a
year) and is submitted to the counter of the institution appointed by the state, collecting the
accrued interest.
The amount of the annual interest (Da) is established based on the interest rate (rd),
which is established in advance, by the issue prospect of the public loan, signifying the
promised annual interest for 100 u.m. loan. The following relation results herefrom:
Da = Vt x rd /100 where: Vt is the value of the public credit security.
Typically, the interest rate on state loans is maintained at a close, but lower level of
the rates on bank loans in order to provide states access to the money resources available on
the capital market, under competition. When the inflation processes are more acute, the
nominal rate of the interest should be higher, and it should normally be at least at the level of
the average inflation rate, thus avoiding a really negative interest to be reached. It should also
be noted that the average interest rate increases as the loan reimbursement deadlines are
longer, the states understanding to protect the interests of individuals who credits them for

At parity (from Latin).

longer periods of time, providing them with an interest rate that would cover the loss caused
by the increase in the inflation at least partially.
One may speak of a (nominal) issue price and of a real interest rate. The issue price
or the nominal rate (rn) is established by relating the annually paid interest (Da) to the
nominal value of the issued documents (Vn). The real interest rate ( rr ) is established by
relating the interest paid by the state (Da) to the amount actually collected as a result of
placing the documents (Vr). It is influenced by the rate which the placement was done at: at
par, below par or above par. Normally, the documents are placed at a below par or at par rate,
making the real interest rate be higher than or at least equal to the nominal interest rate. In
order to determine these rates, the following relations are used:
rn a x100 and rr a x100
Vn Vr
The concept of real interest rate also means net income the creditor receives as a
result of one hundred monetary units lent for one year and shall be determined by correcting
the nominal interest rate with the influence of changing the prices (GDP deflator) in the
country of the creditor (D), according to the formula:
(100 rdn ) 100
rdr 100
r n
where: rd is the real rate of the interest; rd is the nominal rate of the interest.

Any price increase on the domestic market, from one year to another, reduces the real
interest rate in relation to the nominal one and hence the creditors real gain, while lowering
the domestic prices leads to reverse effects.
The difference between the nominal (greater) interest and the real one (lower) is a loss
for the creditor and and advantage of equal value for the debtor. Similarly, in the case of
loans contracted abroad, if the prices of the debtor nations products register a decrease on the
foreign market, the real interest related to the loan increases, which disadvantages the debtor
and brings additional gains to the creditor; when external prices related to the debtor
countrys exports grow, the effects are reverse.
For the state loans with gains (bonuses), the amount that the state would have
normally paid by way of interest (in relation to the annual interest rate) is distributed as
bonuses only to the holders of those documents that were winners following the regular
drawing lots. This type of loan has been designed to increase their attractiveness before
potential subscribers, namely before those tempted to give up a certain but low income
achieved in the form of interest, in favour of a possibly much more important gain, as
In practice, the combined variant of loans with interest and gains may also be
encountered, which involves the subscribers acceptance of a more moderate interest rate
(which is normally paid based on detachable coupons) and the interest difference (up to the
level of average interest on the capital market) is distributed as gains to the subscribers the
documents of which are extracted on regular drawing lots.
Finally, the subscribers revenue may also take the form of rent, meaning an amount
of money that the state undertakes to pay to natural persons who subscribe to public loans
without an express reimbursement deadline. They are also called life annuities for they are
paid regularly and in a fixed amount, set in advance, throughout the subscribers life, and the
states debt is extinguished afterwards.
g) Other advantages and facilities granted by the state to make loans more attractive
are: exemption from taxes and duties of incomes achieved from subscribed public loans or

incomes resulted from stock exchange transactions, with negotiable government securities;
states acceptance of credit securities at the nominal value as payment into the account of
taxes due to the state; assigning the legal privilege that the credit securities would not be
subject to enforcement when the holder has reached a bankruptcy state; guarantee against
monetary fluctuations, etc.
State loans bring about a number of operations related to placing them on the market,
their reimbursement, as well as the potential change in their conditions (interest rate or
reimbursement deadline).
The placement of state loans can be done in three ways: by public subscription; by
means of banking consortia (unions); by sale at the stock exchange.
The placement by public subscription is done by the Ministry of Public Finances (or
another competent institution) and involves the advertising the purpose and condition of
launching the loan, as well as organising counters at the financial administrations,
perceptions, savings banks, banks or directly via civil servants. In practice, two situations are
a) when the amount of the contracted loan is not limited, each subscriber transferring
the subscribed amount;
b) when the amount of the loan is limited, by two alternatives: subscription limits are
established by each counter or placer; subscription is unlimited but, in the case where it
exceeds the forecast level, the transfer is done proportionally to the subscribed amount.
The placement via banking consortia (unions) is also done in two variants:
a) Taking the bonds into the commission, in which case the state comes
into the possession of the amounts to the extent of the placement and bears the risk of
unplaced bonds and the commission charged by the bank for the service provided;
b) the actual purchase by the banks of the loan securities, when the
collecting banks are in charge with the placement risk, instead, the difference between
the rate which the documents are placed and the price at which it purchases these
documents from the state.
Should there remain documents that cannot be placed on the market, they enter the
portfolio of those banks that assumed the risk of placement. Compared to the variant of
public subscription, the placement of loans by banking consortia is more expensive, but much
less convenient and quicker for the state, which rapidly comes into the possession of the
desired amounts.
The sale at the stock exchange is usually done in the cases of new loans, when the
state wants them to go unnoticed. This tap-like technique avoids the decrease of the price
of bonds, which would lower the financial yield of the loan. Such placements have the
advantage of being discrete, easy to achieve and very inexpensive.
In Romania, in relation to the authority that employs them, state loans take the form
of: internal or external loans contracted / guaranteed by central public administration
authorities; internal and external loans contracted / guaranteed by local public authorities.
The loans employed directly by the central and local public administration
authorities are contracted based on:
a) State securities expressed in lei and in foreign currency, in materialised or
dematerialised for, with interest or discount, placed on the domestic and/or foreign market.
They are issued by the Ministry of Public Finances and by the local public authorities, either
directly or through agencies or specialised institutions. The form the state securities take is
that of treasury certificates, municipal bonds, bonds for financing the budget deficit, bonds
issued based on special laws.
b) Conventions concluded with the National Bank of Romania, as well as with other
specialised institutions that acquire the status of state agent. Thus, to maintain an appropriate

balance in the general account of the State Treasury, the National Bank of Romania provides
it with loans with a reimbursement deadline of 180 days at the most, based on the convention,
with an interest at the market level. The authorities of the local public administration may
contract domestic loans based on the agreements concluded with the commercial banks or
other credit institutions, with the approval of the local councils. In addition, they can benefit
from interest free loans from the availabilities of the general account of the State Treasury, up
to 5% of the total incomes estimated to be collected in the year when the loan is employed.
c) Agreements concluded with the governments of other countries and with
international financial institutions.
Placing the state securities on the domestic market is done on the inter-banking
market, through the local treasuries and by means of the stock exchange.
a) By means of the inter-banking market, the following are placed:
- the treasury certificates expressed in lei, on the short-term, sold through the method
of tender and launched on the primary market via the National Bank of Romania, which
operates as state agent. They can be purchased by the intermediaries authorised to trade state
securities on the primary market;
- treasury certificates expressed in foreign currency, on the short term, sold through
the method of public subscription. Securities can be purchased by authorised intermediaries
on the government securities market, which may subscribe on their own behalf and name or
on the behalf of clients, natural persons or legal entities residents and non-residents, through
the National Bank of Romania;
- state bonds issued on the medium and long term to finance the budget deficit or
under special laws. They can be expressed in lei, sold by tender and launched on the primary
market by means of the National Bank of Romania or can be expressed in foreign currency
and sold by public subscription by means of the National Bank of Romania (BNR), which
operates as state agent.
b) The treasury certificates expressed in lei are placed by means of local treasuries,
which are addressed to natural persons, on the short term and sold through the method of
public subscription.
c) The municipal bonds issued on the medium term by the local public administration
authorities are sold to the intermediaries of the stock exchange market through the stock
exchange, in order to finance investment projects.
The state-guaranteed loans are contracted by companies, autonomous
administrations, national companies, administrative-territorial units and public institutions to
finance investment projects, based on letters of guarantee issued by the Ministry of Public
Finance, in the name and on behalf of the State, or by local public authorities.
The conditions which the state loans are contracted under do not remain unchanged
for a long time. Depending on the supply-demand ratio offer on the loan capital market, the
state can operate changes on the interest level for the state loans by operations such as
conversion and augmentation. At other times, in relation to the financial problems it faces, it
proceeds with changing the public debt reimbursement deadline, through the operation of
consolidating its debt which reached maturity.
Conversion is the operation of changing the documents of an old loan with those of a
new loan, issued with a lower interest, the state wanting to gain in the case of favourable
economic circumstances. By conversion, the state gets a material advantage, but suffers a
moral injury, losing the credibility before subscribers.
Augmentation is the operation (reverse to conversion) of increasing the interest rate
of state loans, in the situation of decreasing the price of its documents, in order to preserve
the subscribers interest for state loans, if the state has the intention to contract new loans in
future periods.

Consolidation is the operation of changing the documents of some loans payable
immediately or on the short term (treasury bills, etc.) with documents of some medium and
long term loans (bonds, interest bearing securities) or without term (perpetual interest bearing
securities). It provides the state with an immediate advantage, helping it to overcome the
bottleneck it faces, by cancelling big debts that should be reimbursed on close due dates, but
in the long run, it leads to an increase in expenses with the public debt, because in order to
offset the risk of currency depreciation which its creditors are subject to, the state must
provide an interest rate increase.
Sometimes, in order to hide the financial difficulties it goes through from the public
opinion, the state carries out a disguised consolidation, by reimbursing an old loan that has
reached maturity, from money obtained by contracting a new loan of relatively equal amount
as the old loan.
The amortisation (reimbursement) of the state loans is the operation of redeeming the
credit securities from their holders by repaying the borrowed amounts. It can be of mandatory
or facultative feature. Specifically, the state undertakes to repay only the term loans but it can
also repay the perpetual loans, without however, being bound to do so.
Mandatory amortisation may be done by using several variants, namely:
reimbursement on single date, early reimbursement and staggered reimbursement.
The reimbursement on single date involves making massive payments on the
established deadline, which raises financial issues (ensuring the necessary resources),
monetary issues (massive release of money in circulation) and organisational issue (making
payments to a large number of creditors). To avoid these shortcomings, the state may use the
early reimbursement, either by redemption at the stock exchange of those securities
approaching the due date, or by establishing a period when the redemption would occur.
In its turn, the staggered reimbursement may be done in three ways: by way of
annuities; by drawing lots; by redemption on the stock exchange.
Optional amortisation occurs in the case of perpetual loans, when the state may use
(without being bound to do so) either the direct reimbursement, or the redemption of
securities by way of the stock exchange.
The reimbursement of public loans may be done from the following sources: the
amortisation special fund, formed based on certain public incomes given to the
administration of a specialised institution called amortisation cashiers office; budgetary
resources, in which case the expenses related to public debt are recorded in the state budget
and covered from the ordinary budget incomes; budgetary surpluses, when they exist, and
which are used to reimburse the term-less loans, if that operation is a financial interest for the
The loans contracted by the state can be depreciated not only by reimbursing them,
but also in other ways: states bankruptcy, moratorium, repudiation, inflation.
States bankruptcy or its insolvency manifested by stopping its payments, including
of those into the public debt account, for political or economic reasons (e.g.: wars that ended
with the state militarily defeated and economically ruined). The payments for war reparations
and for rebuilding its own economy, no longer allow it to pay its obligations to creditors.
They are content with the promise that the defeated state would pay them a certain portion of
the outstanding debt as financial arrears, within a given period of time.
The moratorium is the legal postponement of payments into the account of
contracted loans due to exceptional circumstances (economic crises, unfavourable
international situation, etc.) leading to massive deficits of the payment balance, decreased
gold and foreign exchange reserves, a drastic reduction of export incomes. The moratorium is
always accompanied by an agreement of consolidating the external debt, respectively of
rescheduling the payments for the service of the external debt.

Repudiation is the express and explicit refusal of a state to meet its obligations
assumed under the loan agreement. The state is solvent but, for political reasons, it refuses to
pay, and its creditors cannot compel it to do so.
Inflation is the way of extinguishing the loans contracted in a currency subject to
depreciation and which are unprotected by indexation or other clauses. The state pays its
obligation to reimburse the loan at its nominal value, but due to the monetary depreciation,
the real value of the reimbursed loan is lower than that when the loan was launched. That
difference actually remains unreturned even if the reimbursement obligation has been

Covering the general needs of the society requires financing the public expenses
which are incurred based on the taxation from the taxpayers in the form of taxes, duties,
contributions (which are found in various links of the general consolidated budget), on the
external non-reimbursable funds, as well as on the domestic and foreign loans contracted
directly or indirectly by the central or local public administration authorities. In a general
sense, the latter ones generate what we call public debt.
It should be specified that the total debt of a country includes two components,
namely the private debt and the public debt.
The private debt is the debt contracted on the domestic or foreign market by private
debtors (other than those of public law) and not guaranteed by the state or other public
According to the financial doctrine, the public debt represents all the financial
obligations of the state, resulted from loans employed directly from the domestic capital
market and from abroad, as well as from expressly guaranteeing domestic and foreign
reimbursable loans employed by third parties52.
To understand the content of this complex economic category, the public debt can be
analysed from different points of view: the level which it is employed at; the market whereon
it is contracted; the obligations assumed; the status of creditors; the degree of chargeability,
etc. Each criterion of analysis emphasises new forms of public debt manifestation.
1. Thus, in relation to the level which it is employed at, public debt takes two forms:
the governmental public debt and the local public debt.
As it is defined in our legislation, the government public debt53 is all the monetary
obligations at a given time, resulted from loans in lei and in foreign currency on the short,
medium and long term, contracted by the state on its own name or guaranteed by it, as well as
the states obligations to own treasury, resulted from the use of resources from its account for
covering the state budget deficit.
According to the national legislation, the local public debt 54 emphasises all payment
obligations at a given time of the authorities of the local public administration, resulted from
domestic and foreign agreements and contracts, by which the terms and conditions of the loan
between the beneficiary and creditor are stipulated.
2. In relation to the market whereon it is contracted, the public debt may be a
domestic public debt and a foreign public debt.
The domestic (governmental and local) public debt is all the obligations in lei and in
foreign currency resulting from loans contracted/guaranteed by the central or local authorities
on the domestic market (from natural persons or legal entities residents of the debtor nation).

Talpo I., Creditul public, Editura Sedona, Timioara, 1999, pg.75.
Public debt law no. 313 of 2004, Off. Journal no. 172/2004.
Law on local public finances no. 273/2006, Official Journal no.618/18 July 2006.

The domestic (governmental and local) public debt is all the financial obligations
resulting from loans contracted/guaranteed by the central or local authorities on the foreign
market (from natural persons or legal entities non-residents of the debtor nation).
In developed countries, the domestic debt is prevalent as they have a large domestic
market of the loan capital, while in developing countries, the share is of the foreign debt,
practically representing a way to supplement the financial-foreign currency resources which
they need. The higher the foreign debt is, the greater the economic and financial dependence
of that country is.
3. In terms of the obligations assumed, we may speak of direct (actual) public debt
and guaranteed public debt.
The direct public (actual) debt emphasises all the obligations contracted directly by
the central and / or local administration authorities on the domestic and foreign capital
The guaranteed public debt is all the financial obligations guaranteed by the central or
local authorities for loans the beneficiaries of which are central, local authorities, public
institutions or other public or private authorities.
4. Depending on the status of the creditors, in some countries, distinction is made
between the gross public debt and the net public debt.
The gross public debt includes the total value of the government securities, regardless
of their owners.
The net public debt is only the value of the government securities held by natural
persons or legal entities, other than those of public law. The difference consists in the
government securities wherein various funds belonging to the state or loans employed from
the state institutions (the Treasury, the National Bank, state budget for local budgets, etc.)
have been placed.
5. In relation to the degree of chargeability, we encounter the floating public debt and
the consolidated public debt.
The floating public debt represents the short term payable amounts (of up to one
The consolidated public debt is the payable public debt on the medium term (2-5
years) or on the long term (more than 5 years). The higher the floating debt in the total public
debt is, the more urgent the need for financial resources is, and more difficult the acquirement
thereof is.
In the sense of the World Bank, public debt is structured into public debt and debt
guaranteed by the state, the two elements being defined as follows:
- the public debt is the amount of internal and external obligations of the public debtor
consisting of the central government and its bodies (states, provinces, and similar political
subdivisions), as well as of the autonomous public bodies (e.g.: public or mixed enterprises
where the state is a majority shareholder);
- the debt guaranteed by the state is the sum of all internal and external obligations of
the private sector, the reimbursement of which is guaranteed by a public body.
The International Monetary Fund delimits the internal and external debt based on
the creditor's residence, as follows:
- the external debt is the debt libelled both in foreign currencies and in the currency of
the debtor nation, held by non-residents;
- the internal debt is the debt libelled in foreign currencies as well as in the currency
of the debtor nation, held by residents55.

Clin M., Datoria public, Editura Didactic i Pedagogic, Bucharest, 2006, pag.8-9.

To assess the currency indebtedness and effort that the country must do to meet its
obligations related to the public debt, a set of indicators was prepared, by means of which the
level, the structure and the dynamics of public debt and indicators of appropriateness of the
reserves are characterised.
The main indicators regarding the level of the public debt are: the volume of the
public (total / internal / external) debt expressing all the obligations incurred and not
reimbursed at a given time; the service of the public (total / internal / external) debt,
respectively the annual expenses representing payments due into the public debt account
(capital rates, interests and other related costs).
These two indicators have a lower significance, because they are absolute indicators
which are not linked to the financial currency potential of the debtor nation. The analysis
becomes more relevant by calculating some relative indicators, which report the public debt
to other macroeconomic indicators: the share of the public (total / internal / external) debt in
the GDP; the share of the external debt in the export of goods and services, highly expressive
indicator regarding the capacity of the economy to get currency and to ensure the
reimbursement of the external debt; the share of the public debt service in the GDP; the share
of the interests and other costs related to the public debt in GDP; the average interest, which
indicates the average interest rate related to internal and external loans contracted by the
state; the average amount of the (total / internal / external) debt per capita, and indicator that
correlates the indebtedness with the human potential of the nation.
The main indicators regarding the public debt structure are: the share of the domestic
public debt in the total public debt; the share of the foreign debt in the total public debt.
The structure of the internal public debt may be analysed in relation to: the
instruments used to contract it (treasury certificates, state bonds, other state securities); due
date (short term, medium term or long term); holders or creditors (banking sector, non-
banking sector, other holders).
The structure of the external debt may be analysed from the point of view of:
financing sources (multilateral, bilateral, private banks, bonds and bills, other sources); due
date (between 1 and 5 years, between 5 and 10 years, over 10 years); the currency in which it
is contracted (EURO, USD, YEN etc.).
The indicators on public debt dynamics express the absolute or relative change in the
public (total / internal / external) debt from one period to another.
Regarding the external debt, the indicators for the appropriateness of reserves may
also be calculated, namely:
- Short-term external debt/Reserves, which reveal the sufficiency (or insufficiency) of
foreign currency reserves that would ensure the reimbursement of the short-term payable debt
under the conditions of limited access to the capital market;
- Reserves / Imports, an indicator measuring the efficiency of the level of reserves in
relation to the degree of economy openness, expressed by the volume of imports;
- Reserves / broad monetary supply, which reflect the possible impact of the loss of
confidence in the national currency, which would determine the migration of resident

References (selection):
1. Drcea Marcel, Mitu Narcis Buget i Trezorerie public, Universitaria
Publishing House, Craiova, Presa Universitar Clujean Publishing House , 2012;
2. Moteanu Tatiana i colaboratorii - Buget i Trezorerie public, Universitar
Publishing House , Bucureti, 2008.



Chapter 3. The Tax System

3.1. General considerations of the concept of "tax system" and "taxation"

As a result of evolution of human society, to cover some financial and socio-

economic needs was created tax system, system that ensured public sector financing by way
of tax levies and allowed public authority intervention in the national economy and correcting
undesirable fluctuations in economic cycles that occur in the exchange economy.
A meaningful definition of the tax system gives Carmen Corduneanu, it considers that
"the tax system comprises a set of concepts, principles, methods, processes, on a lot of items
(matter taxable allowances, tax subjects), manifested between relationships that occur as a
result of design, enactment, settlement and tax collection and managed under tax law in order
to achieve system goals. "
The tax system is a product created over time by humans the history of human
civilization to meet financial, economic and social needs. Financial needs are met by the tax
system through public sector financing by way of tax levies, economic needs by allowing
public authorities to make interventions in the national economy to correct unwanted
fluctuations of economic cycles that occur in the exchange economy, and social by its
operation on welfare distribution system.
The tax system includes the basic tax structure, and with him include other elements,
such as tax laws and the entire fiscal system which is designed to apply tax laws.
Basic functions of the tax system are:
- function of financing public expenditure in order to bring money to the budget;
- function of redistribution of income and wealth and protection of socially disadvantaged
people, in order to ensure social equity;
- stabilizing function of economic activity and the correction of imbalances, with the
ultimate goal of ensuring economic efficiency.
Tax system functions have evolved in close contact with the state's role in economic
and social development. Etymologically, the IRS comes from the Latin "fiscus" which means
basket, hamper.
The Roman Empire was the levying and tax administration on behalf of a body called
the "fiscus".
In France in the eighteenth century IRS have the meaning of institution responsible
for levying taxes. IRS became "state institution with the right and obligation to settle, to
collect and track the payment of taxes owed to the state by the taxpayer. "1
Taxation is the system of laws relating to the IRS. In the citizen -tax payer, taxation is
seen as a tendency to increase the rights of Tax, to multiply and increase taxes. In terms of
legal, taxation is a set of all laws relating to taxes. Some authors define it as a system of rules
and mechanisms that are designed to achieve the fundamental role it plays in the functioning
of the organism state taxes and, on a larger scale, social life as a whole.1

Gh. D. Bistriceanu, Lexicon de finane, bnci, asigurri, vol. II, Editura Economic, Bucureti, 2001, pg.161

3.2. Tax, the basic structure of the tax system

Taxes and fees were born from the need of the modern state, whose activity is more
extensive and complex, to have at hand the means to satisfy his needs, which confuses most
of the common life of the inhabitants .
Definitions of tax
- Share required of every citizen to public services spending (Smith, J. B. Say i Ricardo)
- Sampling alleged pecuniary persons, about authority, permanently and without direct
consideration, to cover public expenditure and economic and social intervention of public
powers (Alain Euzeby)
Fee means those monetary obligations have to pay individuals and businesses for
various benefits by public authorities.
From the above definitions detach three items related to taxes
- force of public power (the element of Authority)
- transfer of riches
- an enlarged function (wide) of this
Tax is always perceived as an act of authority, an obligation that arises from
constraint definitions by most authors.

Element of authority: For citizen-taxpayer, the tax is above all seen as a restriction
of its freedom, its material opportunities just because of inherent authority.

Transfer of riches: Wealth tax is a levy on the assets of the taxpayer performed. In
addition, this sampling is final tax liability is not subject to refund.
Also, it is not accompanied by a direct consideration. Appears therefore concludes
that tax revenue is depersonalised and are allocated to cover expenses whose benefits do not
directly address the tax payers.

The enlarged function (wide): Fiscal policy is provided by most states to tax
financial traditional function (to cover the collective needs of the state and private) added
gradually and redistributive function of wealth in society and on the interventionist in
resource allocation in the economy in order to stabilize aggregate demand.

Taxes and fees provided in Romanian Fiscal Code is based on the following
tax neutrality measures in relation to various categories of investors and capital, forms
of ownership, ensuring equal conditions for investors, Romanian and foreign capital;
certainty of taxation, through the development of clear legal rules, which do not lead
to arbitrary interpretation and timing, manner and amount of payment to be precisely
set for each payer that they can follow and understand the tax burden they bear, and to
significantly influence their financial management decisions on their tax burden;
fiscal equity at the level of individuals, by imposing different incomes depending on
their size;
effectiveness taxation by providing long-term stability of the provisions of the Tax
Code so that these provisions do not lead to unfavorable retroactive effects for
individuals and businesses in relation to taxation in force upon adoption by them of
major investment decisions.

3.3. Methods and techniques of taxation


is an important link in the tax system which involves a complex of measures and
operations done to establish the tax burden which returns to every natural or legal
from the technical point it involves a laborious activity in order to inventory taxable
subjects and their personal situation, identification and evaluation of determining the amount
of taxable and tax.
Keep in mind: Performing these successive stages involves using an arsenal of
procedures, methods and tools.
From the point of view of the division of responsibilities between the tax
administration and taxpayers we meet either self-taxation or administrative imposition.
Self-taxation: Is encountered for economic operators to whom the task of self-
assessment base, the determination of the amount of term and pay taxes, contributions it owes
public authorities (if corporation tax, value added tax, excise tax due for some products made
the country). Tax authorities have only to verify then the correct determination of the
amounts due and timely payment.
Administrative taxation: The specific taxes owed by individuals and involves
additional responsibilities entrusted to the fiscal authorities to detect the sources of income
and taxpayers paying, to determine the amount due that fall within the tax records and notify
taxpayers through notices of payment as well as supervise and to pay their tax obligations on

Depending on annual results taxation can be:

provisional performed during the year
permanent at the end of the year, after knowing the final results.

In relation to persons who obtain income and their organization imposition can be:
individual aimed at individuals who made individual income (employees, freelancers
collective is encountered in the case of family associations, individual farms where
the imposition of gain realized is the whole team or association for all family

Depending on the items included in the calculation of tax, the imposition can be:
partial, involves separate taxation of the income of a person through multiple payers
and income from several sources.
Example: The tax system has been applied in our country for the income
derived by individuals to January 1, 2000 and after January 1, 2005, which still
applies today.
global, involves aggregating income from various sources or from several units and
applying tax rates to the aggregate tax base.
Example: This system of taxation was introduced to us in 2000-2004, in the
globalization process and included salary income of self-employed and those made of

lease of goods, less the dividends, interest from securities transactions value and
Depending on how the taxable object is evaluated, imposion can be:
direct, is achieved by obtaining information directly necessary for imposition of the
tax authorities to be informed of the nature and size of the object taxable by tax return
prepared and filed by taxpayers (case of land and building tax, tax on vehicles). The
accuracy of the data included in tax returns is subsequently verified by the control
indirect, is based on information obtained indirectly from third parties in connection
with certain activities producing income or the income falling under taxation (case of
income tax from wages, from rentals, etc.).
lump involves substituting a precise determination of taxable value attributed
depending on the tax due is determined. Is the case of rules or income scales
used for taxation taxi activity, peddle, trade with flowers etc.
It is also the case of minimum tax applied in 2009 in Romanian taxation.

Chapter 4. Taxes and fees

4.1. Tax on Profit

Categories of profit tax payers

a) Romanian legal persons. These due tax for the taxable profit derived from any
source, both in Romania and abroad;
b) Foreign legal entities that operate through a permanent establishment in Romania.
They owe tax on taxable income attributable to the permanent establishment;
c) Foreign legal entities and non-resident individuals that operate in Romania in
association with or without legal personality. They owe tax on the portion of taxable profit of
the association attributable to each person;
d) Foreign legal entities that make profit from / or in connection with real estates
located in Romania or from the sale / disposal of shares held in a Romanian legal entity.
These owe tax for the taxable profit related to such incomes;
e) Individual residents associated with Romanian legal entities, for profits made both in
Romania and abroad from associations without legal personality. In this case, the tax payable
by the individual is calculated on the part of the taxable profit of the association attributable to
the resident individual. The tax is withheld and paid by Romanian legal person
f) Legal entities with registered office in Romania, established according to European

Taxation rates
The profit tax rate that applies to the taxable profit is 16% as of 1 January 2005.
Until that date the share was 25%.
Taxpayers engaged in activities such as night bars, nightclubs, discotheques, casinos
or sports betting, including legal persons performing such income under a contract of
association, and at which the profit tax due for the activities under this Article is less than 5%
of the respective earnings shall be obliged to pay a tax of 5% to their incomes.

The calculation base is the taxable profit which is calculated as the difference
between the income from any source and the expenses incurred in order to achieve revenue,

in a fiscal year, from which non-taxable income are substracted and deductible expenses are

Income and expenses taken into account in determining taxable profit

The following are non-taxable income in calculating taxable income:
a) dividends received from a Romanian legal entity; After Romania's accession to the
European Union the are also non-taxable, the following:
dividends received by a Romanian legal person, parent company, from its
subsidiary located in a Member State, if the Romanian legal person meets the
following conditions:
1. pays tax without the possibility of an option or exemption;
2. holds less than 15% of the share capital of a legal person in a Member State,
respectively minimum 10%, as of the 1st of January 2009;
3. at the date of the registration of the income from dividends it holds the minimum
participation provided at point 2, on a continuous period of at least 2 years

There are also non-taxable the dividends received by the Romanian legal entity through its
permanent headquarters located in a Member State , in the case where the Romanian legal
entity fulfills the conditions provided in section. 1-3;
dividends received by permanent establishments in Romania of foreign legal
persons from other Member States, parent companies, which are distributed by their
subsidiaries located in Member States where the foreign legal person meets all the
following conditions:
1. has one of the forms of organisation provided in the Tax Code for legal entities from
the European Union under Title ' Calculation of taxable profit.
2. In accordance with the tax legislation of the Member State,it is considered to be
resident in that Member State and , under a double taxation convention concluded with
a third State shall not be considered to have the fiscal headquarter outside the
European Union;
3. pays in accordance with the tax legislation of a Member State , without the possibility
of an option or exemptions , tax on profit or similar tax ;
4. holds less than 15% of the share capital of the subsidiary in a Member State or a
minimum participation of 10% as from 1 January 2009;
5. At the date of registration of the oncome from dividends by the permanent headquarter
from Romania, the foreign legal person has minimum participation under pt. 4 , for a
continuous period of at least 2 years.

Atention: These provisions do not apply to profits distributed to Romanian legal persons or
permanent establishments in Romania of foreign legal persons of a Member State,
in connection with the liquidation of a subsidiary in a Member State.

a) favorable differences in the value of the shares, recorded as a result of incorporation

of reserves, profits or issue]ance premiums of legal persons who hold participation titles,
and also differences in the value of long-term financial investments representing shares in
related companies, shares and investments held as fixed assets recorded according to
accounting regulations. These are taxable at the time of transmission free of charge, of
sale,of withdrawal, of liquidation of financial investment and of capital withdrawal date at
the legal person holding the participation titles;

b) income from cancellation of the expenses for which no deduction had been granted,
for income from reduction or cancellation of provisions for which no deduction was
allowed, and for the income from the recovery of non-deductible expenses;
c) non-taxable income, stipulated in the agreements and memoranda approved by
normative acts;

Are also considered expenses mde for the purpose of achieving income :

b. expenditures with the purchase of packaging, on the lifetime determined by the

c. expenditure incurred under the law for safety and costs incurred to prevent work
accidents and occupational diseases;
d. expenses representing the contributions to insurance against accidents at work and
occupational diseases, according to the law, and the costs of insurance premiums for
insurance against occupational hazards;
e. advertising and publicity expenses incurred for the purpose of popularizing the
company, its products or services under a written contract and the costs associated with
the production of materials needed for broadcasting advertising messages. Are included
also in this category of advertising and publicity expenses, the goods that are granted
within advertising campaigns as samples for testing of products and demonstrations at
points of sale, and other goods and services provided in order to stimulate sales;
f. costs of transport and accommodation in the country and abroad, carried out by
employees and directors;
g. contribute to mutual guarantee reserve of the central credit unions;
h. registration fees, levies and mandatory contributions covered by the legislation in
force, and contributions to the fund for negotiating collective bargaining agreement;
i. expenditure on training and professional training of staff;
j. expenses for marketing, market research, promotion on existing and new markets,
participation in fairs and exhibitions, business missions, editing own information
k. the cost of research and development expenses that do not qualify for recognition as
intangible assets in accounting terms;
l. expenses for the improvement of the management, information systems, introduction,
maintenance and improvement of quality management systems, obtaining certification in
accordance with quality standards;
m. expenditures for environmental protection and resource conservation;
n. registration fees and contributions payable to the chambers of commerce and
industry, trade unions and employers' organizations;
o. losses from uncollected receivables deregistration in the following cases:
Bankruptcy procedure of debtors was closed on basis of courts rulling;
Debtor is deceased and the receivable can not be recovered from the heirs;
The debtor is dissolved, in the cases of limited liability company with sole
associate, or closed without success;
Debtor has major financial difficulties affecting its entire patrimony.

A number of expenses have limited deductibility, namely:

protocol expenses in the limit of 2% of the difference between the total taxable
income and total expenses related to taxable income, other than protocol expenses
and income tax expenses;

the sum of the travel allowance expenses paid to employees for travelling in Romania
and abroad, up to 2.5 times the legal limit for public institutions (daily allowance of
delegation or secondment for employees of public institutions is 13 lei);
social spending in the limit of up to 2 % , applied to the amount of costs with staff
salaries , according to Law no . 53/2003 - Labour Code , as amended and
supplemented. Subject to these limitations, with priority ,are birth grants , funeral
grants , aids for serious illness or incurable and protesys, expenditure for the proper
functioning of activities or units under the administration of the taxpayers ;
kindergartens , nurseries , health services provided in the case of occupational
diseases and accidents at work up to hospitalization in a medical unit , museums ,
libraries, cafeterias , sports , clubs, dorms for single persons , and the schools under
their patronage. Within this limit can be derived also the expenses representing :
childcare vouchers granted by the employer in accordance with the legislation in
force , gifts in cash or in kind provided to minors and employee, gifts in cash or in
kind granted to employees, the cost of benefits for treatment and the rest, including
transportation, for their employees and members of their families , assistance for
employees who have suffered losses in the household and contribution to the
intervention funds of the professional association of miners , helping children in
schools and orphanages ;
perishabilities, within the limits established by the specialized bodies of the central
government, along with specialized institutions, with the approval of the Ministry of
expenses representing meal vouchers provided by employers, according to the law;
expenditure on provisions and reserves, the limit set by law;
expenditure on provisions and reserves, within the limit set by law;
interest charges and foreign exchange differences, to the extent provided by law;
depreciation, within the limit prescribed by law;
expenses incurred on behalf of an employee to voluntary pension schemes, up to an
amount equivalent in lei of 400 euros within a fiscal year for each participant;
costs of voluntary health insurance premiums, up to an amount equivalent in lei of
250 euros a year for each participant;
expenses for the operation, maintenance and repair of the dwelling where the
service is located in the town where the company has its registered office or
secondary offices, deductible to the extent provided by the law of dwelling areas,
which in terms of tax increases by 10%. Deductible difference must be recovered
from the beneficiaries or tenants / lessees;
operating costs, maintenance and repairs related to an office located in the personal
property of an individual, used for personal purposes also, deductible to the extent of
the appropriate areas available to the company under contracts concluded between the
parties to this end;
operating costs, maintenance and repairs related to cars used by people in positions of
leadership and management of the legal person, deductibles limited to no more than
one vehicle per person with such tasks as follows: to the extent that the payment of
taxes , fees, contributions and other general government revenue shows that it was
without legal basis, who made such a payment is entitled to a refund of that amount.

The following expenses are not deductible in calculating taxable profit:

a) the taxpayer's own expenses with profit tax due, including those representing
differences from previous years and the current year as well as income taxes or

income paid abroad. Are also non-deductible the tax expense that are not retained
at source on behalf of individuals and legal entities non-resident, for income made
in Romania;
b) interest / delay penalties, fines, forfeitures and penalties for late payment owed to
the Romanian / foreign authorities, according to the law.
c) expenditure on assets such as stocks or physical assets discovered as missing or
damaged non-attributable, for which it was not concluded an insurance contract,
as well as their related value-added tax. Not covered by these provisions are
stocks and depreciable fixed assets, destroyed as a result of natural disasters or
other force majeure;
d) costs of VAT on the goods given to employees in the form of benefits in kind if
their value has not been taxed by withholding;
e) expenses incurred in favor of shareholders or associates, other than those arising
from the payment for the goods delivered or the services rendered to the
taxpayer,at the market price for those goods or services;
f) expenditure accounted that are not based on documentary evidence, according to
the law, to prove that the operation took place or its entry into gestion;
g) expenses incurred by agricultural companies constituted under the law, for the
right of use of agricultural land brought by the associated members, over the
distribution quota of its output share of its use, as provided in the partnership
agreement or association;
h) expenditure determined by unfavorable differences in value of the shares in legal
persons who hold shares and unfavorable value differences related to long-term
bonds, except those arising from their sale, assignment;
i) the costs of non-taxable income, excluding income stipulated in the agreements
and memoranda approved by law;
j) expenses with contributions paid over spending limits or not covered by laws;
k) costs of insurance premiums paid by the employer on behalf of employees that
are not included in the taxable income of the employee;
l) other wage costs and / or treated as such, that are not taxed to the employee;
m) expenses with management services, consultancy, assistance or other service for
which taxpayers can not to justify their neccessitie for the purpose of their activity
and for which contracts are not concluded;
n) costs of insurance premiums that do not concern the taxpayer assets and those that
are not related to the object of activity, except those relating to assets representing
the bank guarantee for credits used in the activity for which the taxpayer is
authorized or employed under contracts of rental or lease, according to the
contracts clauses;
o) losses from deregistration of unsure or litigious debts, uncollected, for the
uncovered portion of the provision and losses on deregistration of uncertain debts
or disputes, unearned, in situations other than those referred to as expenditure
incurred in order to achieve the revenue section. n). In this case, taxpayers who
regestired uncashed customers are obliged to communicate to them in writing
their respective claims deregistration, in order to recalculate the taxable income to
the person of the debtor, as applicable;
p) the cost of sponsorship and / or patronage and private expenditure on scholarships
granted by law; taxpayers who make sponsorships and / or acts of patronage,
according to Law no. 32/1994 regarding sponsorship, as amended, and the Law
Library no. 334/2002, republished, as amended and supplemented, and the

granting of private scholarships, according to the law, deduct from profit tax the
related amounts due, if the total of these expenses meet the following conditions:
is within the limit 3 per thousand of turnover;
doesnt exceed more than 20% of profit tax due.
In those limits fall too the sponsorship expenses of public libraries, for the
construction of venues, the facilities, the procurement of information technology
and of specific documents, funding training programs for librarians, exchange of
specialists, specialized scholarships , participation in international congresses;
r) expenses recorded in the accounts, which are based on a document issued by an
inactive taxpayer whose tax registration certificate has been suspended by order
of the National Agency for Fiscal Administration.
s) Expenses with fees and subscriptions by non-governmental organizations or
professional associations related to the work carried out by taxpayers and
exceeding the RON equivalent of 4 000 euros annually, other than those referred
to in expenditures in order to achieve the revenue section. g) and m).
t) Expenses representing the value of fixed assets depreciation, where, as a
result of the reevaluation, there is a decrease in value. 50% of the cost of
motorized road vehicles not used exclusively for business purposes, with a
maximum authorized mass not exceeding 3500 kilograms and not more than
9 seats, including the driver's seat, under owned or used by the taxpayer.
These expenses are fully deductible for situations in which such vehicles fall
under any of the following categories:
1. vehicles used exclusively for emergency services, security and protection
services and courier services;
2. vehicles used by sales agents and procurement;
3. vehicles used for the transport of persons by remuneration, including taxi
4. vehicles used for the provision of paid services, including for rental to others or
for instruction by driving schools;
5. vehicles used as commodities for trading purposes.
Expenses covered by these provisions do not include expenditure on depreciation.
Rules for the application of these provisions shall be established by rules
) costs of benefits granted to employees in equity instruments settled in shares.
They are similar items to expenses at the time the actual costs of benefits if they
are taxed pursuant to Title III of the Tax Code.
u) expenses recorded in the accounts, regardless of their nature, ulteriourly turned
out to be related to corruption by law.

Tax payment
As regarding the method of calculation, declaration and payment of tax, from 2012,
there are three systems:
a) computing system, annual declaration and payment of tax, by making quarterly
advance payments, the the account of the profit tax, amounting to a quarter of the profit tax
due for the previous year, applicable to banking companies, legal romanian entities and
romanian branches of banks, of foreign legal persons, with regularization on 25 March of the
following year;
b) computing system, annual declaration and payment of tax, until 25 February
including, without making quarterly advance payments, applicable also to non profit
organizations and taxpayers who receive income mainly from cereals and industrial crops,
potatoes, horticulture and viticulture;

c) The system applicable to the other categories of taxpayers, consisting of: declaring
and paying income tax by the 25th including of the first month following the end of quarters
I-III; completion and payment of the related income tax of the fiscal year by the deadline for
submission of declaration of income tax , respectively 25th of March of the following year.
As of 1st of January 2013, taxpayers (other than non profit organizations , taxpayers
who receive income majority of cereals and industrial crops , horticulture and viticulture , ie
the banks ) may opt to declare and pay the annual profit tax by prepayments conducted
quarterly. The date by which the payment is due is the deadline for the filling of the annual
tax declaration on profit tax, 25 March of the following year. The option for the annual
system of declaration and payment of profit tax is made at the beginning of the fiscal year for
which it is requested the application of the respective system. The option is compulsory for at
least 2 consecutive fiscal years . Exiting the annual system of declaration and payment of tax
is the beginning of the fiscal year for which exiting the system is requested. Taxpayers
communicate to the territorial tax bodies the change of the annual / quarterly system of
declaration and payment of income tax, under the provisions of the Fiscal Procedure Code ,
by 31 January of the fiscal year .
Legal entities that cease to exist during the fiscal year are required to submit, by
exeption to the provisions of the Filing of the profit tax declaration title, the annual tax
declaration and to pay the tax by the date of submitting of the financial statements to the
fiscal body.

Filling of the income tax declarations

As of the fiscal year 2012, taxpayers are required to submit an annual declaration of
profit tax up to March 25 of the following year and according to the law, are liable for the
profit tax calculation.

Tax on dividends
A Romanian legal entity which pays dividends to a Romanian legal person is required
to withhold, declare and pay tax on dividends, retained by the state budget.
Observation: Dividend tax is determined by applying a tax rate of 16% on the gross
dividend paid by a Romanian legal entity.
Atention: The dividend tax that must be withheld is to be declared and paid to the state
budget until the 25th of the month following that in which the dividend is
paid. If the dividends were not paid by the end of the year for which the
financial statements were approved, the annual tax on dividends is to be paid
by January 25 of the following year.
Exception: The tax does not apply to dividends paid by a Romanian legal entity to
another Romanian legal persons, if the dividend beneficiary holds a minimum
of 15% and 10%, since 2009, in units of its dividend payment date, for a
period of 2 years until the date of payment thereof.
The tax rate on dividends of 16% applies also to the amounts distributed to open
investment funds.
New: Reinvested dividends starting 2009, with the purpose to preserve and increase
new business development jobs for Romanian legal entities that distribute
dividends, according to the objects of their activity enrolled at the National
Trade Register Office, are exempt from tax on dividends. Are also exempt
from tax on dividends the reinvested dividends in the capital of another
Romanian legal entity, in order to create new jobs, to develop the activity of

that business, according to the activity object entered in the National Trade
Register Office.

4.2. Income tax

Taxpayers and area of inclusion of the income tax

According to the law, the following persons are liable for the payment of the income
a) resident physical persons;
b) non-resident individuals that develop an activity through a permanent
establishment in Romania;
c) non-resident individuals engaged in dependent activities in Romania;
d) non-resident individuals who receive income other than the above
Income tax applies to the following income::
a) to Romanian resident individuals, residing in Romania, for the revenues from all
sources, both from Romania and from abroad;
b) for resident individuals other than those listed above, only for the income from any
source, both from Romania and from abroad, as of January 1 of the calendar year following
the year in which they become residents in Romania;
c) in the case of non-resident individuals, self-employed through a permanent
establishment in Romania, for the net income attributable to the permanent establishment;
d) for non-resident individuals, developing dependent activities in Romania,for the net
salary income from this dependent activity;
e) for non-resident individuals who receive income referred to above, the income
determined in accordance with the rules set out in this title, which correspond to the
respective category of income

Categories of income subject to income tax are the following:

a) Income from independent activities;
b) Salary income;
c) income from rental and leasing;
d) investment income;
e) pension income;
f) income from agriculture, forestry and horticulture;
g) income from prizes and gambling;
h) income from transfer of property;
i) income from other sources.

Salary income
Are considered salary income all income in cash and / or kind obtained by a natural
person who carries out an activity based on an individual employment contract or a statute
specifically provided by law, regardless of the period covered, by revenues name or of the
form in which they are granted, including allowances for temporary disability.

Personal deduction
Resident individuals are entitled to the deduction of net monthly income from wages as a
sum of personal deduction, given for each month of the reporting period only for the salary
income at the place of the basic function.
Personal deduction is granted to individuals who have a gross monthly income of up
to 1 000 lei, including the following:
taxpayers who do not have dependents - 250 lei;
taxpayers who have one dependent - 350 lei;
taxpayers who have two dependents - 450 lei;
for taxpayers with three dependents - 550 lei;
taxpayers who have four or more dependents - 650 lei.
For taxpayers who have monthly gross income from wages between 1 000,01 lei and
3 000 lei, including, personal deductions are diminishing/ digresive to the above and fixed
by order of the Minister of Finance.
For taxpayers who make monthly gross income of over 3 000 lei, no personal
deduction is not granted.
The person dependent may be wife / husband, children or other family members,
relatives of the taxpayer or his / her spouse until the second degree, including, whose income,
taxable and non-taxable, do not exceed 250 lei per month.
If a person is maintained by multiple contributors, the amount of personal deduction
is assigned to a single taxpayer, as agreed between the parties.
Minor children, aged up to 18 years old, of the taxpayer, shall be considered

Are not considered dependents:

- individuals who own farmland and forest area of over 10,000 square meters in the lowland
and hilly areas and over 20,000 square meters in mountain areas;

- individuals who make income from the cultivation and sale of flowers, vegetables, and
vegetables in greenhouses, solariums particularly assigned for these purposes and / or
irrigated system, from the cultivation of shrubs, decorative plants and fungi, as well as from
the exploitation of vineyards and tree fruit nurseries, regardless of the surface.

Determination and payment of income tax from wages

Recipients of income from monthly salary, due a monthly final tax, calculated and
withheld at source by the payer of income.
Determination of the monthly tax :
- at the place where the basic function is, by applying 16% to the calculation base determined
as the difference between the net income from wages, calculated by deducting from gross
income the mandatory contributions for a month, and the following:
personal deduction granted for that month;
union dues paid in that month;
contributions to voluntary pension funds, so that the
year level may not exceed the equivalent in lei of 200 euro
- for the income obtained in other cases, by applying 16% to the calculation base determined
as the difference between gross income and mantadory contributions by each place of
The payer is required to determine the total amount of the annual tax on salary
income, for each taxpayer.

Taxpayers may decide the destination of an amount of up to 2% of the tax to support
non-profit entities that are established and operate under the law, for religious
establishments, and for private scholarships grantings and the obligation to calculate,
withhold and remit this amount the fiscal body competent.
Payers of salaries and similar income are required to calculate and withhold tax on
income for each month from the date of payment of such income and to transfer it to the state
budget until the 25th of the month following the month for which these revenues are paid.

4.3. Tax on buildings

For individuals, the tax on buildings is calculated by applying the tax rate of 0, 1% of
the taxable value of the building.
In the case of a building which has exterior walls made of different materials, to
determine the taxable value of the building, it identifies in the following table the most
appropriate taxable value of that building type.
The taxable value of the building,, expressed in lei, is determined by multiplying the
area constructed, expressed in square meters, with corresponding taxable value, expressed in
lei / sqm.
The deployed built area of a building is determined by summing all building levels
sections surfaces, including balconies, loggias or those located in the basement, except for
the attics areas that are not used as home and stairs and uncovered terraces areas.
The taxable value of the building is adjusted according to the locality rank and the
area where the building is located, by multiplying the determined value by the corresponding
correction coefficient.
Note that Craiova is a rank I locality.
For an apartment located in a building with more than 3 levels and 8 apartments, the
set correction coefficient is reduced by 0, 10.
The taxable value of the building is reduced according to the year of its completion,
as follows:
a) by 20%, for the building that has existed for over 50 years on 1st of January of the
reference fiscal year;
b) by 10%, for the building that has existed between 30 and 50 years inclusive, on
1st of January of the reference fiscal year.
For a building used as a home, which built area exceeds 150 square meters, its
taxable value is increased by 5% for every 50 square meters or fraction of these.
For a building to which reconstruction, consolidation, modernization, modification
or extension work has been performed, from a fiscal point of view, the year of termination is
updated, so this one is considered as being the one in which the latter works have been
If the external dimensions of the building cannot be actually measured on the outer
contour, than the deployed built area of the building is determined by multiplying the useful
area of the building by a conversion coefficient of 1, 20.
Individuals owning two or more buildings owe a tax on buildings, increased as
a) by 65% for the first building except the one at the home address;
b) by 150% for the second building except the one at the home address;
c) by 300% for the third and subsequent buildings except the one at the home

Individuals who own buildings acquired by legal succession are not covered by these
In the case in which someone owns two or more buildings except the one at the home
address, the increased tax is determined according to the order in which the properties were
acquired, as shown in the documents that certify the ownership quality.

Calculation of the tax owed by legal persons

For legal entities, the tax on building is calculated by applying a tax rate on the
inventory value of the building.
The tax rate is determined by the decision of the local council and can be between 0,
25% and 1, 50% inclusive. In Bucharest, this task rests to General Council of Bucharest.
The inventory value of the building is the buildings value of entering in to the
patrimony, recorded in the accountability of the buildings owner, as required by law.
For a building to which reconstruction, consolidation, modernization, modification or
extension work has been performed, by the lessee, from a fiscal point of view, this one must
communicate to the lessor the value of the executed works for the submission of a new fiscal
statement, within 30 days from the date of termination of that works.
For a building whose value has been fully recovered by the depreciation way, the
taxable amount is reduced by 15%.
If a building was revalued, according to the accounting rules, the taxable value of the
building is the accounting value resulted from the revaluation, registered as such in the
accounting of the owner - legal entity.
For a building that has not been revalued in the last 3 years preceding the reference
fiscal year, the rate of the tax on buildings is determined by the local council/General
Council of Bucharest between 5% and 10% and it is applied to the inventory value of the
building recorded in the accounting of legal entities, by the end of the month in which the
first revaluation was made. Exceptions are buildings that were depreciated according to the
law, where the rate of the tax on buildings is the normal one.
For a building subject to a financial leasing contract, during its whole duration the
following rules are applied:
a) the tax on buildings is owed by the lessee;
b) the value taken into account in calculating the tax on buildings is the buildings
value in the contract, as it is recorded in the accounting of the lessor or lessee, according to
the legal provisions in force;
c) if the leasing contract is terminated in other way than by reaching the maturity, the
tax on buildings is owed by the lessor.
Tax on buildings applies to any building owned by a legal entity in operation, reserve
or conservation, even if its value has been fully recovered by the depreciation way.
For a building that was acquired or constructed by a person during the year, the tax
on building is owed by the respective person starting with the first day of the month
following to that in which the building was acquired or constructed.
If a building was alienated, demolished or destroyed, as appropriate, during the year,
the tax on building cease to be owed by the respective person starting with the first day of the
month following to that in which the building was alienated, demolished or destroyed.
In these two cases the tax on buildings is recalculated in order to reflect the time of
the year in which the tax applies to that person.
In case of extension, improvement, partial destruction or other modifications brought
to an existing building, the tax on building is recalculated starting with the first day of the
month following to the month in which the change was completed.

Any person who acquires, builds or alienates a building must submit a fiscal
statement at the specialized department of the local public administration authority in whose
jurisdiction the building is, within 30 days from the date of acquisition, alienation or
Anyone who expands, improves, demolishes, destroys or modifies in otherwise an
existing building must submit a statement to that effect at the specialized department of the
local public administration authority within 30 days from the date on which they produced
these changes.
The alienation of a building, through any of the means provided by the law, cannot be
performed until the holder of the respective buildings ownership right has not extinguished
any local fiscal receivables, except fiscal liabilities in dispute, due to the local budget of the
administrative-territorial unit where the building is located or where the taxpayer in question
has the fiscal domicile, with payment terms due to the first day of the month following to that
in which alienation occurs. The payment of the financial obligations is attested through the
fiscal certificate issued by the specialized department of the local public administration
authorities. The documents by which buildings are alienated with the violation of the
respective paragraph provisions are null and void.

Tax payment
The tax on buildings is payable annually, in two equal rates, until 31st of March and
30th of September inclusive.
For the advance payment of the tax on buildings, owed for the full year by the
taxpayers, until March 31st of that year, a bonus is awarded of up to 10%, established by the
decision of the local council. In Bucharest, this task rests to General Council of Bucharest.
The annual tax on buildings, owed to the same local budget by the taxpayers,
individuals or legal entities, of up to 50 lei inclusive, is fully paid until the first payment
term. If the taxpayer owns several buildings located across the same administrative-territorial
unit, the amount of 50 lei refers to the cumulative tax on buildings.

1. Buziernescu Radu - Fiscalitatea la zi - teorie i aplicaii practice, Editura
Universitaria Craiova, Craiova, 2011

2. Georgeta Vintil, - Fiscalitate, Editura Economic, Bucuresti, 2002

Magdalena Clin,
Nicoleta Vintil




conf. univ. dr. Daniel CRCIUMARU

Chapter 1: Basics of Analysis
a. Definition and types of analysis

Analysis means the decomposition of a phenomenon into its component parts and
then each part is studied as individual in order to establish the causal relationships, to
determine the factors that generate the relationships, to formulate conclusions about the
evolution of business.
The subject of decomposition may be a result or a change of the result against a basis
of comparison.
In the first case, the subject of analysis can be expressed as:
X xi

and we are dealing with a structural analysis whereby a phenomenon is decomposed

into its components. For example, we can analyse the gross profit of the year, which,
according to the Profit and Loss Account, is split into the following components: operating
profit, financial profit and extraordinary profit. The share of each component gives us an
insight into the sources of the profit.
In the second case, the subject of analyse is the change of an indicator against a basis
of comparison:
X X1 X0

X1 the current level of indicator;

X0 the reference level of indicator (used as basis for comparison).

This is a causal analysis which explains the change on account of the influence
Synthesis involves reuniting all the components of a phenomenon in a whole. While
analysis involves splitting a result, synthesis aims at examining the elements as a whole.
Analysis of financial statements is an attempt to assess the efficiency and performance
of an enterprise. Thus, the analysis and interpretation of financial statements is very essential
to measure the efficiency, profitability, financial soundness and future prospects of the
business units.
Financial analysis serves the following purposes:

Measuring the profitability

The main objective of a business is to earn a satisfactory return on the funds invested
in it. Financial analysis helps in ascertaining whether adequate profits are being earned on the
capital invested in the business or not. It also helps in knowing the capacity to pay the interest
and dividend.

Indicating the trend

Financial statements of the previous years can be compared and the trend regarding
various expenses, purchases, sales, gross profits and net profit etc. can be ascertained. Value
of assets and liabilities can be compared and the future prospects of the business can be

Assessing the growth potential of the business
The trend and other analysis of the business provide sufficient information
indicating the growth potential of the business.

Comparative position in relation to other firms

The purpose of financial statements analysis is to help the management to make a
comparative study of the profitability of various firms engaged in similar businesses.
Such comparison also helps the management to study the position of their firm in respect
of sales, expenses, profitability and utilising capital etc.

Assess overall financial strength

The purpose of financial analysis is to assess the financial strength of the business.
Analysis also helps in taking decisions, whether funds required for the purchase of new
machines and equipment are provided from internal sources of the business or not. And
also to assess how much funds have been received from external sources.

Assess solvency of the firm

The different tools of an analysis tell us whether the firm has sufficient funds to
meet its short term and long term liabilities or not.

Users of financial statement analysis, i.e. the parties interested in a companys

financial position and performance are:
companys management uses information provided by financial statement
analysis to base decision-making in the area of financial decisions. The analysis
helps the managers in preparing budgets and assessing the performance of various
companys owners (shareholders) want to know the evolution of their wealth,
objectified by the proportion of companys equity owned by each of them.
Shareholders or proprietors of the business also like to know the earning capacity
of the business and its prospects of future growth.
investors to make their investment decisions on the stock exchange.
banks (lenders) provide loans for the company and are interested in the
companys reliability as a business partner and its capability to repay these loans
and corresponding interest. They are particularly interested to know short term as
well as long term solvency position of the entity.
business partners (clients or suppliers) are interested to know about the solvency
of the business i.e. the ability of the company to meet the debts as and when they
fall due or to deliver products in time. They change their strategic options
depending on partners financial situation.
trade (labour) unions track companys financial situation in order to negotiate the
wages or bonus agreement with the management.
employees: they are interested to know the growth of profit. As a result of which
they can demand better remuneration and pleasant working environment.
public institutions (especially tax authorities), both local and national, are
interested in companys financial situation for determining the tax liability.
competitors are interested in the companys financial state in order to strengthen
their own market position.

Analysis could be classified according to several criteria:

Depending upon the moment the analysis is carried out:
- Post-factum analysis represents an investigation of financial situation of the
company during past periods; this kind of analysis is useful only if it indicates
factors that generated weaknesses in the past that could be limited or eliminated in
the future, as well as factors that lead to strengths in order to maintain their action
during future periods;
- Real-time analysis is carried out to asses companys financial situation at any
time in order to take immediate actions when the situation tends to deviate from
the established objectives; in order to carry out such a type of analysis it is
required an up-to-date information system that allows information to be supplied
to the analysts as soon as events happen;
- Prospective analysis is undertaken based upon forecasts regarding future periods.
Some opinions expressed in the specialized literature consider this type of analysis
as being the most important of all of them, as it reflects a proactive attitude of
decision makers towards future challenges that a company will encounter.

According to the time coverage of financial information:

- Static analysis studies financial condition of a company at a certain moment in
time, usually based upon the balance sheet data, highlighting the relationship
between different elements and factors that cause a certain position of the
- Dynamic analysis tackle financial position based upon financial flows data
covering a certain period of time.

According to manner of balance sheet correlations analysis:

- Horizontal analysis includes comparisons between assets and liabilities (capitals),
highlighting the extent to which fixed and current assets are funded from proper
- Vertical analysis studies the structure of different balance sheet elements,
comparing their value to the value of groups of elements they are part of or to the
total value of assets/liabilities;
- Combined analysis mixes the two approaches presented above.

According to the extent to which the essential features or quantitative issues of

financial information are analysed:
- Qualitative analysis pursue the essence of financial phenomena, their basic
features, factors that are of the same nature as the element they cause;
- Quantitative analysis implies the examination of financial phenomena by
measuring them in terms of quantity.

Depending on the provenience of the financial analyst:

- Internal analysis carried out by specialized personnel from within the company;
- External analysis that is carried out by external specialists or institutions (banks,
tax authorities, consultancy companies etc.).

The steps for carrying out an analysis are:

1) Establishment of a purpose and identification of objectives for analysis;
2) Selection of the indicator or set of indicators that define best and in the most
realistic and exact fashion the issue that is being analysed;

3) Collecting and processing information required for analysis:
- the level, dynamics and structure of the financial issue or indicator that is
being analysed;
- factorial analysis measuring the causal relationship;
4) Companys financial condition diagnosis, identification of strengths and
weaknesses related to the analysed financial issue or indicator;
5) Devise an improvement measures plan to limit weaknesses and generalize the

b. The main concepts used in economic-financial analysis

Financial statement analysis process development requires use of some specific

concepts such as phenomena, factors, causes, financial indicators.
A phenomenon is any observable occurrence. Phenomena are often, but not always,
understood as 'appearances' or 'experiences'. From a financial point of view, a phenomenon is
an observable form of financial reality, i.e. those aspects, sides and relations between
financial happenings that could be known by people in a direct way.
Financial indicator a figure that express through numbers an aspect or a group of
aspects that describe a phenomenon, a process or a financial occurrence, defined in time,
space and organizational structure. Financial indicators could be:
- analytic or synthetic;
- expressed as absolute, relative or average measures.
Absolute measures express quantitatively, from a physical or value perspective, the
volume or the level of certain phenomena. Elements that these measures are based upon
should comply with certain rules: to be homogeneous, to refer to the same period of time etc.
Relative measures allow comparisons between absolute measures in time, space or
structure. These are calculated by dividing the compared value of an absolute measure to the
comparison basis value.
An element is one of the simplest or essential parts or principles of which anything
consists, or upon which the constitution or fundamental powers of anything are based. A
financial element is a component of a financial occurrence.
A factor represents that driving force that, in certain circumstances, causes or induces
an occurrence.
A cause is the source or reason of an event or action. Causes directly explain the
genesis of a phenomenon.

c. Influence factors

Analysis involves identifying the influence factors. Factors explaining the occurrence
and the evolution of phenomena can be classified according to several criteria:

1) Depending on the nature:

a) social factors;
b) technical factors;
c) economic factors;
d) political factors.

2) Depending on the way they influence the phenomenon:

a) direct factors;
b) indirect factors.

3) According to the place of action:
a) internal factors;
b) external factors.

4) According to their content:

a) simple factors - cannot be decomposed into other factors;
b) complex factors - can be decomposed into other factors.

5) Depending on the position and the feature in a causal relationship:

a) quantitative factors;
b) structural factors;
c) qualitative factors.

Quantitative factors reflect the extensive side of the phenomenon analysed and are
material bearers of qualitative factors. They are expressed in measures different than the
Structural factors indicate the proportion of the elements in the overall size of the
phenomenon investigated. They are closely related to the quantitative factors.
Qualitative factors are similar in nature to the phenomenon and are expressed in the
same measures. These factors reflect the intensive side of the phenomenon analysed.

d. Financial statements

Since financial statements are the source for a good portion of analytical efforts, we
must first understand their nature, coverage and limitations. Financial statements reflect the
cumulative effects of all of managements past decisions. However, they involve
considerable ambiguity. Financial statements are governed by rules which leave reported
accounting results open to considerable interpretation, especially if the analyst seeks to
understand a companys economic performance and to establish the basis for shareholder
value results. Its common practice among professional analysts to adjust the data reflected
on financial statements for known accounting transactions which do not affect cash flows and
to make assumptions about the economic values underlying recorded asset values.
Financial statements comprise:
- Balance Sheet or Position Statement;
- Profit and loss Account or Income Statement;
- Statement of Changes in Shareholders' Equity;
- Statement of Cash Flow;
- Notes.
These are prepared at the end of a given period of time. They are the indicators of
profitability and financial soundness of the business concern.

Balance Sheet

Gives a snapshot of the companys financial position at a specific point in time

showing what it owns and what it owes at the report date. The balance sheet is always divided
into two halves: Assets (presented first) and Liabilities and Shareholders Equity (presented
below). In the standard accounting model,

Assets = Liabilities + Shareholders Equity,

so the two halves will always be in balance. Liabilities are specific obligations that
represent claims against the assets of the business, ranking ahead of the owners in repayment
priority. In contrast, the recorded shareholders equity represents the net assets available to
shareholders after all the liabilities have been paid.
The major categories of assets are:

I. Long term assets (long lived asset, noncurrent assets) are assets with a useful life
greater than one year and not intended for sale. They are used to manufacture, display,
warehouse and transport the companys products, along with buildings and improvements
used in operations. The category includes:

a) Intangible assets lack physical substance and usually are very hard to
evaluate. They include constitution costs, development costs, concessions, patents,
licenses, trademarks, commercial fund, intangible assets in progress.
b) Fixed assets are purchased for continued and long-term use in earning profit
in a business. They include property (land and constructions), plant and equipment,
other equipment and furniture, fixed assets in progress.
c) Financial assets securities held on group companies, receivables over group
companies, securities as participation interest, receivables from participation interests,
securities held as assets.

II. Current assets are cash and other assets expected to be converted to cash, sold, or
consumed either in a year or in the operating cycle. These assets are continually turned over
in the course of a business during normal business activity. There are four major items
included into current assets:

a) Inventory raw materials, consumables, work in process goods, finished

goods, merchandises (goods purchased for resale).
b) Receivables commercial receivables, intercompany receivables, receivables
for the subscribed and unpaid capital.
c) Short time financial investments: securities held on short time.
d) Cash in hand and at bank.

III. Prepaid expenses include prepaid expenses only. These are expenses paid in cash and
recorded as assets before they are used or consumed (a common example is insurance).

Liabilities and equity include five groups:

I. Debts payable in one years term - are short-term financial obligations that are paid off
within one year or one current operating cycle. These liabilities are reasonably expected to be
liquidated within a year and include bank loans, bonds, operating debts, invoices cashed in
advance, bills payable, other debts.

II. Debts payable over one years term are liabilities that are not paid off within a year, or
within a business's operating cycle (long-term or non-current liabilities). Such liabilities often
involve large sums of money necessary to undertake opening of a business, major expansion
of a business, replace assets, or make a purchase of significant assets. These liabilities are
reasonably expected not to be liquidated within a year and include the same elements as the
previous group.

III. Provisions (contingent liabilities) there are instances in which a company reports that
there is a possible liability for an event, transaction, or incident that has already taken place;
the company, however, does not yet know whether a financial drain on its resources will
result. It also is often uncertain of the size of the financial obligation or the exact time that the
obligation might have to be paid.

IV. Advance revenues (deferred revenues) represent a temporary liability, until the
services have been rendered or products have been delivered. Deferred revenues refer to
revenues that have not yet been earned, but represent products or services that are owed to the
customer. As the product or service is delivered over time, it is recognized as revenue on the
income statement.

V. Equity: owned capital, share capital premium, re-evaluation reserves, reserves, profit/loss
carried forward, profit of the financial year.

Balance sheets are static because they reflect conditions on the date of their
preparation. Theyre also cumulative because they represent the effects of all decisions and
transactions that have taken place since the inception of the business and have been
accounted for up to the date of preparation.
Balance sheets (being cumulative) display assets and liabilities acquired or incurred at
different times. Because the current economic value of assets can change, particularly in the
case of longer-lived items (such as buildings and machinery) or basic resources (such as
land), the costs stated on the balance sheet are not likely to reflect true economic values.
Moreover, changes in the value of the currency in which the transactions are recorded can,
over time, distort the balance sheet.
Ultimately, the recorded book value of owners equity is affected by all of these value
differentials. There generally is quite a divergence between this residual accounting value and
the current economic value of the business as reflected in share prices or in valuations for
acquisition. In fact, the shares of successful companies are usually traded at price levels far
above their recorded book value.

Profit and Loss Account

Profit and Loss Account, also called Income Statement, Profit and Loss Statement and
Statement of Operations, is a financial statement that summarizes the revenues and expenses
incurred during a specific period of time - usually a fiscal year. These records provide
information that shows the ability of a company to generate profit by increasing revenue and
reducing costs. The purpose of the income statement is to show managers and investors
whether the company made or lost money during the period being reported. The important
thing to remember about an income statement is that it represents a period of time. This
contrasts with the balance sheet, which represents a single moment in time.
The income statement reflects the effect of managements operating decisions on
business performance and the resulting accounting profit or loss for the owners of the
business over a specified period of time. The profit or loss calculated in the statement
increases or decreases owners equity on the balance sheet. Thus, the income statement is a
necessary adjunct to the balance sheet in explaining this major component of change in
owners equity, and it provides a variety of performance assessment information.
Revenues, expenses and results are being classified into three groups: operating,
financial and extraordinary.

Operating revenues comprise: net turnover or sales, sold production, sales of
merchandises, subsidies related to turnover, stocked production, capitalized production, other
operating revenues.
Turnover includes sales of products manufactured, work performed and services
rendered, sales of goods purchased for resale, subsidies related to turnover.
Stocked production includes the change in stocks of finished goods and work in
progress, at the end of the year against the beginning of the year.
Capitalized production includes the value of long lived assets (intangibles or fixed
assets) the company makes by itself and the goods manufactured and retained to be consumed
by the company.
Stocked production and capitalized production are recorded at costs of production
rather than at selling price.
Operating expenses contain expenses for raw materials and consumables, expenses
on energy and water, cost of merchandises, personnel expenses, depreciation and provisions
for fixed and intangible assets, expenses for third party services, expenses for other taxes,
duties and related payments, expenses with compensations, donations and sold assets.
Operating result (profit or loss) is being calculated by subtracting the operating
expenses from the operating revenues.
Financial revenues include revenues from interests, dividends, growth of securities
market value, earnings from foreign exchange transactions.
Financial expenses include interest expenses, provisions for securities and losses
from foreign exchange transactions.
Financial result occurs by comparing the financial revenues and the financial
Extraordinary revenues and expenses regard noncurrent activities the company run.
Profit and Loss Account also contain indicators such as total revenues, total expenses,
gross result, income tax, net result.

Statement of Cash Flow

This document reports on the companys cash movements during the period,
separating them into operating, investing and financing activities. The cash flows are being
calculated by two methods: direct and indirect method.

Statement of Changes in Shareholders' Equity

It reconciles the activity in the Shareholders Equity section of the balance sheet from
period to period. Generally, changes in owners equity result from company profits or losses,
dividends and stock issuance.


Provide more detailed information about the financial statements (such as salaries of
managers, average number of employees etc.).

e. Statement of accumulation margins

It is not a mandatory statement, but rather a management tool, useful in current and
strategic management. Its being completed based on the Profit and Loss Account.
Accumulation margins are actually regular indicators, some of them included in Income

Statement, which emphasize the stages of getting the net result, as a difference between
revenues and expenses.
A model of Statement of accumulation margins is presented below:

Revenues Expenses
Sales of merchandises Expenses of merchandises Trade margin
(goods purchased for resale)
Sold production Production of financial
Stocked production (Cr Stocked production (Dr balance) exercise
Capitalized production
Production Expenses for third parties (cost of Value added
Trade margin inputs, outside expenses or
intermediate consumption)
Value added Taxes (Expenses for other taxes, Earnings before interest,
Subsidies related to turnover duties and related payments + Social taxes and depreciation
security expenses) (EBITDA)
EBITDA Depreciation and provisions
Other operating revenues Expenses with compensations, Operating result
donations and disposed assets
Operating result
Financial revenues Financial expenses Gross result
Extraordinary revenues Extraordinary expenses
Gross result Income tax Net result

f. Techniques and tools of analysis

A. Division

The financial reality is extremely complex, so that it is difficult to study it as a whole.

In order to overrun this inconveniency, financial analysts use the method of division, which
allows studying the financial phenomena by understanding their structure, their basic
The use of this method implies separating the contribution of each factor to make the
whole, expressing the global change of the analysed phenomenon in its constituent parts and,
as well, pinpointing in space and time the source and causes of these components.
A phenomenon could be decomposed using several criteria, such as:
1. division by time of financial phenomena genesis (semesters, quarters, months,
days, weeks) has the purpose of identifying the contribution of different time units
to the whole;
2. division by place of phenomena formation (plant, department, workshop,
workplace) has the purpose of highlighting the degree to which each place
contributed to the analysed aspect. This type of division is used to indicate at each
place the correlation between the effect yielded and the resource allocated;

3. division by parts and components specific to the analysed phenomenon (for
instance: assets could be divided into noncurrent and current, short term liabilities
into financial and operational etc.).

B. Comparison

No judgments related to analysed issues could be made without a standard or a basis

of comparison. Any financial performance could not be assessed without a reference value
that is considered as such, even if it was established statistically (empirically).
Based upon the criterion which it is made by, there are several types of comparisons:

1. time comparisons a phenomenon is compared in different moments of its

2. space comparisons between the analysed enterprise and similar enterprises. It
also known as cross-sectional analysis or inter firm comparison. This analysis
helps in analysing financial characteristics of an enterprise with financial
characteristics of another similar enterprise in that accounting period.
3. mixed comparisons (time and space);
4. comparisons with a previously established level: programs, regulations, standards,
contract clauses etc.

Comparisons allow calculating the changes (absolute and percentage) of the analysed
indicator (R):
R R1 R 0
R % 100
R1 the current level of the indicator;
R0 the level of the indicator used as reference.

C. Common size statements

The common size statements (Balance Sheet and Income Statement) are shown in
analytical percentages. The figures of these statements are shown as percentages of total
assets, total capital and total sales respectively. Take the example of Balance Sheet. The total
assets are taken as 100 and different assets are expressed as a percentage of the total.
Similarly, various liabilities are taken as a part of total liabilities.

C.1. Common size balance sheet

On a common size balance sheet, an asset is compared to total assets, a liability to

total liabilities and stockholder equity to total stockholder equity. Common size balance
sheets make it easier to analyse changes to a companys balance sheet over multiple time
periods. By indicating a percentage in addition to the actual entry value, analysts can tell not
only if the total value of a companys inventory increased in real terms compared to the
previous year, but whether the inventory represents the same percentage of total assets.
Thus the common size statement may be prepared in the following way:
- The total assets, liabilities or equity are taken as 100;
- The individual assets, liabilities and equity are expressed as a percentage of total
assets, liabilities and total equity.

C.2. Common size income statement

The items in income statement can be shown as percentages of sales or operating

revenues to show the relations of each item to sales/operating revenues.

D. Trend percentage analysis (TPA)

The trend analysis is a technique of studying several financial statements over a series
of years. In this analysis the trend percentages are calculated for each item by taking the
figure of that item for the base year as 100. Generally the first year is taken as a base year.
The analyst is able to see the trend of figures, whether moving upward or downward. In brief,
the procedure for calculating trends is as:
- One year is taken as a base year which is generally is the first year;
- Trend percentages are calculated in relation to base year.

E. Chain substitution method

This technique is used to analyse the influence of factors in case of deterministic

relationships that take the mathematical form of multiplication or division.
The method is based upon successive variation of factors specific to the analysed
phenomenon. The use of this method implies applying several rules:
1. the factors are arranged according to the criterion of economic conditioning: the
factors are classified as quantitative, structural and qualitative;
2. substitutions are made successively, beginning with quantitative factors, following
structural factors and ending with qualitative factors;
3. a substituted factor is maintained at current level in all the following substitutions.

These rules are conventional, they resulted and have been accepted by economic and
financial theory and practice based upon applicative experiments.
a) Product
R a bc
data from period considered as basis for comparison:
R0 a 0 b 0 c0
data from the current period:
R1 a 1 b1 c1

The change of the financial indicator:

R R1 R 0 a1 b1 c1 a 0 b0 c0 ;
R % I R 100;
IR 100

Change of R is generated by changes of a, b and c. The influences of these three

factors are calculated according to the following order:


R 2.b


Calculation of influence for each factor:

R a1 b0 c0 a 0 b0 c0 ;

R a1 b1 c0 a1 b0 c0 ;

R a1 b1 c1 a1 b1 c 0 ;

R R R R .
a b c

b) Division

a a a
R ; R 1 0 R1 R 0
b b1 b 0
Taking into account the principles of chain substitution and especially the fact that
substitution should begin with the quantitative factor, the calculation of each factors
contribution to total change of the indicators depends upon the place the factor holds within
the mathematical expression:

b1) The quantitative factor is numerator:

a1 a 0 a1 a 0
1. R
b0 b0 b0
a1 a1
2. R

b1 b0
R R R R .
a b c

b2) The quantitative factor is denominator:

a0 a0
1. R ;

b1 b0
a1 a 0
2. aR
b1 b1
R R R R .
a b c

F. Balance method

This method is used to measure the influence of different factors upon the change of
certain phenomena expressed by mathematical expressions of sum, of subtraction, or that
combines the two:

R R1 R 0 (a1 b1 c1 ) (a 0 b0 c0 )

1) influence generated by factor a change:

(a1 b0 c0 ) (a 0 b0 c0 ) a1 a 0

2) influence generated by factor b change:

R (a1 b1 c0 ) (a1 b0 c0 ) b1 b0

3) influence generated by factor c change:

(a1 b1 c1 ) (a1 b1 c0 ) (c1 c0 ).

R R R R .
a b c

G. Ratio method

Financial ratios provide a quick and relatively simple means of examining the
financial condition of a business. A ratio simply expresses the relation of one figure
appearing in the financial statements to some other figure appearing there (for example, net
profit in relation to capital employed) or some resource of the business (such as net profit per
employee, sales per square meter).
Ratio analysis can be applied to financial statements and similar data in order to
assess the performance of a company, to determine whether it is solvent and financially
healthy, to assess the risk attached to its financial structure and to analyse the returns
generated for its shareholders and other interested parties.
Ratios can be very helpful when comparing the financial health of different
businesses. Differences may exist between businesses in the scale of operations and so a
direct comparison of the profits and other measures generated by each business may be
misleading. By expressing profit in relation to some other measure (e.g. sales) the problem of
scale is eliminated. These ratios can be directly compared whereas comparison of the
absolute profit figures would be less meaningful. The need to eliminate differences in scale
through the use of ratios can also apply when comparing the performance of the same
business over time.
By calculating a relatively small number of ratios, it is often possible to build up a
reasonably good picture of the position and performance of a business. Thus, it is not
surprising that ratios are widely used by those who have an interest in business performance.
Although ratios are not difficult to calculate, they can be difficult to interpret. For example, a
change in the net profit per employee of a business may be for a number of possible reasons
such as:
- a change in the number of employees without a corresponding change in the level
of output;
- a change in the level of output without a corresponding change in the number of
- a change in the mix of goods/services being offered which, in turn, changes the
level of profit.

It is important to appreciate that ratios are really only the starting point for further
analysis. They help to highlight the financial strengths and weaknesses of a business but they
cannot, by themselves, explain why certain strengths or weaknesses exist or why certain
changes have occurred. Only a detailed investigation will reveal underlying reasons.
Ratios can be expressed in various forms (percentage, fraction, proportion). The way
a particular ratio is presented will depend on the needs of those who will use the information.
Although its possible to calculate a large number of ratios, only a few, based on key
relationships may be required by the user.
There is no generally accepted list of ratios which can be applied to the financial
statements nor is there a standard method of calculating many ratios. Variations in both the
choice of ratios and their precise definition will be found in the literature and in practice.

However, it is important to be consistent in the way in which ratios are calculated for
comparison purposes.
Ratios can be grouped into certain categories:
Profitability ratios express the profits made in relation to other indicators from
the financial statements or to some business resource. E.g.: return on capital
employed, profit margin.
Efficiency (activity) ratios may be used to measure the efficiency with which
certain resources have been utilized within the business. E.g.: debtors ratio,
creditors ratio, stock turnover, fixed asset turnover.
Liquidity/solvency ratios a business must generate sufficient liquid resources to
meet maturing obligations. These ratios emphasize the relationship between liquid
resources held and creditors due for payment in the near future. E.g.: current ratio,
quick ratio.
Asset and liability structure ratios reveal the structure of assets and liabilities.
E.g.: long term assets ratios, financial stability ratio.
Gearing ratios gearing is an important issue which managers must consider
when making financing decisions. The relationship between the amount financed
by the owners of the business and the amount contributed by outsiders has an
important effect on the degree of risk associated with a business. E.g.: capital
gearing, debt/equity ratio, interest cover, operating gearing.
Investment (investor) ratios assess the returns and performances of shares. E.g.:
dividend per share, price/earnings ratio.

The use of ratios allows:

- highlight some aspects that could not have been made obvious through separate
analysis of the two measures used to form a ratio;
- make some time, space or mixed comparisons;
- forecasting companys activity either in part or as a whole;
- synthetic assessment of companys activity.

The practical use of the method should take into account certain rules that a ration
shall comply with:
- to be financially meaningful;
- ratios calculated for several successive periods should be compatible between
- compared enterprises should be from similar industries and have similar size;
- to bare informational value greater that the two separate indicators that form it
taken independently.

H. Scoring method

Its a method of multidimensional discriminant analysis, which is based on a

comparative analysis of two groups of companies, bankrupt and non-bankrupt. This method
requires the construction of a function based on several financial ratios which are likely to
differentiate the healthy firms from the bankrupt ones. By identifying the significant ratios
able to accurately differentiate the two groups of firms, the score function Z can be built:

Z = aR1 + bR2 + + yRn,

a, b, y weighting coefficients;

R1, R2, Rn financial ratios.

The score a company gets for a certain year is given by the value of this amount and it
indicates its financial vulnerability and the likelihood to go bankrupt.
The main scoring models used in theory and practice are: the Altman model, the
Conan and Holder model, the French National Bank model.

I. Pareto chart (ABC analysis)

Pareto chart (sometimes referred to as the 80/20 rule and as ABC analysis or ABC
method) is a method of classifying items, events, or activities according to their relative
importance. The precise shape of a Pareto curve will differ for any analysis but the broad
shape remains similar - following 'the 80/20 rule'. Vilfredo Pareto was a 19th century
economist who observed that 80% of Italy's wealth was owned by 20% of the population.
Pareto charts are extremely useful for analysing what problems need attention first
because zone A on the chart clearly illustrate which variables have the greatest cumulative
effect on a given system.



Zone C
Zone B
Cumulative no. of
variables 100 %
Figure 1.1. Pareto Chart

This method is frequently used to analyse turnover, stocks, costs, customers, suppliers
Making decisions on the phenomenon studied is based on the difference between the
real curve and the theoretical one. If the real curve lies below the theoretical curve, the
company has a high percentage of its results in the areas B and C (which means a low degree
of concentration). In the opposite case, the results located in zone A prevail and the
concentration of results is higher.

Chapter 2: Financial Position Analysis

a. Financial Balance Sheet

Financial analysis is based both on patrimonial concept of the enterprise as well as on

different classification criteria of balance sheet elements. This approach regards an enterprise
as an economic and juridical entity that owns a patrimony that consists of assets (long-lived
and current) as well as liabilities and equity. The simplest version of an enterprise value is
given by its net worth calculated by subtracting liabilities (to external creditors, both
operational as well as financial) from the value of its total assets (free of all fictive elements).

Financially speaking, each asset element represents an allocation of funds in order to
establish a value creating a structure adequate to the industry and objectives of the enterprise.
The simplest definition of its assets is: the enterprise patrimony components capable of
generating future benefits to its owner. Liabilities and equity reflect the origin sources of
funds that assets are formed upon.
Unlike the accounting balance sheet that has a vertical form, the financial balance
sheet is based upon the horizontal concept, all the assets being placed in the right pane,
whereas the liabilities and equity are placed in the left pane.
The order of assets and funds (equity and liabilities) is based upon liquidity-
chargeability criteria. The assets are listed in terms of their increasing liquidity (the assets
feature of transforming into cash), whereas the funds in terms of their increasing
chargeability (the funds feature of becoming payable at a certain moment in time).
The specificities of the financial balance sheet include the fact that assets, equity and
liabilities are taken into account by their net value. Thus, financial balance sheet represents a
realistic inventory of the companys patrimony.
The financial balance sheet construction implies going through two stages:
correction of balance sheet elements;
regrouping of corrected elements according to their true liquidity and
chargeability nature.

A. Corrections

Financial balance sheet construction implies several corrections applied to the

elements of accounting balance sheet:
- intangible assets are taken into account at their net value; this requires the
elimination of all fictive elements they contain; fictive elements include those
components that are not usually included in the calculation of net worth of a
company, thus for the construction of financial balance sheet these are withdrawn
from the assets and, as well, in order to keep the equality of the balance sheet, the
appropriate values are subtracted from equity; as fictive elements are considered
constitution and development expenses;
- fixed assets are taken into account at their net value; in order to respect the
principle of realistic representation of balance sheet elements, fixed assets should
be re-evaluated, thus their value is modified compared to the value from
accounting balance sheet; the difference is also summed up to the value of equity;
considering that usually, in Romania, assets re-evaluation happens once in five
years (from taxation reasons), and a re-evaluation as a time consuming and
expensive endeavor, usually the analyst will consider the accounting value as the
real value of the assets to be taken into account in the financial balance sheet;
- prepaid expenses are also considered fictive assets and will be eliminated, the
value being also subtracted from equity;
- equity is diminished by the value of capital subscripted but not paid by
shareholders, subsequently reducing the value of accounts receivable from
- provisions are considered as elements deducted from current revenues in order to
constitute reserves for any future risks or uncertain expenses; in the case they are
legitimate, they will be moved either to long term liabilities or to short term
liabilities, depending on their maturity; if they are not legitimate, will be
considered as equity;
- advance revenues will also be assimilated as equity.

B. Regrouping corrected elements

This stage of financial balance sheet construction focuses on obtaining groups of

homogeneous elements in terms of liquidity in the asset pane and in terms of chargeability in
the capital pane:
- for assets: long term assets (with a period of liquidity over a year) and current
asset (with a period of liquidity less than a year);
- for liabilities: long term capital (with a period of chargeability over a year, both
own and external) and short term liabilities (with a period of chargeability less
than a year).

For this purpose the following operations will be carried out:

- long term financial investments will be separated based upon their real liquidity
period and will be either left in long term assets component (those with a liquidity
period over a year) or inserted in current assets (those with a liquidity period less
than a year);
- slow turnover or unsalable inventories will be inserted into fixed asset group, the
rest being left in current assets component;
- accounts receivable will be classified by the term of the liquidity: the component
that will be collected in less than a year will be held within the current assets, the
rest will being moved to long term assets;
- short term financial investments that will be cashed in less than a year will be
kept in short term assets, whereas those with a liquidity more than a year away
will be moved to long term financial investments;
- the component of long term debt payable in less the 12 months will be moved to
current debt;
- short term liabilities that have a chargeability period of more than a year will be
moved to long term liabilities.

Financial Balance Sheet changes to accounting balance sheet

(corrections and regrouping)


I. Long term assets: I. Equity
1.1. Intangible assets constitutive expenses
constitutive expenses development expenses
development expenses +/ re-evaluation differences
1.2. Fixed assets receivables from shareholders
+/ re-evaluation differences prepaid expenses
+ slow turnover or unsalable + non-legitimate provisions
inventories + advance revenues
1.3. Long term financial investments II. Long term liabilities:
long term financial investments 2.1. Long term loans
(liquidity < 1 year) long term loans with payment < 1
+ accounts receivable (liquidity > 1 year
year) + short term loans with payment > 1
+ short term financial investments year
(liquidity > 1 year) 2.2. Operational long term liabilities
+ legitimate long term provisions
+ short term liabilities with payment >
1 year


II. Current assets: III. Short term liabilities:

2.1. Inventories 3.1. Operational liabilities:
slow turnover or unsalable 3.1.1. Suppliers accounts payable
inventories liabilities with payment > 1 year
2.2. Accounts receivable 3.1.2. Other short term operational
receivables from shareholders liabilities
accounts receivable (liquidity > 1 + legitimate short term provisions
year) + long term liabilities with payment < 1
2.3. Cash and short term financial year
investments: short term liabilities with payment >
2.3.1. Cash at bank and in hand 1 year
2.3.2. Short term financial 3.2. Short term financial debts
investments + long term loans with payment < 1
+ long term financial investments (< year
1 year) short term loans with payment > 1
short term financial investment (> year
1 year)
Total Assets Total Capital

Finally, financial balance sheet has the following structure:

Financial Balance Sheet


I. Long term assets: I. Equity
1.1. Intangible assets II. Long term liabilities:
1.2. Fixed assets 2.1. Long term loans
1.3. Long term financial investments 2.2. Operational long term liabilities
II. Current assets: III. Short term liabilities:
2.1. Inventories 3.1. Operational liabilities:
2.2. Accounts receivable 3.1.1. Suppliers accounts payable
2.3. Cash and short term financial 3.1.2. Other short term operational
investments: liabilities
2.3.1. Cash at bank and in hand 3.2. Short term financial debts
2.3.2. Short term financial

Total Assets Total Capital

b. Asset structure analysis

Structure analysis aims to reflect the relationship between different balance sheet
elements and changes that take place in a companys capital and its allocation. This type of
analysis is called a vertical analysis because it tackles separately assets as well as liabilities
and the manner in which each of these is structured.
Factors that affect the balance sheet structure are:
Economic and technical factors:
- intensity of capitalization;
- the duration of enterprises operational cycle;
Juridical factors:
- Current business rules and regulations;
Conjectural factors;
Strategic options of the enterprise;
Size of the enterprise.

Structure ratios are calculated as a ratio between an asset or liabilities element (or
group of elements) and total assets or liabilities, as well as an asset or liabilities element and
the total amount of the group it is part of.
The assets structure analysis emphasizes the following:
- the economic destination of the invested capital;
- the liquidity of the invested capital;
- the ability of the enterprise to modify its assets structure under the influence of
external (market or industry) factors.
The most important asset structure ratios are:

1) Long-term assets ratio (RLTA)

This ratio measures the degree of investment of companys capital and is calculated as
a ratio between long term assets (LTA) and the total assets (A). The long-term asset ratio is
assessed according to companys industry. For a manufacturing company, the values of this
ratio that indicate a normal situation are situated around the 60% level.

RLTA = 100

In order to further advance the analysis there could be used some complementary
structure ratios for long-term assets analysis, as shown below:

1.1) Intangible assets ratio (RIn)

Reflects the proportion of intangible assets (In) in either total assets or long-term
assets. When calculated as a ratio to long-term assets, it reflects the relative importance of
intangible assets for companys activity and operations the intensity use of research &
development (R&D) processes in generating new products and technologies, or the
dependence on certain specific software systems.

In In
RIn = 100 or R*In = 100

1.2) Fixed assets ratio (RFA)

Reflects the proportion held by tangible investments in total non-current assets of the
company or in total assets; moreover, the ratio indicates the potential flexibility of the
company in its efforts to adjust to the changes that affect its markets and used technologies.
The higher is the percentage of fixed assets, the more focused and specialized are the
companys assets as a whole, the lower is the emphasis on intangible assets (that reflects
innovation concern of the company) as well as the financial long-term assets (that reflect the
degree of companys involvement of the financial markets or the membership in a holding).

RFA = 100 or R*FA = 100

1.3) Long-term financial investment ratio (RLTFI)

Reflects the financial investment policy of the company and expresses the intensity of
its equity relations with other companies.

RLTFI = 100 or R*LTFI = 100

There are some validation equations for these ratios:


2) Current assets ratio (RCA)

Current assets ratio expresses in relative terms the amount of capital invested in
companys operations. Due to the fact that this amount of capital is renewed with each
operating cycle, it is also called circulating capital. As well, this ratio measures the liquidity
degree of a companys assets. Its value depends greatly upon the industry the company runs
in, but a value of 40% is considered convenient for a manufacturing company.

RCA = 100

The long-term and current assets ratios should meet the following principle:

RLTA + RCA = 100%

As in case of long-term assets, current assets structure could be broken down into
complementary ratios.

2.1) Inventory ratio (RInv)

Inv Inv
RInv = 100 or R*Inv = 100

The level of this rate depends upon many factors, for instance:
- the enterprises industry or industries;
- duration of enterprises operational cycle;
- market price fluctuations.
An increase of inventory proportion is justified when it comes as a result of turnover
growth, whereas it is considered improper if it results in buildup of slow moving or unsalable
A closer look on the inventory structure, in case of a manufacturing enterprise,
requires the analysis of other three complementary ratios: ratio of raw materials, ratio of wok-
in-progress inventories and ratio of finished goods. In case one of the three elements is
prevalent in the inventory structure it can indicate industry or enterprise specific inventory
management situations. As well, exaggerated levels of some inventory components can
indicate poor inventory management situations. For instance, an oversized raw material
inventory can either signify a prudential supply management policy, but as well it can
indicate problems in value and structure of raw material inventory management, which lead
to accumulation of slow moving or unusable inventories.
If an enterprise carries out only trade operations, than the sole structure ratio which is
useful for analysis is merchandise inventory ratio.

2.2) Accounts receivable ratio (RAR)

RAR = 100 or R*AR = 100

This ratio is greatly influenced by the companys industry, the nature of business
relations with its partners and as well by the average period outstanding for the payment of
deliveries by the companys clients. This ratio is quite small or nil if the company sells its
products or services for cash to individual clients (retail, some services rendered directly to
the consumers) and has large values when the company has as clients other companies.

2.3) Cash and cash equivalent ratio (Rcash)

Cash Cash
Rcash = 100 or R*cash = 100

The ratio expresses the proportion of cash (cash at bank and in hand) and cash
equivalent (short term financial investments) in total assets or current assets. A high level of
this ratio means cash might not be used in an efficient way especially if it results in a large
amount of money in bank accounts. A low level might lead to difficulties in covering short
term debts.
The ratio can be split into two ratios:

2.3.1) Short-term financial investment ratio (RSTFI)

RSTFI = 100 or R*STFI = 100

The level of this ratio depends upon two cumulative factors: the operational activity of
the enterprise generates cash flows available for long periods of time due to certain reasons
(profitable operations, seasonal variations of cash-flows etc.) as well as risk acceptance from
the management team that makes possible the placement of cash flows on the financial
market using different available instruments (shares, bonds, futures etc.).

2.3.2) Cash at bank and in hand ratio (RCBH)

RCBH = 100 or R*CBH = 100

A high cash ratio can indicate a favorable situation of an enterprise in terms of

financial balance, but it can as well be a sign of inefficiently used resources. Moreover, the
level of cash can fluctuate greatly over short periods of time, so that it can rise steeply when
important amounts of cash are incurred from clients or it can decrease swiftly due to
important payments made to suppliers or other partners. The normal level of this ratio is
about 5% to 10% compared to total assets. In the long run, the existence of a large amount of
cash at bank or in hand signifies as well a risk aversion management attitude, that do not
accept placement of free cash using alternative risky but, at the same time, more profitable
There are some validation equations for these ratios:

R Inv R AR R cash R CA and R*Inv R*AR R*cash 1 .

c. Financial structure analysis

The financial structure ratios highlight the way the capital is structured in terms of its
provenance and its degree or chargeability. Financial structure analysis aims to assess main
financial strategies and policies regarding formation of financial resources in terms of their
origin (own, borrowed or attracted from operational creditors) and in terms of their
chargeability (short term and long term).
The capital a company uses can be classifies according to several criteria:

a. Chargeability (maturity):
- long term capital: equity and long term liabilities;
- short term liabilities.

b. Ownership:
- equity;
- liabilities (debts).

c. According to their nature, liabilities can be:

- suppliers payables;
- other operational liabilities;
- financial liabilities (loans).

A. Financial structure analysis according to chargeability

1) Financial stability ratio (RFS)

This ratio reflects the proportion of long-term capital (LTC) in total capital (C). Long-
term capital comprises both equity and long-term liabilities.

RFS = 100
Financial stability of an enterprise is as high as the value of this ratio closes to 100%.
The minimal accepted value for a manufacturing company is 50%, while normal value being
around 67%.
Dynamically, the ratio should have an increasing trend, an effect of enterprises profit
generating activity, increases in shareholders equity and attraction of new long-term bank

2) Short term liabilities ratio (RSTL)

This ratio reflects the proportion of short term liabilities (STC) in total capital (C).
RSTL = 100

For a manufacturing company, the maximum value of this ratio is 50%, while the
normal value is around 33%.
Validation equation:


B. Financial structure analysis according to ownership

1) Financial autonomy ratio

Financial autonomy highlights the extent to which financial sources of an enterprise

belong to its shareholders (owners). The greater is the proportion of equity in total capital
the larger is the companys independence from external lenders.

There are two types of financial autonomy:

- Global financial autonomy, when equity is compared to total capital;
- Long-term financial autonomy, when equity is compared to long-term capital.

1.1) Global financial autonomy ratio (RGFA)

It is calculated as ratio between equity (E) and total capital (C).

RGFA = 100 .

This ratio is especially important to lending institutions such as banks, when the
company request a new loan.

The minimal accepted value for this ratio is 33%, while normal value being around

1.2) Long-term financial autonomy ratio (RLTFA)

It is calculated as a ratio between equity and long-term capital.

RLTFA = 100 .

It is considered that for a healthy financial structure (a low indebtedness risk) this
ratio must have a value of at least 50%.

2) The debt (indebtedness) ratio

The indebtedness ratios (the leverage ratios) express in percentage measures the level
of a company debts compared to either its total capital or long-term capital.
Business environment uses two main indebtedness ratios:
- Global indebtedness ratio;
- Long-term debt ratio.

2.1) Global indebtedness ratio (RGD)

This ratio compares total debts (D) that a company has accrued in its balance sheet
with total capital.

RGD = 100 .

The maximal level of global indebtedness, that indicates an acceptable risk level, is
around 67%. Dynamically, the ratio should have a downward trend, as an effect of debt
growing slower that total capital, the most favorable situation being that of long-term debt
reimbursement by the company as well as the reduction of short-term debt.

RGFA + RGD = 1.

2.2) Long-term debt ratio (RLTD)

This ratio compares long-term debt (LTD) (usually comprised of bank loans) with
long-term capital.

RLTD = 100 .

If the value of this ratio exceeds 50%, the enterprise is in danger of insolvency. The
possibilities of getting approved new bank loans are as high as this ratio is low.


d. Static financial balance analysis

Out of many available definitions of financial balance we will retain the one that
expresses it as the equality between financial sources and financial requirements of the
operational processes carried out in an enterprise, short term and long term alike.
Financial balance analysis can be approached in two different ways, namely:
- a static approach financial balance indicators are calculated based upon information
from financial balance sheet and reflect a static image (at a certain moment) of the
manner financial balance is reached;
- a dynamic approach financial balance of the enterprise is referred to in terms of
cash-flows, so that it analyses the extent to which incoming cash flows cover outgoing
ones (payments) over a period of time.
The two basic equations of a financial balance are:

Long-terms assets = Long-term capital

Current assets = Current liabilities.

Static financial balance analysis is done with the help of the following indicators:
- Working capital, working capital requirement and treasury;
- Liquidity and solvency.

A. Working capital, working capital requirement and treasury

The three specialized indicators cover a certain segment of financial balance in terms
of time extent:
- working capital (floating capital): long-term financial balance analysis;
- working capital requirement: short-term financial balance analysis;
- treasury: global financial balance analysis.

A.1. Working capital (WC)

Working capital (also known as net working capital) represents the amount of long-
term capital that is used to fund current assets.
When long-term capital is in excess of long-term assets, one could say that an
enterprise have a working capital that can be used (rolled over) to renew some components of
the current assets. Thus working capital plays the role of a financial safety margin that allows
a company to meet its operational requirements whenever current liabilities do not stand up to
the challenge.
WC is calculated in two different ways:

a) based upon the upper part of the balance sheet, as a difference between long-term
capital (LTC) and long-term assets (LTA):


Long-Term Assets Long-Term Capital

Working Capital

b) based upon the lower part of the balance sheet, as a difference between current assets
(inventory + accounts receivable + cash & cash equivalents) and current liabilities
(CL) (operational liabilities + short term financial liabilities):

WC = CA - CL

Current liabilities
Current assets
Working Capital

Cash includes cash at bank and in hand, while cash equivalents include short term
financial investments.
Each of the two methods used to calculate working capital highlights a certain specific
but nevertheless complementary aspect regarding this indicator:
establishment of working capital based upon the upper part of the balance sheet
reflects the manner in which firms financial structure affect the process of
operational financial sources build up;
establishment of working capital based upon the lower part of the balance sheet
reflects in real terms the future liquidity of the enterprise, playing the role of
potential liquidities excess that is used as a safety net in the operational activity
and can lower operational risks that affect the company.
If current assets are less than current liabilities, an entity has a working capital
deficiency, also called a working capital deficit.
A company can be endowed with assets and profitability but short of liquidity if its
assets cannot readily be converted into cash. Companies with huge assets have still collapsed
because they could not generate enough cash to sustain the business and pay short term debts.
Positive working capital is therefore required to ensure that a firm is able to continue its
operations and that it has sufficient funds to satisfy both short-term debts and upcoming
operational expenses (salaries, equipment rental, inventory, and so on). The management of
working capital involves managing inventories, accounts receivable and payable, and cash.
A negative working capital (more immediate liabilities than cash assets can be a bad
signal to investors. This figure indicates that creditors cannot be paid and the firm could go
bankrupt in the near future. It might also suggest that the sales volume is gradually
decreasing, resulting in shrinking accounts receivable, or that the excessive inventory
requires too much money.

A.2. Working capital requirement (WCR)

Working capital requirement represents the part of current assets (excluding cash) that
should be covered from long-term capital (from working capital, more accurately).
Normally, current assets (inventory and accounts receivable) should be covered from
operating liabilities. In case there arent sufficient, long-term capital is used to cover the

difference. WCR reflects the amount of inventory and accounts receivable which are not
funded by operating liabilities.

WCR = (Inventory + Accounts receivable) Operating liabilities

WCR may be both positive and negative:

WCR > 0: the operating liabilities no longer cover the short-term assets.
WCR < 0: the firm attracted commercial debts large enough to cover short-term

A positive WCR means the company needs additional resources (other than operating
liabilities, which are not sufficient) in order to completely cover inventory and accounts
receivable. The capital used in this respect is the WC (if positive). But in the eventuality that
WC is not sufficient as well to cover the difference, bank loans are to be used.
Inventory and accounts receivable can be there covered by the following resources:
- operating liabilities;
- working capital (long term capital);
- bank loans.
Each of these resources is being used if the previous resource(s) is (are) not sufficient
to cover the current assets.
A negative WCR means the operating liabilities fund a part of the long lived assets.
Despite commercial debts require no interest to be paid a great level of them could increase
the financial dependence of the company on its suppliers. This further leads to higher
financial risks for the firm. Thats why it is advisable to reduce working capital needs in the
Both the working capital and the working capital requirement are different for each
company, depending upon many factors. For this reason, there is no ideal amount of the two
figures that is universally applicable to all businesses, or even to companies engaged in the
same industry.

A.3. Treasury

Treasury (T) or net cash of a company is the image of company cash and cash
equivalents, generated by ongoing evolution of cash collection and payments, respectively of
short-term cash investments.
Treasury can be calculated based on two formulas:
- as a difference between working capital and working capital requirement:


- as a difference between cash and cash equivalents, on one side, and short-term
financial liabilities, on the other hand:

T = (Cash + Cash equivalents) - Short-term financial liabilities.

The treasury analysis covers two possible situations:

a) T > 0; WC > WCR

If treasury has a positive value, then the excess of funding sources over needs will
take the form of cash at bank and in hand.
This is a convenient case for an enterprise; it has a short-term financial independence
and overall financial balance.
Not always a positive value of treasury is a sign of an efficient company, because
long-term cash abundance could highlight an insufficient use of those cash resources.

b) T < 0; WC < WCR

A negative treasury indicates a global financial misbalance, a cash deficit that is

covered by short-term bank loans.
Such a situation shows out a dependence of companys operations on external short-
term financial sources which tend to be more expensive, especially when funding gap is
acute. The company dependence on external capital limits its financial independence in the
A negative treasury could be favorable to a company only if the cost of short-term
external funding is inferior to operational returns, meanwhile the period for which the
company uses short-term bank loans is carefully calculated so that it does not stay dependent
on external funding when this situation changes.

B. Liquidity and solvency

Liquidity and solvency analysis reflects enterprises ability to repay its debts,
comprised both of short-term and long-term liabilities. Meanwhile, liquidity and solvency
belong to measures used to assess the companys financial balance. Liquidity and solvency
analysis highlights a certain financial condition of the enterprise in terms of its ability to
repay its debts with different chargeability terms.
Liquidity refers to the companys ability to sell short term assets quickly to raise cash
in order to pay its short-term obligations. A firm with adequate liquidity has enough cash
available to pay its bills.
Solvency regards the company's capacity to repay its long-term debts. A solvent
company owns more than it owes. It has a positive net worth and a manageable debt.
Solvency and liquidity are equally important for the financial health of the firm.
Healthy companies are both solvent and possess adequate liquidity.
Both measures are approached by financial statement analysis using ratio method. A
number of financial ratios are used to measure a companys liquidity and solvency, the most
common of which are discussed below.

B.1. Liquidity ratios

Current ratio (Rlc) measures the firms ability to pay off its current liabilities (due
within one year) using its current assets (inventory, accounts receivable, cash and cash
equivalents). It is calculated as a ratio between current assets (CA) and current liabilities


Generally, the higher the current ratio, the more liquid the firm is considered to be.

A current ratio of 2 is occasionally cited as accepted, but a values acceptability
depends on the industry in which the firm operates. For example, a current ratio of 1 would
be considered acceptable for a public utility company but might be unacceptable for a
manufacturing firm. The more predictable a firms cash flows, the lower the acceptable
current ratio.
The generally acceptable values of the current ratio are:
the minimum value is 1, and a ratio bellow this threshold usually indicate an
insufficient current liquidity;
the maximal value is 2, a ratio that exceeds this value indicating an inefficient use
of firms current assets.

Quick ratio (Rlq) is similar to the current ratio except that it excludes inventory,
which is generally the least liquid current asset. Quick ratio measures the firms ability to
meet its short-term obligations with its most liquid assets. It is also known as the acid-test

CA - Inv
Rlq =

The generally low liquidity of inventory results from two primary factors:
many types of inventory cannot be easily sold because they are partially
completed items or special-purpose items;
most of the times goods are sold on credit, which means that inventory becomes
an account receivable before being converted into cash.
The acceptable values of this ratio are:
the minimum value is 0,8, and a ratio lower than this indicate an insufficient
firms quick liquidity;
the maximal value is 1,0, a ratio that exceeds this value indicating an inefficient
use of firms liquid assets.
Liquidity ratio analysis is usually carried out using financial balance sheet data. This
data reflects the assets and liabilities at a certain moment in time, usually on 31st of
December of the year used in the analysis. Thus, an assessment of liquidity is made for the
whole year using the balance sheet information reflecting a single day of that year. The asset
components of the balance sheet, especially the most liquid ones (such as cash, accounts
receivable etc.), as well as a part of current liabilities have quite a volatile nature, as in having
large variations over short intervals of time. Consequently, the value of certain current asset
and current liability elements might not be relevant for the entire year. In such a case,
interpretations and conclusions could be distorted by this unrepresentative nature of financial
data, so that firms liquidity will be judged based upon values either too big or too small in
comparison with the companys real financial position.

B.2. Solvency ratios

Assets to debts ratio (RA/D) reflects the firms ability to satisfy its overall debt (D)
using the total assets (A).

R A/D =

This ratio measures the amount of assets that have to be sold in order to repay the debt
(short-term and long-term). It is considered that total assets represent a guarantee for
exceptional situation, as bankruptcy, in which coverage of debts is accomplished selling all of
the companys assets. A higher ratio indicates a greater coverage of debt and therefore a
lower risk.
The minimal acceptable value of this ratio is considered to be 1.5; a normal value for
this ratio is 2 or higher.

Interest coverage ratio (Ric) reflects the degree the operating result (OR) covers the
interest expense (I). The ratio is calculated as follows:

Ric =

This ratio measures the companys ability to meet the interest expense on its financial
liabilities with its operating result (if positive). The higher the ratio, the better the companys
ability to cover its interest expense.
The minimal acceptable value is 1, which means that the company is capable of
covering bank loan interest from operating profit.

Chapter 3: Output Analysis

The purpose of any business is to gain profit by selling goods to customers. The main
measures that assess the volume of goods sold are sales (turnover) and value added.

3.1. Sales (turnover) analysis

Financial analysis must provide management with accurate information on sales in

order to improve company profit margins. Sales analysis allows knowing which products are
selling and which are not. As well, analysis can help designing a sales strategy by identifying
the influence factors.
Sales or turnover (S) represent the total revenue generated by business over a period
of time. Turnover can be determined by multiplying the volume (quantity) of production sold
(q) and the selling price per unit of product (p):

S q p

The volume of production sold reflects both the influence of internal factors
(production capacity, selling network, promotion etc.) and external factors (demand,
competition etc.). Also, the selling prices comprise the influence of several factors, some
internal (price policy, product quality, cost of production) and some external (demand,
competition, market trends, taxes etc.).
Usually, price is taken into consideration as an average sale price. Average sales price
(or average selling price) is the average price for which a good or service is sold to
customers. It equals the total revenue from a products sales divided by the total number of
units sold in a given period of time. Financial analysis usually deals with average prices, as
managers charge customers different prices for the same product. Price levels depend on
regions, stores, customers, number of units purchased, sales channels etc. so individual prices
are difficult to use in analysis. Average sales price are used to determine how the market is

responding to different price levels, forecast future sales revenues or determine the number of
units needed to reach break-even.
According to Profit & Loss Account, turnover comprises three elements:

Turnover = Sales of goods purchased for resale + Sold production +

+ Subsidies related to turnover

Dynamics of turnover

Aims to identify the trends of business. If turnover grows, the company must search
new financial resources for business. If turnover drops, new markets have to be found or the
range of goods has to be changed.
Dynamics is reflected by the following indicators:

S S1 S0 ; S% 100 ; S% IS 100

S1 the current level of sales;

S0 the reference level of sales.

Structural analysis of turnover

Turnover structure can be analysed by several criteria: products, markets, customers

etc. Structural analysis requires calculating the weight of each element:
w i i 100
Si sales for element i.

Structural analysis can be also made with the help of Gini-Struck coefficient:

n w i2 1
n 1
n number of products (elements).

The coefficient can range from 0 to 1. If approaches 0, it means that turnover is

relatively evenly distributed on the products. If it approaches 1, it means that a few products
have a large share in turnover.

Herfindhal index may be used for the same purpose:

H w i2
Herfindhal index can range from 1/n to 1. The significance is similar to Gini-Struck
Pareto chart (ABC method) is the fourth method used to analyse turnover structure.


Zone C
Zone B
A 183
Cumulative no. of
products 100 %
Figure 3.1. Pareto Chart
Three areas can be seen in the figure above:
Zone A: 10-15% of number of products have 60-65% of turnover;
Zone B: 20-25% of number of products have 20-25% of turnover;
Zone C: 60-65% of number of products have 10-15% of turnover.

Zone A includes products with a fast turnover and usually a low profit margin. They
might lead to problems related to supply and management of inventory. The operational risk
is high as the offensive of a competitor may easily threaten the market share of the enterprise.
Zone B contains items with average turnover and margin. Zone C has products with a low
turnover and a high margin. The operational risk is lower as these products have a low share
in total sales.
Considering the above, companies should choose for a certain diversification of
production in order to get a reduced risk.
Structural analysis of turnover allows identifying the type of strategy adopted by the
firm. The company can choose to concentrate on a few products or on the contrary to
diversify the production.
ABC method can also be used to analyse turnover by type of customers. The
following zones result:
- Zone A a small percentage of customers has a large share in turnover;
- Zone B comprises average customers as weights in number and sales;
- Zone C a high percentage of customers has a small share in turnover.
This analysis allows as well drawing some conclusions regarding the risk of the firm.
Zone A has the highest share in sales but as well the highest risk. If the company loses some
of these customers, the impact on sales is considerable. More, since the customers place large
orders of products, the company has to offer them discounts. This obviously affects its
Zone C has a large number of customers and therefore generates high operating costs.
In these circumstances we consider that zone B has an average degree both as safety and
profitability and the firm should pay attention to this zone.

Factorial analysis of sales

Turnover is under the influence of a large number of internal and external factors that
can increase or reduce its level. Factorial analysis aims to identify these factors, to establish
the level and the direction of their influence, and finally to set appropriate measures of
The relationship between sales and the utilization of human and material resources
can be expressed with the help of the following model:
S N L RS / P N
N average number of employees;
L labour productivity;
RS/P ratio of sales to production;

P production.

Labour productivity can be further divided into ratio of technical endowment of

labour (EL) and efficiency of fixed assets (E):
FA fixed assets.

Chain substitution method can be used to calculate the influence of previous factors.
Sales analysis is important to management as it allows comparing the actual sales to
company objectives. It is a measurement process used by firms to evaluate sales effectiveness
(what goods and services have and have not sold well), compare sales force performance,
evaluate sales by product or location in order to consider improvements. The analysis is used
to determine how to stock inventory, how to set manufacturing capacity and to see how the
company is performing against its goals and competitors. Sales analysis is also important for
finance department (to analyse the company pricing strategy and its impact on sales) and
manufacturing department (in order to plan capacity). Through sales analysis, a business will
keep up with emerging trends of the market. When sales fluctuate, the company must adapt
its strategy according to competitors strategy, especially if they are selling performing better.
Sales analysis allows making:
- period comparisons: one time period to a comparable period in the past (e.g.
month-over-month sales);
- competitor comparisons: show how well a company competes against the rest.
Sales analysis means working with increases or decreases in sales but they have to be
completed with additional explanatory notes, especially if extraordinary events occur
(introducing new products, recession, price fluctuations etc.). The sales analysis needs
therefore a context to be fully understood.
Demographics are a key factor in making a sales strategy. Including demographics in
sales analysis helps a business draw a successful sales strategy. It is always useful to know
which product is selling at a particular time and where. In this respect, a business is able to
identify which market segment is growing and bringing in more revenues and which segment
is declining. This information is further used to forecast sales in every given market segment
at a given time.
Sales must be analysed together with gross profits or losses. Businesses go bankrupt
because managers dont do a good job analysing sales and company performance. When
doing this, it is important to know which the goals of the company are: increasing sales,
increasing profit or increasing rates of return. All these are references the firm must always
looks at.
There are a number of ways to increase the sales volume: promotional events,
giveaways, discounts etc. Mathematically, the growth of turnover can be achieved by
increasing the volume of production or by increasing the selling price. The two factors are
closely related. Most of the times, an increase in sales prices entails a reduction in sales,
while lower prices lead to increased sales. However, this might also decrease the revenue.
Thats why, when analysing sales, marginal revenue from price and quantity must be also
determined. Marginal revenue is the amount of revenue that is expected to be received from
additional sales volume. Marginal revenue is important for managers because profit increases
as long as marginal revenue exceeds marginal cost. Marginal revenue can be calculated by
multiplying the additional sales quantity by the average sales price. But, due to diminishing
marginal utility managers must reduce price in order to increase sales.
When analysing sales performance, one should consider the following:

price changes (increases or decreases);
competitors entering or existing on the market;
new product or service launch;
new product or service cannibalises existing product or service;
customers moving between products or services;
changes in customer demand (increasing or decreasing);
the segments and distribution channels.
Sales analysis has the following benefits:
- allows managers to establish growth trends, by providing early warning signs;
- in the case of a range of products or services, analysis outlines which ones are
causing the growth or decline;
- analysing sales over several years enables to establish sales patterns. This will
help managers to create sales budgets;
- allows developing marketing plan each year. The marketing activities can be
planned accordingly to support the products or services that represent the greatest
opportunity for future profitable growth (especially if one product or service
represents the majority of sales);
- allows comparisons with the market and identifying strengths and weaknesses of
company relative to competition.

3.2. Value added analysis

A business means performing an operating activity by which technology is combined

with material and labour inputs, and then processed inputs are assembled and sold on the
market. A single firm may perform only one stage in this process, or it may be vertically
integrated, carrying out a large range of operations.
Since various companies may produce and sell similar products, its important to
know the companys contribution to total price. This contribution is reflected by value added.
Value added measures the value created by the operating activity of enterprises in a
certain period of time. For industrial companies, it corresponds to the difference between the
value of the products (sales) and the expenses for third parties (intermediate consumption or
intermediate expenditure). Intermediate consumption consists of the total value of goods and
services consumed or used up as inputs in production by enterprises (raw materials, services
and various other operating expenses).
Value added is an important indicator as it reflects the contribution of the enterprise in
the value of goods sold. When a company sells a product or provides a service, it is not the
creator of the whole value of product or service. Companies must purchase raw materials and
services produced by other firms (comprised in intermediate consumption). They further
perform a production or a resale by adding own resources (manpower and productive capital).
They create value because the value of the goods is higher than the sum of the value of
inputs: the difference between the selling price of goods and the total value of raw materials
and services purchased and included in these goods is added value.
Expenditure on the purchase of goods and services represents intermediate
consumption: these goods and services are consumed during the production of a good and
consequently are intermediaries.
For goods that are not processed (merchandises), the value added is the difference in
selling price against purchasing price (also named trade margin).
Value added can be calculated using the formula:

Value Added = (Value of goods and services - Intermediate consumption) +

+ Trade margin

Value added is the difference between the price of the finished product/service and
the cost of the inputs involved in making it. Added value is equivalent to the increase in value
that a business creates by undertaking the production process. A finished good has a value
(price) that is more than the cost of the sum of the parts. How much value has been added is
determined by the price that a customer pays.
Value added represents the part from the value of goods corresponding to each stage
of production. Value added has a higher portion in revenue for integrated companies (e.g.
manufacturing companies) and a lower portion for less integrated companies (such as retail
In fact, value added is approximated by total labour expense (including wages,
salaries and benefits) plus "cash" operating profit (defined as operating profit plus
depreciation expense or operating profit before depreciation). The first component (total
labour expense) is a return to labour and the second component (operating profit before
depreciation) is a return to capital (fixed assets). The value added is shared between factors of
production and this sharing gives rise to issues of distribution.
In business, a unit value added can also be calculated, as a difference between the sale
price and the intermediate cost of a product.

Unit value added = Sale price Unit intermediate cost

Total value added results by summing value added per unit over all units sold.

Dynamics of value added

Dynamics is reflected by the indicators:

VA VA1 VA 0 ; VA % 100 ; VA % I VA 100
VA 0

VA0, VA1 the reference and the current level of value added.

Structural analysis of added value

Value added can be analysed using the same indicators as in the case of turnover.
The weight of a product in total value added is:
VA i
wi 100
VAi value added for product i.

The other indicators (Gini-Struck coefficient and Herfindhal index) can be calculated
in the same way. As well, ABC method can be applied.
Businesses can add value by:
Building a brand a reputation for quality that customers are prepared to pay for.
Delivering excellent service high quality, attentive personal service can make
the difference between achieving a high price or a medium one.
Product features and benefits additional functionality in different versions of
products can enable a manufacturer to charge higher prices.

Offering convenience customers will often pay a little more for a product that
they can have straightaway, or which saves them time.

Finding ways to add value is an important activity for a business. It can make the
difference between survival and failure, between profit and loss.
The advantages to a business of adding value include:
Charging a higher price;
Differentiation from the competition;
Protecting from competitors charging lower prices;
Focusing a business more closely on its target market segment.

Chapter 4: Expenses Analysis

4.1. Total expenses

Total expenses (TEx) can be grouped according to several criteria. According to their
nature, total expenses include: operating expenses (OpEx), financial expenses (FEx) and
extraordinary expenses (EEx):
TEx = OpEx + FEx + EEx.

Operating expenses are costs associated with running the business's core operations
on a daily basis. Operating expenses contain expenses for raw materials and consumables,
energy and water, cost of merchandises, personnel expenses, depreciation and provisions,
expenses for third party services, expenses for other taxes, duties and related payments,
expenses with compensations, donations and sold assets.
Financial expenses comprise the value of expenditures due to interest, fees, and
commissions related to financial liabilities or to other financial operations during the
reporting period.
Extraordinary expenses include expenditures that are not related to current activity
(such as losses from disasters).
Total revenues (TRev) comprise operating revenues (ORev), financial revenues
(FRev) and extraordinary revenues (ERev):
TRev = ORev + FRev + ERev.

Operating revenues include sales (S), stocked production (SP), capitalized production
(CP) and other operating revenues (AORev):
ORev = S + SP + CP + AORev.

Financial revenues include revenues from interests, dividends, growth of securities

market value, earnings from foreign exchange transactions.
Extraordinary revenues include revenues that are not related to current activities of
the company.
Total expenses can be divided according to other criteria:

a) According to the relationship to output:

Variable costs;
Fixed costs.

Fixed costs do not vary with output, while variable costs do. Fixed costs remain
constant in spite of changes in output. Variable costs fluctuate to changes in output. Most of

labour and material costs are variable costs that increase as the volume of production
Some costs are considered mixed costs. They contain elements of fixed and variable

b) According to the content:

Material costs;
Personnel costs.

Material costs are the costs of the raw materials used to create a product, of the
utilities and the depreciation.
Personnel expenses are the value of expenditures related to personnel, including
salaries, wages, benefits and payroll taxes (employer's funding of the social security system).

c) According to the way of attributing to goods or services:

Direct costs;
Indirect costs.

Direct costs can be accurately and directly attributed to the production of output. They
can be easily traced to a cost object (a product, a department, a project etc.). Most direct costs
are variable costs.
Indirect costs are not directly related to the volume of output. They usually benefit
multiple cost objects and it is impracticable to accurately trace them to individual products,
activities or departments etc. Cost of depreciation, insurance, power are indirect costs.
The effectiveness of total expenses can be analysed with the help of the ratio total
expenses-to-total revenues:
R TEx / T Re v .
T Re v

A reduction of the ratio reveals a favourable situation, as the amount of money spent
in order to get a monetary unit of total revenues decreases.

4.2. Operating expenses

Operating expenses can be grouped into four categories, corresponding to the

revenues that they generate: cost of goods sold (C), cost of stocked production (Csp), cost of
capitalized production (Ccp) and cost of compensations, donations and sold assets (Ccdsa):
OpEx = C + Csp + Ccp + Ccdsa.

The effectiveness of operating expenses is also made using the ratio operating
expenses-to-operating revenues:
R OpEx / O Re v .
O Re v

A similar ratio can be built for analysing the effectiveness of cost of goods sold:
C q c
S q p
q quantity (volume) of units sold;
p - price;

c unit cost of goods sold.

4.3. Amortization and depreciation expenses

Amortization refers to spreading an intangible asset's cost over that asset's useful life.
Depreciation refers to spreading a tangible asset's cost over that asset's life.

The purpose of both terms is to:

reflect reduction in the book value of the asset due to usage or obsolescence;
spread a large expenditure over a fixed period.
Both the amortization and the depreciation expenses are fixed costs. Thats why, by
increasing production, the cost per unit decreases.
Depreciation cost analysis can be done using the following relationship:
D FA r

D - depreciation cost of fixed assets;

FA - fixed assets (annual average);
r - depreciation rate.

Depreciation cost must be correlated with the output. Since depreciation cost is fixed,
output should increase at a higher rate than depreciation cost.
The effectiveness of depreciation cost can be analysed with the ratio depreciation
RD /S .

4.4. Personnel expenses

The personnel expenses are among the most important of the operating expenses, as
they usually have a large share in the cost of goods sold.
Salary analysis can be done by decomposing the wages (W) into the average number
of employees (N) and the average annual wage (wa):
Sal N wa N t hr

Sal salaries;
t average annual working hours per employee;
hr hour rate.

Salary cap

Salary cap (SalCap) is the top limit on the amount of money a company can spend on
salaries, according to the dynamics of output:
SalCap Sal 0 IOutput

Sal0 amount of salaries of the base year;

IOutput index of output (usually sales).

Cap space is equal to the salaries (payroll) of the current year (Sal1) minus salary cap:
Cap space = Sal1 SalCap.

Cap space should be negative in order to get a favourable situation. This means the
payroll is below the maximum limit the company can afford to pay its employees.
The effectiveness of salaries is appreciated with the ratio salaries-to-sales:
RSal / S .
4.5. Interest expense

Its the cost incurred for borrowed funds (loans, bonds, lines of credit). The interest
expense depends on the level of interest rates in the economy. Interest expense will be higher
during periods of rampant inflation and lower during periods of low inflation.
The interest expense has a direct impact on profitability, especially for companies
with a high debt ratio. Heavily indebted companies may have difficulties in paying back their
loans during economic downturns. This is the reason which for managers pay a close
attention to solvency ratios.
Interest expense (I), as absolute figure, depends on the borrowed capital (K) and the
interest rate (r):
I Kr .

If the borrowed capital is designated to finance the current assets, interest expense can be
analysed with the model:
I CA R K / CA r CA
CA current assets;
RK/CA the proportion of current assets financed by borrowed capital.

The effectiveness of interest expense can be analysed using the ratio interests-to-
I K I A K I RK / A r
RI / S

A assets (long lived and/or current assets) financed by borrowed capital;

RK/A the proportion of assets financed by borrowed capital;
TA assets turnover.

4.6. Marginal cost

Marginal cost is the change in the total cost due to the increase of the quantity
produced by a unit (the cost of producing one more unit). At each level of production
marginal cost includes all the additional costs required to produce the next unit. For a specific
level of production and for a time period being considered (short time), marginal costs
include all costs that vary with the level of production.
Marginal cost includes:
- Variable costs (dependent to quantity);
- Fixed costs (independent to volume), occurring with the respective lot size.
Marginal unit cost (MUC) can be calculated as a ratio between the change in costs (C)
and the change in quantity (Q):

Marginal cost analysis allows determining the level of production for which the
company has the lowest costs. As well, the managers may decide whether to increase or not
the production, by comparing MUC with the average cost (c) and the selling price (p). The
evolution of the three indicators depending on the quantity of production (q) is shown in
Figure 4.1.

c, MUC, p c

q1 q2 q3 q4 quantity
Fig. 4.1. Marginal unit cost curve

We assumed that the sale price remains constant regardless the volume of production.
Hence, the following observations can be done:
MUC first decreases and then an increases much faster than c;
minimum of MUC is lower than minimum of c;
quantity corresponding to minimum of MUC (q1) is lower than quantity
corresponding to the lowest c (q2).
These differences are due to fixed costs, which are constant on short-term. But, while
production grows, fixed costs will occur, so MUC will increase faster than c.
The following conclusions can be drawn from the previous chart:
If q < q1, both MUC and c decrease. For q = q1 the economic optimum level of
production is reached (MUC is minimal).
If q1 < q < q2, MUC increases, while c keeps on dropping until reaches the
minimum level for q2. This level of production is known as the technical optimum.
If q2 < q < q3, MUC is higher than c, but both are lower than p. Although unit
profit falls, total profit grows as production increases.
If q3 < q < q4, MUC is higher than p. Each additional unit produced brings losses,
although c is smaller than p.
If q > q4, c exceeds p and the activity of the company becomes unprofitable.

Chapter 5: Profitability Analysis

Profitability analysis is carried out with the help of specific ratios, depending on the
goal of analysis. Profitability ratios are constructed by dividing a profit or equivalent value to
revenues, expenses, assets or equity. When calculating a profitability ratio, it is mandatory to
use correlated output measures (profits, on one hand, and revenues, expenses, assets and
equity, on the other hand).

1) Profit margin (operating profit margin or return on sales - ROS) relates the
operating profit to the sales during the period:

Pr ofit margin 100

The ratio indicates the efficiency of companys activity and its capacity to generate
profit from turnover. The ratio indirectly reflects the efficiency of companys marketing
policy and competitiveness of its goods, mainly reflected in pricing policy.

Profit margin ratio is the most important measure of operational performance used to
make comparisons as it is not influenced by the way the business is financed.
The level of profit margin depends upon factors, such as:
industry characteristics;
price policy;
type of customer;
degree of competition;
cost of used resources;
economic climate.

2) Return on assets (ROA) measures the global performance of the company, as a

result of using all of its assets:
Operating profit
Re turn on assets 100
Total assets

The ratio expresses the operating profit generated by all the assets the company uses.
ROA should be higher than the cost of borrowed capital, in order to get a positive
result from the financial leverage.
The factorial analysis of ROA is based on Du Pont method and means decomposing
the ratio in two financial ratios that highlight the ways through which this ratio could be
Sales Operating profit
ROA 100
Total assets Sales

total assets turnover.
Total assets

Du Pont method represents a way of using the financial ratios in order to build a
simple system which allows managers to identify measures that can be taken to increase
In order to increase ROA there could be increased either assets turnover, either ROA.
Most of the times, using one or another of the two ways is done with the help of the selling
price. The company may decide to increase the prices, which will lead to a higher ROS, while
assets turnovers will decrease (the quantity sold drops as well). In exchange, if the prices
drop, the sales and the assets turnovers increases (the quantity sold increase), while ROS
decreases. The sensitivity of demand on changes occurred in prices explains how ROA can
vary as a result of changing the price.

3) Return on capital employed (ROCE) measures the profitability of the capital

employed, used to finance the business:

Operating profit
Re turn on capital employed 100
Capital employed

Capital employed comprises equity and borrowed capital (the capitals which are not
cost free). Capital employed is also referred to as Fixed assets plus Working capital.

4) Return on equity (ROE) is used to measure the profitability of the shareholders

investment within the company and compares the shareholders earnings with the funds they
have invested in the business:
Net income
Re turn on equity 100

Relying on the level of this ratio, investors decide whether to buy or sell shares of
ROE is higher than ROCE if the company gets a positive financial leverage. As long
ROCE exceeds the cost of borrowing, ROE increases by using borrowed money.
The Du Pont models for ROE are:
Total assets Net income
Re turn on equity 100
Equity Assets
Total assets Sales Net income
Re turn on equity 100
Equity Total assets Sales
Total assets Sales Cost of goods sold Net income
Re turn on equity 100
Equity Total assets Sales Cost of goods sold




conf. univ. dr. Mirela CRISTEA


conf. univ. dr. Cristian STANCIU



1. The need for insurance and insurance concept

The appearance and evolution of the insurance activity at the international level
indicate that the need for protection existed since ancient times, being indispensable for every
people, whereas, on the one hand, on the lifetime, there are accumulated a lot of goods,
different values, which can disappear anytime, after a theft, a fire or an earthquake, for
instance. On the other hand, physical integrity, health, work capacity may also be affected,
which may lead to the impossibility of carrying out an activity to obtain income.
Therefore, the hazards, which people and their property are exposed, are numerous
and various, and demonstrate the necessity and importance of the insurance activity. The
benefits deriving from insurance depend not only by the insurer companies, but also by a
healthy insurance market, the strict regulations which do not permit the functioning of the
unprofessional companies, whose failures would affect the customer confidence and, in the
same time, the performance of the entire insurance market.
Still, in spite of these, there are different degrees of insurance development from
one country to another, the economic growth level being an important factor for insurance
Nowadays, the insurance becomes a major field of the national economy, its turnover
growing continuously. The weight of insurance to every country GDP is more and more
higher, reaching at 12% on some countries (as Netherlands), and the higher the economic
growth is, the higher is the insurance contribution to GDP. We can say that, the percentage of
insurance in GDP of a country represents the measure of the development of that state.
In the developed countries, the insurance is part of the education, the tradition and
life, while in Romania, in the current period, we are far from an education at the level of
entire population, in this field. Moreover, at the terms of our country, there are added also the
financial factors, the offer being limited and less adapted to the market needs, with limited
The variety and diversity of the insurance products depend by the sector, market and
customer maturity on the specific market. There are insurance markets where prevails a larger
number of products for life insurance, providing protection, as well as the opportunity to save
money, being a way for financial investment, while on other markets their weight is smaller
(usually among countries with less financial power), in favor of the compulsory insurance
and of those with a higher likelihood of risk occurrence.
The profile of the potential insured in Romania is defined and shaped by the
Romanian environment society, the factors which are closely related to the population
incomes, lifestyle, the degree of knowledge, the civilization and the culture level.
Concerning the insurance concept, in the literature are expressed different meanings.

A common definition of the insurance concept is that the insurance represents the
financial protection for the losses caused by a wide and varied range of risks56.
Some experts consider that the insurance is based on the existence of common risks
which can cause serious damages to the national economy and population. The existence of
the common risks leads to the formation of risk community, which accepts the payment of
insurance premiums to a specialized insurance company in order to constitute the insurance
Other economists consider the following basic features for defining the insurance
notion: the existence of the risk, the risk community and mutuality in covering the
Others highlight the essence of insurance, which consists of its purpose and method:
the purpose - compensation for damages caused by natural disasters and accidents, damage
prevention; the method the risk hedging, the formation of the risk community, all of these
being materialized through the formation and using the insurance fund.
To a large extent, the insurance is based on an agreement (an insurance contract)
between the insurer and the insured person (the two main parts of the insurance contract),
through which the insurer provides protection to the insured person for the risks assumed,
undertaking for covering the claims (compensations) to the insured person (or the sum
insured for life insurance) in the case of the risk occurrence, in return of payment by the
insured of an amount, called the insurance premium.
As defined by law57, the insurance represents "the operation by which an insurer
constitutes, on the principle of mutuality, an insurance fund by contribution of a number of
insured persons, exposed to the occurring of certain risks, and indemnifies those who suffer
a damage on account of the fund consisted from the earned premiums, and other income
resulting from whole activity".
Therefore, there are different meanings of the insurance concept, without a consensus
in this regard, due to economic, social and legal difficulties.
From all opinions expressed above, it can be outlined an unitary point of view
regarding the characteristics of insurance, namely:
a) the existence and action of some risks, under the insurance protection;
b) the existence of a risk community, comprising all individuals and legal entities
who, threatened by the existence of the common risks, accept to pay money as
insurance premiums, which will cover the damage caused by these risks;
c) mutuality in bearing damages, which represents an act of human solidarity,
whereby the risk is supported and covered by all persons included in the insurance
(all for one and one for all);
d) formation and using the insurance fund only as money (not material or other
type of assets);
e) the event (the occurrence of the risk) must be accidental and its implementation
do not depend by the willingness of insured person, either because it is
impossible (eg. natural disasters), or the interest of the insured or the law prevents
him to produce it (accidents, fires, etc);
f) the event, subject of assessment, to be based on statistical and mathematical
calculations, both in terms of its frequency, and proportions of every insured case.
These features underline the essence of insurance concept, of traditional insurance,
valid for any kind of economy.

Ciurel, Violeta Asigurri i reasigurri: abordri teoretice i practici internaionale, All Beck Publishing
House, Bucharest, 2000, pp. 17.
The Law 32/2000 regarding the insurance companies and insurance supervision, published in the Official
Journal, Part I, no. 148 of 10 April 2000, Art. 2

2. The functions and role of insurance
Through his functions, the insurance justifies the role, the social purpose, directions
and action strategies, as well as the expected effects.
Regarding some economists, it is considered that, the insurance fulfills the following
1) The function of damages compensation caused by natural disasters and accidents
(for goods and liability insurance) and payment of sums insured (for life insurance), when
certain events occur in the life of insured person. This is the function which represented the
basis for the appearance and development of insurance. Thus, the insurance has the role to
reconstruction of damaged or destroyed goods, the damage compensation for which the
insured persons are legally responsible, and granting some money in the case of some events
on human life or their integrity;
2) The function of damage prevention appeared and developed especially after the
Second World War and it is carried out through two main ways, namely:
a) through funding by the insurance companies of some prevention activities of
disaster and accidents (construction of flood protection dikes, forestation works, drainage,
irrigation, funding the educational programs for policyholders, etc.);
b) by setting of some insurance conditions in order to force the insured to a
permanent and preventive behavior (participation of policyholder for covering a part of the
loss, the insured person obligation to eliminate or mitigate the damage, etc.).
3) The financial function arises from the high period of time between the moment of
receipt the premiums and the moment of payment for damages or sums insured, an important
gap, especially in the case of life insurance. Thus, the insurance companies focus,
temporarily, important amounts, which will place them on the capital market (for opening the
deposit accounts at banks, providing the short-term loans or performing various operations
through resources mobilized), in order to obtain the additional revenue and increase business
Other prestigious economists from our country treat insurance as a component of
the financial system of our country and, therefore, they believe that the insurance fulfill the
general functions of finance, namely: the distribution and the control function.
1.The distribution function occurs in the distribution and redistribution process of
GDP and has two distinct phases, but strongly linked one each other: the formation of
insurance funds and the distribution of insurance funds. Insurance funds are formed in the
distribution process of GDP from insurance premiums received from individuals and legal
entities, covered by insurance. So, a first relationship is established between insurer and
insured person, generated by the collecting the insurance premiums. Secondly, the
distribution function of insurance is manifested in the distribution of insurance funds, formed
for covering the damages caused to insured by the risks insured, or payment of insured sums
for life insurance products.
Also, this function is manifested in relations with public budget on the line of funding
by insurance companies of some preventive actions of events, which generates the need of
insurance, as also through taxes paid to the public budget.
2. The control function is manifested both in using of insurance by the state as a
mean of detecting causes which generate damages to the economy, and to control the
formation and distribution of insured funds. The control function is carried out also in
relation with the way of collecting premiums and other income of the insurance company,

with the way of payment of compensation, risk prevention actions, obligations to the public
budget, etc.
The importance of insurance within a society comes from the social and economic
role of insurance.
The social role appears when, through the collected money, the role of insurance is to
pay the compensation those who are victims of unwanted events. To insure the finances
resources for widows and orphans after the untimely dissapearance of the head of the family,
to offer support for reconstruction of the house or buying a new one for those whom their
home was destroyed by a fire (for instance), to pay money to compensate the professional
losses those who wont be able to work after an accident, to insure to the sick or wounded
ones to be in medical attendence and have a better chance for recovering, all of these are
fundamental objectives of insurance.
Another aspect of the social role is its incidence to the companies survival. Allowing
the companies survival, victims of unwanted events (fire, a client bankruptcy, etc.) the
insurance saves the employees and their jobs, with all the implications, and contributes to the
reestablishment of the social and work relationships.
The economic role of insurance. In all countries, the insurance contributes to the
formation of Gross Domestic Product (GDP) through the added value of insurance
companies. In Romania, the contribution of insurance at formation of GDP is 1.29% of GDP,
at the level of the year 2013, known as insurance penetration degree. The insurance
participates also on the labor market with a significant number of jobs. The insurance
contributes to the financial market investments by capitalizing the money from the clients
accounts, through investment in bank deposits, treasury bills, stocks, bonds, lending the sums
insured to policyholder account for the life insurance, and other forms of investment.
Placement these amunts is done according to the possibilities of investments, the regulations
regarding the liquidity to be provided and the proportions of investments in various types of
assets. Insurance fulfills also a role of intermediary between policyholders, who hold
temporary resources available through insurance premium payments and beneficiaries of
damages (compensation) or sums insured. For the reinsurance operations (yielding the
reinsurance premiums or payments of insurance claims abroad), the insurance companies
influence the payments balance of the country. The insurance offers also the guarantee of
investment through that, any modern investment or development project requires the
participation of insurance, without it the contractor and, especially, the bank would not risk
the necessary funds for that project.

3. Classification of insurance
Knowing the different types of insurance from the whole market can be achieved on
the basis of the representative classification criteria.
1. By the manner of the legal insurance relationships on the contract, there are
compulsory and optional insurance.
Compulsory insurance arises from the economic and social interests of the entire
community and it is established when a large number of goods of individuals and legal
entities are threatened by certain risks, so that each holder of that good would have to support
the damage at the occurrence of insured events. In the most countries, as in Romania, too, the
compulsory insurance form is the motor third party liability insurance (MTPL).
In Romania, the MTPL was established by the Law no. 136/1995 regarding insurance
and reinsurance in Romania. The law requires individuals and legal entities owning the motor

vehicles, subject to registration in Romania, to insure the third party liability in cases of
damages caused by accidents.
Since over 70% of housing fund in Romania presents a high degree of wear, and our
country is located in a region liable to earthquakes and floods, to which is added the lack of
education of the population in terms of life and non-life insurance, at compulsory insurance
category was included, after long discussions and proposals of law, the home insurance
belonging to individuals for natural disasters (earthquakes, landslides or floods)58.
In other countries, there are also other types of compulsory insurance, such as
professional liability insurance.
The optional insurance is based on agreement between the insurer and the insured
person, materialized into the insurance contract, which establishes the rights and obligations
of the parties and all other elements of insurance (risks, premiums, indemnity payments, etc.).
Compulsory insurance presents a series of features, which distinguish it from the
optional insurance, as follows:
a. The compulsory insurance covers all of the same type of goods belonging to
individuals or legal entities, so it is a total insurance. Being total, the compulsory insurance
excludes the possibility of risk selection, allowing their wide dispersal. As a result, premiums
are lower than those established through voluntary insurance. In contrast to compulsory
insurance, voluntary insurance is not total, it includes only a part of the objects (goods) of the
same kind.
b. The indemnity payments are established by law, such as insurance norms, which
means that the compulsory insurance is a standardized insurance. Insurance norms
(maximum limits) are set according to the value of goods of the same kind.
In Romania, starting with 2007, the compensation limits for MTPL set by insurance
companies were established through norms at a minimum level, insurers being free to
establish the maximum liability, according to their technical and financial results, and their
Compensation limits for MTPL, since 2012, maintained for 2013, were at least EUR 1
million for property damage and EUR 5 million for personal injury or death, regardless the
number of victims.
For compulsory home insurance, the maximum sum insured is of EUR 20,000 for
houses built from durable material (concrete, metal, wood, fired brick) and EUR 10,000 for
houses built from less resistant material (unburnt brick).
For optional insurance, the insured amount is not determined on the basis of norms,
but according to the proposal of insured person, having as maximum limit the real value of
property at the time of underwriting of insurance. For life insurance, there are established a
certain amount through the insurance contract.
c. In contrast with the voluntary insurance, where the insured amount is reduced each
time with the compensation paid before in the same period of the contract, for compulsory
insurance, the payment of damages does not take into account the previous
compensations. We can say that, the insured person will be compensated at each occurrence
of the insured risk, the only condition being that, the damage to be within the limits set by the
2. Considering the field of insurance, there are: insurance for goods (assets); third
party liability insurance; and life insurance.
For good insurance, the insured object consists of certain goods: a building, motor
vehicles, ships, aircraft, crop, animals, etc, which are exposed to some risks provoking
Law no. 260/2008 concerning compulsory home insurance against earthquakes, landslides or floods, published in the
Official Gazette, Part I, no. 757 of 10/11/2008, set to come into force on 10 March 2009, postponed until 1 July 2010.

In the case of third party liability insurance, called also the liability insurance, the
object of insurance consists of a patrimonial value equal to the compensation that insured
person would pay as a result of damage caused to a third party, being responsible for,
according to the law.
The good insurance and third party liability insurance are insurances against damages,
called also damage insurance (or non-life insurance), having the purpose of compensation
for damage threatening the insured goods. Consequently, these have a character of indemnity,
named in the language of insurance, indemnitar character.
Life insurance has as object the individual, the life and his integrity, subject to the
threat of some events, which can cause illness, disability or death. For this insurance, the
insured person or the beneficiary of insurance is entitled to receive the indemnity payment,
without any connection to the damage suffered. Life insurance has a neindemnitar character,
representing a precaution measure, or/and capitalization of money.
Although this criterion is most often referred to, when referring at categories of
insurance, it is not exhaustive, because there is another category of insurance, the insurance
financial risks (insurance risk of default by the borrowers in case of insolvency of these,
found in the classes named "credit insurance and guarantee (suretyship) insurance"), which is
not covered clearly into any of the categories above. However, most insurance specialists
include the insurance financial risks into the category of goods, while others treat it
separately, along with the three basic categories, thus, considering the insurance field criteria,
there are: insurance of goods, liability insurance, life insurance, and financial risk
3. According to the subjects of insurance relationship, there are direct insurance
and indirect insurance (reinsurance).
Specific to direct insurance is that the insurance relationships are established directly
between the insurer and the insured person, under the insurance contract or based on the law.
The direct insurance is also the co-insurance, where there are more insurer companies and
one insured person.
In contrast to the direct insurance, reinsurance (or indirect insurance) appears as a
relationship established every time between two insurance companies, one of them acts as
reassured (reinsured), and the other as reinsurer. Reinsurance is based on the reinsurance
contract, by which the reinsurer gives to reinsured, a part of its liability under its contract
taken in insurance. Reinsurer takes the responsibility to participate at covering the damages,
in the limits agreed in the contract of reinsurance.
4. After the insured risk, there are insurances for the following risks:
- fire, lightning, explosions, earthquakes, hail, etc., known as risks of natural
- slip, collision, accident;
- various animal diseases and accidents of animals, risks of agricultural crops, known
as agricultural insurance;
- events that may occur in the life of individuals: sickness, disability, death and
- damage to the third parties: civil liability cases.
Over the time, companies and individuals looking for discovering and applying
various means of protection against damage risks, that their business, life and goods were
exposed. Nowadays, there are various of risks, because of continuous improvement of
techniques and technologies, the creating of urban areas, the increasing of number of

5. In the international statistical yearbooks, insurance are classified in: life
insurance and non-life insurance. The differences between the two types of insurance are
summarized below.

Life Insurance and non-life insurance
Table no. 1.1.
Life Insurance Non-life Insurance
- covers, primarily, the risk of death; - the insured risks are various, and the risk of death is
covered only for the civil liability towards third parties;

- the death, as insured risk, is a certain -the occurence of the insured risk is uncertain,
event, but its moment is uncertain; probable, possible;

- the insurance contract mandatory - the insurance contract mandatory presents two
presents three parts: the insurer, the parts: the insurer and the insured, only sometimes
insured and the beneficiary, sometimes the beneficiary, which receives the damage
the policyholders (contractor); compensations;
-there are not indemnity -there are indemnity contracts for paying of
(compensation) contracts or damages: compensation damages: indemnity character;
neindemnity character;
-the beneficiary of the policy is, - the beneficiary of the compensation is, usually,
usually, a third party; the same person with the insured party;
- determining of the sum insured (the - determining of the sum insured (the maximum
amount of insurance) takes into amount covered by insurance) takes into account
account the need for protection and the real value of the good (asset, property) at the
financial possibilities of the insured time of risk;
-at the time of the insured risk -the amount paid by insurer to the insured party, at
occurence, the amount paid by insurer the time of the insured risk occurence, is called the
to the insured party is called the sum compensation (damage compensation or claim),
insured (indemnity); and it is up to the sum insured, established into the
insurance contract;
-the insurer calculates mathematical - the insurer calculates technical reserves, needed
reserves (the life insurance fund) from for payments of compensations (claims);
which there are paid the sums insured
- the insurance period is relatively -the insurance period is usually up to 12 months,
high, for terms of 5-20 years (or even with the possibility of renewal of the contract.

In Romania, according to the Law 32/2000, insurance classification includes two

categories of insurance: life insurance and general insurance (good insurance, liability
insurance and life insurance, other than the people insurance, such as health insurance and
According to the former Insurance Supervisory Commission regulations (replaced
since 2013 with the Financial Supervisory Authority), the general (non-life) insurance in
Romania includes 18 classes of insurance, numbered as follows:
Class I. Accident and sickness insurance (including labor accidents and professional
Class II. Health insurance;
Class III. Insurance for land vehicles (other than railway rolling stock);
Class IV. Insurance for railway rolling stock;
Class V. Aircraft insurance;
Class VI. Insurance for ships (sea, lake, river and canal vessels)

Class VII. Insurance of goods in transit;
Class VIII. Insurance against fire and other natural forces;
Class IX. Other insurance against damage to property;
Class X. Motor liability insurance (motor third party liability insurance MTPL, and
green paper insurance);
Class XI. Aircraft liability insurance;
Class XII. Liability insurance for ships (sea, lake, river and canal vessels);
Class XIII. General liability insurance;
Class XIV. Credit insurance;
Class XV. Suretyship (guarantee) insurance;
Class XVI. Insurance against financial loss;
Class XVII. Insurance of legal expenses;
Class XVIII. Touring and travel assistance insurance.
The life insurance presents the following components of insurance classes:
Class I - Life assurance, annuities and supplemental life assurance;
Class II - Marriage insurance, birth insurance;
Class III Unit-linked life assurance and annuities;
Class IV - Permanent health insurance.
According to the European legislation in the field, adopted also by our country, to these
four classes were added another two additional classes, as policy attached to the life
insurance, representing classes I and II of the general (non-life) insurance, as follows:
Class B1 Accident and sickness insurance;
Class B2 Health insurance.
Thus, the new regulations allow to an authorized company for practicing life insurance to
subscribe also the insurance for the risks related to the classes B1 and B2, without being
required to have an authorization for the non-life insurance.
6. After the territorial scale, the insurance can be divided into internal insurance
and external insurance.
The internal insurances are characterized by the following: the contracting parties
(insured, insurer, beneficiary and the contractor), insured objects and insured risks exist or are
produced within the same country. Also, the insurance premiums, sums insured and
compensation or indemnities are payable in the currency of the state in which the property is
located or the risks are occurring.
The external insurances are characterized by that: either the contracting parties, the
object of insurance or the insured risks are located in another state. Characteristic of these
insurances is that the parties may determine and pay the insurance premium in foreign
currency. In the category of external insurances may be included: the insurance of goods
during the international transport, the see and river ships insurance for international routes,
the international civil liability insurance of car accidents in another country (Green Card
insurance) and others.

4. Insurance on the international markets at the worldwide level

International insurance markets are characterized by a high degree of heterogeneity,
as a result of the diversity of events that cause the damage, and of the activities that may
affect them. Each insurance market is characterized by the preponderance of certain
categories of insurance, the existence of certain insurance and reinsurance intermediaries,
norms and specific rules, larger coverage or more extended exclusions.

The most relevant indicators for the insurance market, used in the international
statistics, are:
the weight of the insurance penetration within GDP (insurance penetration
the medium value of the insurance money paid by a person along one year
insurance density.
The Insurance Market on the international level presented fluctuating developments from a
period of time to another. Thus, years ago, the American market generated more than half of the total
received insurance premiums in the whole world, while, at present, it is under the level of the
European one. Currently, with a 35% share of the global market, the European insurance industry is
the largest in the world, followed by North America (30%), and Asia (28%), as shown in Figure no. 1.

Fig. no. 1. The distribution across the world of insurance premiums, in 2013
Source: Sigma magazine, No. 3/2014, World insurance in 2013 steering towards
recovery, Swiss Re
Europe covers Western, Central and Eastern Europe and therefore includes Russia and
Ukraine (which together account for 1% of global premiums)

Thus, at the end of the year 2013, the insurance market was dominated by a few
economically developed areas, such as: Western Europe, with almost 32%; North America
with a market share of approx. 29% of the entire insurance world market; Japan with the new
industrialized countries (Hong Kong, Singapore, South Korea, Taiwan, Israel), 20% market
share, holding together 81% of the insurance world market.
The insurance sector is the largest institutional investor in the European Union, with
over 8500bn euros of assets under management invested in the economy in 2013. This
represents 60% of the GDP of the EU.
Developments in the investment portfolio of European insurers are mainly driven by
the life business, since the investment holdings of the life insurance industry account for
more than 80% of the total. The UK, France and Germany jointly account for over 60% of all
European insurers investments. In 2012 the largest components of European insurers
investment portfolio were debt securities and other fixed income assets (42%), followed by
shares and other variable-yield securities (31%). Loans represented 11% of the total.

Analyzing their structure, insurance will be divided into two classes of insurance - life
insurance and non-life insurance, the larger share of life insurance as opposed to the non-life
insurance should be noted. European life premiums accounted for 36% of 2013 global life
premiums, and the European non-life premiums accounted for 34% of 2013 global non-life
premiums. Total European gross written premiums increased by 2.7% in 2013, life premiums
grew by 4.7%, property, casualty (P&C) and accident premiums marginally reduced by 0.1%,
while the health insurance premiums grew by 4.9% (Insurance Europe, European Insurance -
Key Facts, August 2014, page 10,
The area with the highest contribution of domestic life insurance market is Japan,
having established itself as a distinct region, with 80%, Asia, with a proportion of life
insurance on the entire domestic market of 71%. Countries in Europe have a proportion of
life insurance of an average of 57%, being on the 4th place from this point of view, after
Japan, Asia and Africa.
The economy of each country seeks the share of life insurance to be higher than of
non-life insurance, as they participate in the loan offer in the financial market by bringing
reserves in the form of investment in bank deposits, treasury bills, stocks, bonds, giving loans
to insured persons on behalf of the insured amounts of life insurance and other forms of
investment. The placement of these reserves is made based on the possibilities of building
upon, on the legal provisions regarding the level of cash flow and on the proportions of
investments in various types of assets.
As regards the insurance participation in the development of the Gross Domestic
Product, this is rather significant in Japan, with more than 11% of the GDP, while in areas
such as North America, Europe, it is around 8%. The smallest of the insurance participation
in the creation of per capita GDP is in Latin America, with 3%. At the world level, the share
of gross premiums received insurance in the GDP is 6.5%.
During 2012, at the world level, an inhabitant has paid on average 656 USD for the
purchase of insurance. The highest amounts for insurance have been paid by the inhabitants
of Japan, with more than 5,000 USD/per capita, North America with about $4,000 per capita.
The European insurance market records rapid change and consolidation, in particular
as a result of the plans and strategies developed by the European Union, aimed at extending
transactions with insurance. Differences between organizational and national cultures have
prevented the creation of the necessary financial mechanisms. The best results have been
obtained on the life insurance market that has promoted rendering work more effective by
reducing costs. As a result, regional globalization creates favorable conditions for Europe,
reduces the relative share of the United States, but fortifies particularly the Japanese pole.
Thus, the main indicators that characterize the insurance market on European level,
i.e. received gross premiums, the insurance density and the degree of penetration shall be as
received gross premiums - the United Kingdom, France, and Germany are on
the first three positions;
according to the degree of density, an average of 1887 euro per capita was
spent on insurance in Europe in 2013, compared to 1541 euro, ten years earlier (in nominal
terms). Of the per capita spent in 2013, 1124 euro was on life insurance, 564 euro on property
and causality (P&C), and 199 euro on health insurance;
the degree of insurance penetration in GDP, the top three places are the
Netherlands (more than 12% gross premiums in the GDP), the UK (around 12% of the GDP),
and France (more than 10% gross premiums in the GDP). In 2013, the penetration (gross
written premiums as a percentage of GDP) increased by 0.1 of a percentage point, to 7.7%,
varying from 1.3% in Romania, to 13.0% in the Netherlands.

Fig. no. 2. European insurance premiums by country, 2013
Source: Insurance Europe, European Insurance - Key Facts, August 2014, p. 11,

Insurers sell their products either directly or through a variety of other distribution
channels, of which the most familiar are brokers, agents and bancassurance. The diversity of
distribution channels benefits consumers, whose cultures, needs and preferences vary across
markets. It ensures that consumers have better access to insurance products and stimulates
competition in the price and quality of products between providers and distributors.
Bancassurance has developed in parallel with the life insurance business over the last
decade and is today the main life distribution channel in many European countries. Agents
and brokers also play an important role in the distribution of life policies. However, direct
sales through employees or distance-selling are less developed in life than in non-life
insurance. The distribution of nonlife policies in Europe is mainly carried out through
intermediaries (agents and to a lesser extent brokers) and direct sales by employees and
distance-selling (Insurance Europe, European Insurance - Key Facts, August 2014, p. 27,
Romania has low enough indicator results that characterize the insurance market,
being at the bottom of the list in Europe, before Turkey, Serbia and Ukraine - considering the
degree of density, and Liechtenstein, Lithuania and Turkey taking into account the degree
of penetration.
At the end of 2013, 38 companies were authorized to carry out the insurance-
reinsurance business (Financial Supervisory Authority, 2013) on the insurance market in
Romania, of which: 20 companies to carry out the activity of general insurance (non-life); 10
companies to carry out the activity of life insurance; 8 companies for both categories of
insurance. As such, at the end of the year 2013, in the field of life assurance there were
recorded 18 insurance companies, and in that of general insurance (non-life), 28 companies.
In Romania, for the period 2000-2013, the share of life insurance on the entire market
has had a swinging evolution, increasing from 16% to 25% for the period 2000-2002, then

dropping to 22% up to the year 2004, a slight increase in 2005, while in 2013 it came to
represent 18 percent of the total insurance market (as it is shown in Figure 3).

60,00 84,00 79 75 77 78 76,5 80 79,81 79 82 80 77,8 78,2 82
Non-Life Insurance
Life Insurance
16,00 21 25 23 22 23,5 20 20,19 21 18 20 22,2 21,8 18
2000 2002 2004 2006 2008 2010 2012

Figure no. 3. The structure of insurance in Romania,

Source: Selected data from Annual Reports of Insurance Supervisory Commission (ISC) and
Financial Supervisory Authority, for the year 2013

In the countries of the European Union, the highest level of gross insurance premiums
is held by the life insurance business to the detriment of that of non-life, i.e. almost 61% of
the total insurance market. For the economy of each country, it is desirable for the share of
life insurance to be higher than that of the non-life, since they will participate in the offer of
the loan agreement on the financial market by leveraging reservations which constitute them
in the form of their heavily investing in bank deposits, treasury bills, stocks and shares,
bonds, loans to be granted to the account holders in exchange for the amounts provided to life
insurance and other forms of investment. Placing such reserves shall be made on the basis of
the fructifying possibilities, of the legal provisions concerning the liquidity to be insured, and
investment proportions in terms of the various types of assets.
The degree of insurance penetration - expressed as the ratio of gross premiums
subscribed and gross domestic product - has reached the level of 1.29% at the end of the year
2013, in slight decrease compared with the previous year, when it recorded the level of 1.4%.
In the field of life insurance, the degree of insurance penetration was 0.25 percent in 2013,
and for general insurance (non-life), 1.13%.
The insurance density in Romania, at the end of the year 2013, was 91.83 euro per
capita. The life insurance sector has been less affected by the economic crisis than the general
insurance, the population facing a decline in the living standards, an increase in
unemployment, and, ultimately, a decrease in trust of the insurance products.

5. The mandatory elements of the insurance contract

The insurance contract has the following mandatory elements: the interest of
insurance; the object and risk insured; the sum insured and the insurance premium; the
damage and insurance compensation.

5.1. The interest of insurance

Insurable interest consists of the existence of a particular relationship of the insured

party with the object insured, with concrete forms of manifestation depending on the specific
insurance: insurance of goods, liability and life insurance.

For the insurance of goods, the interest of insurance is given by the existence of a
lawful patrimonial relationship with the insured object. Usually, the interest in insurance is
held by the owner of the property, the usufructuary, the creditor of real guarantees, persons
from the owner's family, etc. Cessation of the interest triggers the ending the insurance
relantionship for that person.
For the liability insurance, insurable interest consists in avoiding the decreasing of
the insured property due to his civil liability towards third parties injured by illegal acts.
For life insurance, the insurable interest (the damage valued in cash) is immaterial,
since the insurance indemnity is payable regardless of the existence of damage. Thus, the
insured or beneficiary of insurance must not prove any interest to underwrite the insurance
contract, because the interest accompanies the event related to a person: death, accidents or
disability, or reaching a certain age (at retirement, the age for starting the higher education for
children, etc.).
To conclude, a person has an insurable interest if an event may cause financial loss or
injury to a person, and insurable interest can be defined as exposure to financial loss.

5.2. The object and the risk insured

The object of insurance means what is covered by insurance: certain goods (assets),
damages caused by the insured as a result of its liabilities to a third party (the patrimony of
which he would pay), or an attribute of the person (life, labor capacity, etc.). The object of
insurance represents the patrimonial (property or non-patrimonial (non-property) values
exposed at a risk.
The risk represents the essential element of an insurance contract, without the existence
of insurance would be impossible.
The risk covered by insurance represents the uncertain phenomenon or event, possibly
and future, which may affect the property, assets, life, health or physical integrity of a person.
Risk, once produced, undertakes the insurer company for paying the compensation or the
indemnity to the insured party or the beneficiary. The insured risk represents the probability
of occurrence of future events, which may cause loss or material damage to the property of a
Therefore, the notion of risk insured has several meanings: a) the probability of the
event occurrence for that insurance; b) the possibility of partial or total damage of goods, due
to the possible occurrence of phenomena or events into the lives of people; c) the size of
responsibility taken by the insurer to pay compensation or the indemnity to the insured party.
To qualify an event into the category of insurable risks, it is necessary to fulfill certain
its occurence to be possible, because the insurance would not make sense if
there would not be a threat to produce a certain event or phenomenon;
to have an accidentally character, meaning its occurrence to be uncertain,
both as time, and as intensity of its action;
the phenomenon occurence do not depend on the will of the insured party or
the beneficiary of insurance, whereas, in this case, they shall be liable for his
actions, penal or contraventional;
certain risks can not represent the subject of a insurance, for reasons of public
policy, the risk must have a licit character.
Therefore, from point of view of their insurable character, the risks are: insurable
risks; and uninsurable risks (excluded).
Insurable risks are those which insurers cover them through the insurance contract,
offering his protection. Usually, insurable risks are divided into general risks (fire, explosion,

shipwreck, aircraft crash, volcanic eruption, etc.), which are included in the general
conditions of insurance; and special risks (theft, drought, corruption, burglary, mold), which
are not included in the general conditions, but can be covered at the request of the insured
party, paying an additional premium.
Uninsurable risks (excluded) are those risks which insurers do not accept for their
protection: those events whose occurrence is uncertain or is approaching to certainty
(evaporation of liquids, natural death of livestock, physical wear), the events produced by the
insured party (improper packaging of goods insured, the willful misconduct of the insured),
and the large-scale damage that may affect the insurer's financial situation (war, strikes,
revolution, atomic explosions, etc.).
Each insurance company is free to group its risks as it considers to be optimal to
make, both for insured party, and for it. Also, including of a risk into insurable risk,
uninsured or excluded, does not have a permanent character, being possible to move from one
category to another, depending on the insurer's underwriting policy or on the size of the
possible damage. For example, on the insurance market in the UK, the risk of terrorism was
included a long time into the category of insurable risks, but from 1993, due to its increased
frequency of manifestation, it was dropped by the insurance, becoming a fundamental risk,
covered by the British government. Association with the government support solutions, for
risk of terrorism, have been proposed in other countries, too, such as: Spain, South Africa,
Israel, France.

5.3. The sum insured and the insurance premium

The sum insured is the part from the insurance amount for which the insurer company
assumes its liability, for the whole period of insurance agreement, in case of the event
occurrence. The indemnity represents the maximum limit of the insurer liability and it is one
of the elements which underlies to the calculation of the insurance premium.
For the goods (property, assets) insurance, the sum insured may not exceed the real
value of that good at the time of insurance (the insurance value) and it is determined by the
parties into the insurance contract. Through the insurance mechanism, it is not allowed the
greater compensation than the real (actual) value of the good (called over-insurance), because
it can attract the interest of of the insured policyholder for its occurrence. Instead, the sum
insured may be lower than the real value of the good, the procedure called under-insurance.
In the case of liability insurance, since there is no an insurance value, the sum insured is
determined by an agreement between the insured and the insurer, and in the case of
compulsory insurance, the insured amount is set by the law.
In the case of life insurance, the insured amount is not limited. As regards the human
life and health, it can not be established a minimum or a maximum value. The notion of over-
insurance and under-insurance are not applicable to life insurance, and the insured amount is
determined by the agreement between the parties, as they choose. In the case of life
insurance, the insurance contract has a neindemnity character, meaning, in exchange of
premiums, the insurer does not undertake to cover the damage, but to pay the sum insured at
the occuring of the insured risk, because the human life and health are not assessed in money.

The premium is the amount which the insured party is obligated under the contract of
insurance, to pay to the insurer, in exchange for its guarantee. The insurance premiums
collected are used to constitute the insurance fund, the reserve funds to finance the actions to
prevent and combat the damage-producing events and to cover the expenses of insurance
administration. Thus, the insurance premium is the price paid by the insured party to the
insurer in order to take the risks.

Among the factors that influence the size of the insurance premium are: the nature of
the good insured; the extent of risks; the number and the type of risks; risk intensity; the
possible size of damages; the sum insured; the term of the contract; the deductible amount
(supported by the insured party); the geographic extent of coverage; loss history over a
number of years before; the way of payment of premium; the business size.
Usually, the insurance premiums are determined by multiplying the sum insured with the
quota (share percentage) of insurance premium, determined on the basis of tables insurer, ie:

Insurance premium= Sum insured x Quota of insurance premium (%)

The premium rates are established on the statistical data, using the methods and
principles of the actuarial calculation, which revolutionized the practice of insurance. For
example, for life insurance, the premium rates are established according to the age of the
insured party, the gender, and the duration of the contract. For property insurance, the
premium rates are different, depending on the type of the property insured, by the frequency
and intensity of the insured risks arising from the statistical data. Variable intensity of the risk
is reflected properly in the premium level. Thus, in case of a variable risk, during the
contract, the premium may change in the same proportion.
Gross premium (tariff) is the amount that the insured pays and it is composed of two
elements: the net premium (pure, theoretical or basic quota) and the supplement or the
premium addition.

Gross premium = net premium + supplement or the premium addition

The net premium is used for formation the fund required for payment of damages or
sums insured. Net premium calculation takes into account the probability of the risk and the
intensity or frequency of the event. The probability of risk is determined on statistical
calculations based on the application of Law of large numbers, which demonstrates that, for a
large number of cases, the probability of a particular phenomenon can be calculated with
greater approximation, unlike a few cases, for which the event can not be predicted with the
same approximate, due to the errors that can occur in the absence of outlining of some trends,
as close to reality. Thus, the premium is better determined, as there were several cases on
which it was determined before. The intensity of risk occurrence are also reflected in the
premium level, for the risks whose intensity is high, the higher is the premium, and the vice
versa. In the case of variable risks, during the contract, the premium may change in the same
The supplement or the premium addition covers the general expenses of acquisition and
management of the insurer, and obtaining a profit. These costs vary depending on the types of
insurance products and on distribution ways.
Taking into account that, the amount of the insurance premiums depends on the period
of insurance, it is evident another element of insurance, namely, the duration of insurance.
The duration of insurance represents the period on which there is valid the relationship
between the insured and the insurer, and it also depends on the nature of insurance. There
may be established insurance for a determined period (one year or less, for goods and liability
insurance, or over 20 years, for life insurance), or in order to run a process (eg during
transport freight - cargo).

5.4. The damage and compensation (claim)

The damage or prejudice (injure) represents the loss expressed in money, suffered by
an insured good (asset, property, contents of property, equipment, vehicles, etc.) due to the
occurrence of an insured risk.
The notion of damage or prejudice is applicable only to goods and liability insurance,
also known as damage (claims) insurance. In the case of life insurance, the damage or loss
does not make sense because the sum insured (the insured amount) is paid regardless of this,
and it has not a compensation character, but a neindemnitar one.
Since damage can be equal or less than the value of the good insured, the concepts of
total loss and partial loss are met. The total loss is met in the situation when the good has
been completely destroyed. The partial loss is for less value than the value of the good
The compensation insurance represents the amount of money of which the insurer pays
to the insured person, in order to restore the damaged good by an insured risk or to
compensate a prejudice for the liability insurance. In the case of life insurance, the term of
compensation insurance is not met, but the insurance indemnity or payment of the sum
The compensation insurance shall not exceed the sum insured, and it is lower or uo to
the value of the damage, according to the policy of the insurer (principles or rules).
In the practice of the good insurance, there are applied three principles (rules) for the
compensation of damages:
the principle of proportional liability;
the principle of the first risk;
the principle of limited liability.
The principle of proportional liability consists in that, the compensation represents the
same part from damage, of which the sum insured represents compared to the value of
insurance. According to this principle, the compensation is calculated by the formula:
C D ,
C represents the compensation (or claim);
D- the damage;
S- the sum insured;
V- the value of insurance.
For instance, a good with a value of 500 m. u. (monetary units) is insured for the value
of 400 m.u. We suppose that, the good is partially destroyed, for the value of 300 m.u.
Regarding this principle, the compensation is equal to 240 m.u., calculated by the formula:
S 400
C D 300 240 m.u.
V 500
If the sum insured is equal to the value of insurance (real value of the good insured), the
compensation is equal with the damage.
The principle of the first risk is more often applied to the goods which have a more
decreased risks occurrence of total loss (such us, buildings insurance). Regarding this
principle, the insurer bears the damage entirely, in the limits of the sum insured, regardless of
the real value of the good insured.
Thus, the amount of the compensation calculated on the basis of this principle, from the
previous example, is 300 m.u. If the damage would have been of 500 m.u., then, the
compensation would have been of 400 m.u., the maxim amount of the sum insured.

If we compare the values of the compensations calculated on the basis of the two above
principles, we can observe that, these values are different when the sum insured is lower than
the value of insurance, and the damage is partial.
We can notice that, the first principle risk is more advantageous for the insured persons
than the proportional liability one, because the damages are covered in a greater extent. As a
rule, this compensation involves a higher collection from the insured persons of the premiums
than in the case of the principle of proportional liability.
The principle of limited liability consists of that, the compensation is paid only if the
damage caused by the insured risk exceeds a certain limit, previously determined. Therefore,
according to this principle, a part of the damage is on responsibility of the insured person, and
the level of this is written in the insurance agreement.
The part from the value of damage which is on the responsibility of the insured person is
called deductible. The deductible could be: the simple deductible (or attained) and the
absolute deductible.
In the case of simple deductible (or attained), the insurer fully covers the damage, if it is
higher than the limit established through the contract. The absolute deductible is subtracted
(deducted) from any damage, no matter the amount of damages (up to the amount insured).
If in the previous example, for the sum insured of 400 m.u., the insurance agreement
states a deductible of 5% of the sum insured (20 m.u.), then, for the damage of 300 m.u., the
compensation level would have been:
- in the case of simple deductible, the compensation is 300 m.u., since the damage value
exceeds the value of deductible (it was attained by the damage), and insured person receives
entirely the damage value;
- in the case of absolute deductible, the compensation represents 280 m.u., meaning the
difference between the value of damage and the level of deductible, which is subtracted from
the damage, at every occurrence of the insured event.
Regardless of the type of deductible, the insurer does not pay compensation, if the value
of damage is up to the level of deductible.
For instance, if the level of damage would have been 15 m.u., for both situations, the
insurer would have not pay the compensation.
Applying the deductible component in the insurance agreement leads to avoidance of
expenditures regarding the assessment, the establishing of damages and compensation for
slight damages, that will situate them below the deductible level, and, at the same time,
causes the insured person to exercise more care in terms of maintenance of goods insured.
Applying this principle of compensation, involves the reduction of the insurance premium, at
the time of concluding the insurance contract.
Each of these principles is reflected in practice, depending on the type of insurance
contract. Thus, the principle of proportional liability is applied to cargo for international
transport insurance, insurance of crops or animals. The first risk principle is applicabil to
buildings insurance, car insurance, etc., and the principle of limited liability is commonly
applied in practice, either at the option of the insured (involving insurance premium
reduction), or commonly, included in the terms of the insurance contract.

6. Underwriting the insurance agreement

The proper underwriting of the insurance agreement is preceded by several steps, from
which it determines the final terms and conditions of this.
1.Drawing the application form for insurance (the statement or the demand for
insurance) is a step in which the insured person expresses his/her desire to underwrite the
insurance and to provide information needed for the risk assessment.

By this document, the insurer identifies the insured person, and the insured shows the
interest for the insurance contract. Filling the insurance application includes information on
the subject and risk covered by insurance.
The application form for insurance includes data relating, primarily, to the following:
identification of the insured person - name, personal or business address, scope of activity
(for companies); period of insurance required; data regarding the property or any good
insured; estimation of the sum insured; deductible amount; the beneficiary of insurance;
conditions of insurance required; health, age, medical history for life insurance; working
environment - for accident insurance, and other factors specific to each type of insurance
Based on these information, the insurer shall evaluate the risk for the proper assessment
of insurance premium. Written answers of the insured allow to the insurer to make an opinion
regarding the risk and to establish the corresponding premium.
For the most types of the life insurance, for some external insurance or good insurance,
the application form for insurance shall be written separately and previously of the insurance
agreement, being necessary a specific period of time for the risk assessment. For other types
of insurance, the application form is written simultaneously with the insurance contract. The
application form, as unilateral act of will, does not take legal effects, specific to insurance,
only after the acceptance by the insurer. Risk-taking by the insurer is made upon the signing
of the contract.
2. The assessment of the risk level.
The risk represents for insurer a great importance, since, according to this element, it is
decided if the insurance protection is accepted or not, and the dimension of the premium.
This operation is called underwriting (subscription).
The level of risk can be assessed in two stages:
a) immediately after receiving the application form for insurance, based on the data
filled by the applicant in order to present an insurance offer, if that was required;
b) after an inspection of risk by the insured.
The assessment of the level of risk is intended to establish:
if the risks from insured party, required for including in insurance, are in
acceptable limits in order to takeover by the insurer;
the adjustment coefficients of the premiums, specific to each type of insurance, in
order to calculate the value of premium;
possible compulsory measures or recommendations for insured person in
connection with the underwriting of the insurance policy (agreement), for
preventing and mitigating the risks.
The risk inspection can be performed also during the period of insurance, in order to
verify the evolution of the level of risk.
Given that, the insurers often take risks for goods which are in areas far away from them,
being not possible a risk assessment at the place of them, the good faith, as a basic principle
of insurance, must be unanimous respected. The evaluation is based only on information
provided by the insured and, therefore, he must give complete and accurate statements.
Otherwise, the insurer reserves his right to modify, cancel the contract or reject the payment
of the indemnity.
3. The moment of underwriting the insurance contract is considered along with the
payment of the insurance premium (at least, a part of it) and issue of the insurance agreement,
and it is available exclusively for goods and risks specified into the policy. The agreement
may take the form of insurance policy, for life insurance and some types of goods insurance,
or certificate of insurance, for goods or liability insurance. In practice, the term of insurance
policy is generic, and, thus, the most commonly used.

There are two distinct moments related to insurance contract, ie: the actual underwriting
of the contract and the entry into force of it, after of its drawing up. An insurance contract
may be perfected with the entry into force at a specific date (later). Also, the entry into force
of insurance may not coincide with the beginning of the insurer's liability. For example, in the
case of life insurance, if there are any doubts on the health of the insured or if the statements
of the insured's health do not confirm a normal situation, it is follow the medical
examinations in order to obtain an accurate medical assessment. The applicant, paying the
insurance premium, becomes the insured person, but only for the risk of death by accident
and not for reasons involving his health. Under the terms of insurance, risk-taking is done
only after a proper evaluation of risk, respectively in the moment of issue the insurance

7. The rights and obligations of the insured and insurer

Being a synallagmatic contract, the insurance agreement requires correlative rights and
obligations between parties, which can be bounded in two periods:
until the occurrence of the risk insured;
after the occurrence of the risk insured.
A. The rights and obligations for insured person
The rights and obligations of the insured person until the occurrence of the risk
The main rights of the insured until the occurrence of the risk insured are:
- the right to modify the contract, such as the possibility to change the beneficiary
of insurance or payment method of insurance premiums, when they are paid in
- the right to submit for supplementary insurance, such as the increasing of the sum
insured, established initially;
- the right of redemption in case of life insurance, for which the insured may
request the cessation of the agreement, by paying a surrender refund, which is
usually up to 95% of the premium reserve, constituted until this time.
The obligations of insured until the occurrence of the risk insured are:
- the payment of premiums. Usually, the person underwriting the contract is the
same with the insured person and he has the obligation of premium payment;
- the obligation to inform the insurer on changing the circumstances which
aggravate the risk;
- the maintenance obligation of the goods insured in proper conditions, according
with the legal dispositions. In case of default of this obligations, the insurer may
terminate the insurance or, at the moment of risk insured appearance, he has the
right to refuse the payment of compensation if, from this reason, he could not
determine the cause and the extent of damage occurrence or to reduce the
compensation in the case of increased damage;
- notifying the insurer about all circumstances which aggravate the risk. If, during
performing of the contract, new circumstances arise which modify the initial risk,
the insured must notify the insurer about that. Worsening the risk can determine
appropriate modifications on the amount of the premium, or, in the extreme case,
the impossibility to continue the contract. This requirement allows the adaptation of
the contract to the new situation, the insurer having the right to stop the contract.
Aggravation the risk may occur, for example, as a result of moving the goods,
insured against the theft risk, in other place than the places specified in the contract,
less risky (positive effect) or abstention of the insured person in taking appropriate

measures, within his obligation to maintain the property and to prevent the insured
The rights and obligations of the insured person after the occurrence of the risk
The main right of the insured person in this stage is to receive the indemnity (or claim).
The obligations of the insured person are:
- the effectively countering of the events for limiting the damages and saving the
goods insured, preservation and protection of the remained goods to prevent further
- notifying the insurer, within the deadlines specified into the insurance conditions,
regarding the occurrence of the insured event;
- attending at the establishment of the insured case which was emerged and the
- providing the documents and data related to the insured event;
- full allocation for supporting the establishment and assessing the damages.
We conclude that, the insured persons have a lot of rights and obligations, which vary
according to the policy and the quality of insured person.
B. As with the insured person, the rights and obligations for insurer are bounded on
the two distinct periods: the period until the occurrence the risk, and the period after the
occurrence the risk.
The rights and obligations of the insurer until the occurrence of the risk insured.
During the execution of the contract, the insurer has, in particular, rights, so that to each
obligation of the insured person corresponds a right of the insurer, as follows:
- the right to verify the existence of the good insured and the way in which it is
- the right to apply legal sanctions when the insured infringed its obligations
regarding the maintenance, use and protection of the goods insured.
Until the occurrence of the insured goods, the insurer has some obligations, such us:
- the obligation to issue, upon request, the duplicate of the insurance agreement, if
insured person lost the original one;
- the obligation to issue, upon request, the certificates of insurance confirmation, in
the case of liability insurance, for the carrier towards passengers for their baggage
and cargo carried, and to third parties liabilities, indicating the sums insured.
The rights and obligations of the insurer after the occurrence of the risk insured.
The main obligation of the insured consists of payment the indemnity to the insured
person. In order to pay the indemnity, the insurer has to establish the facts from which the
insured right to receive the compensation results and the correlative obligation of the insurer
to pay it.
The insurer will proceed, on the one hand, to conclude the occurrence of the insured
event and to assess of the damages, and, on the other hand, the determination and payment of
In order to determine the payment obligation and the level of indemnity, the insurer will
establish the causes of damages and the circumstances in which they occurred. For that, there
are necessary to verify:
- if the insurance was in force when the contingency was arising;
- if the premiums were paid and the period for which they were paid. If the
premiums were not paid for whole period, the insurer will retain the remaining
premiums from the indemnity (claim);
- if the goods affected by risk occurrence are covered by insurance;

- if the event which caused the damage is due to a risk covered by insurance
After establishing the causes and circumstances of the damage, the insurer shall proceed
to the damage assessment depending on the insurance type and the principles applied for the
coverage the damages by the insurer.
If the insured event was deliberately caused by the insured or the beneficiary, the insurer
does not owe the indemnity insurance. Establishing the intentional character of the
occurrence the insured event is expressly provided under the terms of insurance. For
example, the terms for fire insurance state that there is a culpa in the occurrence of the event,
using the open fire, including an open flame light sources in a room where flammable
products are stored or in the case of insuring the goods during land transportation, loading on
the same vehicle, along with the goods insured, the flammable liquids, acidic liquids or toxic
materials, if the damages were produced by this way of loading.
In practice of insurance, the serious negligence produces special effects for the insured
and, therefore, each case must be analyzed and compared to the actual circumstances of its

8. Cessation of insurance agreement

Usually, the insurance contract, with limited duration, stops when it came to the end,
namely, at the expiration of the period for which it was concluded.

In other cases, the insurance contract ceases at the occurrence of the insured event for the
accident and life insurance. After the indemnity payment (or sum insured), the obligations of the
insurer toward the insured person are done, which is equivalent to the automatic termination of the

For the insurance of goods and liabilities, the agreement ceases if, through the risk
occurrence, the insured good was completely destroyed. If damage is partial, the contract
continues to have effects, usually, for a lower amount of the sum insured.
There are also more other ways to terminate the contract before the expiration of its
period, also before the insured risk occurence, namely: denunciation, rescission and nullity
of the insurance contract.
Denunciation consists of ending the insurance agreement through unilaterally way, from
causes authorized by law. Thus, the insurer may denounce the insurance contract for the
following cases:
- when the insured person did not communicate, in writing, the contract changes during
the contract performing, related to the data considered at the underwriting of the insurance
contract, if the changes occurred exclude the maintenance of the contract;
- non-compliance from the part of insured person of the obligation of proper
maintenance of the goods or when there are not taken the preventive measures imposed by
the law and which can determine the rising of risk probability.
Denunciation shall not have the retroactive effects, but only effects for the future. Thus,
the insurance premiums are retained for the period in which the insurance contract was valid,
but there are no longer retained, after the denunciation of the contract.
Rescission of the insurance contract occurs, for example, when the insured event
occurred before the start of the insurer's liability (usually, the insurer's liability begins after 24
hours from underwriting of the insurance contract) or if, after starting its responsibility, the
event becomes impossible and the insurance is lack of its purpose. Premiums paid for the
further period are returned.

Also, the rescission may occur when the insured person does not comply with the
obligation of payment the premium rates at the due date, after the term of respite, granted by
the insurer (usually one month after the expiration of the due of payment rate). So, the
rescission of the contract means the abolition for the future of the contract, because of a
default of one party, from causes which may be charged to him/her. The effects of the
contract until the data of rescission remain valid.
Nullity of the insurance contract may result from incorrect or incomplete statements
made by the insured person during the contracting the insurance, due to the termination of
stipulations of the insurance conditions or lack of interest regarding the goods insured, at the
moment of underwriting the insurance contract. In contrast to denunciation and rescission, the
nullity of the insurance contract operates for the previous period, too, not only for the future.
The nullity of the contract returns the insurer and insured persons to the legal position taken
at the moment of underwriting of the contract, proceeding to the mutual restitution of the
financial expenses provided before. The insurer will refund the premiums earned, and the
insured person, the claims or the compensation which was paid.


1. Bistriceanu, Gheorghe - Asigurri i reasigurri n Romnia, University

Publishing House, Bucharest, 2006;
2. Cristea, Mirela - Asigurri Comerciale, Universitaria Craiova Publishing
House, 2013;
3. Annual Reports of Insurance Supervisory Commission (ISC), 2001-2012,
4. Annual Report of Financial Supervisory Authority, for the year 2013;
5. Insurance Europe, European Insurance - Key Facts, August 2014,
6. Sigma magazine, No. 3/2014, World insurance in 2013 steering towards
recovery, Swiss Re
7. The Law 32/2000 regarding the insurance companies and insurance
supervision, published in the Official Journal, Part I, no. 148 of 10 April 2000;
8. Law no. 260/2008 concerning compulsory home insurance against
earthquakes, landslides or floods, published in the Official Gazette, Part I, no.
757 of 10/11/2008, set to come into force on 10 March 2009, postponed until 1
July 2010


Chapter .9. Terms and concepts used in security portfolio management

9.1. Saving

The difference between the incomes obtained by a sector and the expenses it makes
constitutes the saving of the respective sector. The concept of saving is applied both to
individuals and economic organizations, as well as to the economy as a whole.

Contemporary concepts, stemmed from Keynesian theses, depict economies as a

current resources flow, which are not used for immediate expenses. The financing capacity
thus created has to be put at the disposal of other economic agents in order to provide funds
for a part of the investments which exceed their own economies. This is why one has to
permanently correlate economies with investments, as a fundamental side of the economic
balance. In this respect, Samuelson stated that: At a macroeconomic level, economies
(personal, incomes redistributed by enterprises, depreciation and governmental economies)
are always equal to investments. This equality has to be checked irrespective of the fact that
the economy goes through periods of calmness, it experiences a crisis or it is an emergent

Individuals or families, as economic agents, refrain themselves from consumption for

one or more periods of time in order to benefit from a greater consumption later on, as well
as the possibility of a current consumption through borrowing, having to reimburse these
debts from future incomes.

The tendency toward saving is influenced by the specificity of human behaviour and
by a series of economic factors, among which the financial factor is of utmost importance, as
it can act as an incentive or as an inhibitor for the tendency toward saving.

9.2. Investment

The term of investment comes from Latin (investire to dress, to cover) and it was
initially used in the military field (with the meaning of surrounding a fortress in order to
conquer it), from where it was taken by financial-economic terminology (pecuniary effort
made in order to achieve certain goals).

P. Mass considers that the investment is an actual and certain expense, realized in
order to obtain future effects, which were mostly uncertain. The same author establishes the
four main elements defining an investment: the subject the person who invests (natural or
legal person); the object the way in which the investment is made; the cost the financial
effort made in order to obtain the object; the value effects resulted from the realization of
the investment, which are obtained in the future and represent a more or less certain hope.

In brief, investments can be defined as those material, financial and human expenses
realized in different fields in order to purchase new fixed and current assets or for the
modernization of the existent ones so that a subsequent flow of liquidities is ensured,
resulting in growing the wealth of natural or legal persons.

There are numerous disputes regarding the scope of the term. For example, Samuelson
in his manuals on Economics underlines the fact that investments are represented only by
those shares through which real capital is created, namely supplementations of the available
productive assets, such as production equipment, buildings or stocks. He shows that it is
incorrect to consider as investments the purchase of value securities, property securities in
general. Nevertheless, Samuelson accepts two definitions of the investment term:

a) the economic activity through which the current consumption is adjourned in order to
enhance future incomes. It comprises its tangible capital (structures, equipment, stocks), as
well as immaterial or intangible investment (education or the investment in human capital,
considered to the most profitable investment, investments in research and development,
health, etc.)

b) financially speaking, the term has a whole different meaning, namely the purchase of a
financial security such as a share or a bond, hoping to gain profit as a result of the
favourable rate exchange differences.

9.3. Financial market

The financial market represents that mechanism through which financial assets
(documents, value papers, account records) are issued and introduced in the economic
circuit. It lies at the confluence of funds offer (made by trade and industrial corporations,
banks, savings banks, national and foreign insurance companies) with funds request
(expressed by public and private industrial and trade corporations, local governments and
administrations, financial public institutions, banking and insurance companies, international
financial banking bodies) and it comprises two major segments:

a) banking market includes the totality of credit relations based on nonnegotiable assets
(they do not involve the existence of a secondary market);

b) financial security market (financial market, strictly speaking) includes the totality of
transactions using medium- and long-term bonds (capital market) and short-term bonds
(monetary market) with which financial assets are bought and resold without changing their

Financial securities market has two major components:

- primary market the market on which are sold or bought newly issued securities
when establishing or raising the share capital of an enterprise through the issue of shares,
when contracting loans through the issue of securities, through the putting into circulation
the securities issued by the state or local administrations etc. The primary market attracts

available medium- and long-term capitals from the economy and transforms short-term
financial assets into available long-term capitals.

- secondary market also called second-hand market (stock exchange in the broad
sense) concentrates the demand and the offer for securities previously issued on the primary
market. It can be organized in two ways: as a stock exchange (NYSE, BVB); as an
interdealer market or over-the counter OTC, also called negotiation market (NASDAQ,

The secondary market has to meet several requirements, which bring it, more than the
other, closer to the conditions of a perfect market: the liquidity the abundance of monetary
funds and financial assets, which can be mutually converted without restrictions and losses:
the efficiency results from the operability and reduced costs of transactions; the
transparency the availability of relevant information for financial assets holders. It
conditions the efficiency, the free competition, the suppression of monopoly trends, the
reduced cost of transactions; the adaptability the readiness with which the market reacts to
the changes and opportunities occurred; the fair trading the precise regulation of their
performance, the market organization and the promotion of free competition.

9.4. Financial security

As a result of the segmentation of financial market, it can be enumerated the main

financial negotiable securities categories:

- on the capital market : share and other participation securities, investment

certificates, subscriptions bills, bonds (including state bonds), bonds issued by local
administrations and other fixed-income securities, shares of closed investment funds and
participation securities to the open investment funds (mutual), as well as the distinct
category of derived products (futures and options).

- on the monetary market : certificates of deposit, treasury certificates, treasury bills,

inter-banking market securities and derived financial instruments (swap, futures and

9.5. Income (gain)

We will refer below to the gain (rate of return) resulted from owning the two main
categories of financial securities: shares and bonds.

a. Shares can generate two types of earnings: dividend income, rate exchange
differences income.

b. The gain generated by bonds falls into several forms:

- The interest is calculated by applying the percentage interest rate (coupon) to the
amount of the principal and is paid at 6 month- or 1 year-interval, depending on the type of
the bond.

- The first issue represents the difference between the nominal value of the bond
(bigger) and the price at which it is bought (smaller) ;
- The reimbursement premium appears when the redemption is made at a bigger price
than the nominal value;
- Favourable rate exchange differences are recorded on the bonds secondary market
as a result of the principle Buy cheap and sell expensive!.

9.6. Risk

The risk defines the probability that an event causes losses or damages to an entity or
to the economy in general, namely the context of circumstances where an unwanted event is
associated with a certain probability of occurrence.

The gain and the risk are directly proportional, the theories formulated by the
specialized literature include: the sacrifice of an immediate advantage or the absence of an
immediate consumption in exchange for future advantage; the loss of a certain and
immediate advantage ensured by the acquisition and the ownership of a real good or the
consumption of a service in exchange for a future and uncertain advantage generated by the
investment in securities; the uncertainty over the future value of a financial asset.

It is important nevertheless to make a distinction between the uncertainty (the

recognition of the fact that different results from the anticipated ones can occur) and the risk
(the possibility unwanted results occur).

Financial investments associated risks are numerous and include:

- the market risk stems from the unfavourable modification of the price or of the
traded asset value/owned as a portfolio investment, as a result of several objective factors
(economic performances) or subjective (optimism/pessimism of investors).
- the moment risk stems from the choice of the inappropriate moment for the
performance of a transaction;
- the political and country risk stems from the degree of economic and political
stability of the country, its commercial politics, traditions and ethics, national security,
possible military or social conflicts. It can also reflect the negative impact of decisions taken
by national/local authorities, who can intervene through: taxes, charges, capital restrictions,
limitations of imports/exports, nationalizations, expropriations, etc.
- the jurisdictional risk is generated by the probability of the legislative framework
modification, with impact on different securities value;
- the liquidity risk reflects the incapacity of a market to convert into liquidities certain
assets in the quantity and at the time wanted ;
- the rate exchange risk has a strong influence on the externally diversified portfolios,
at the time when the conversion of dividends, interests or favourable rate exchange
differences obtained abroad is sought,
- interest rate risk the modification of the interest rate can have a negative impact
on the market rate exchange of certain securities ;
- the marketability risk starts from the ease/difficulty with which a security can be
sold on the market and from the way in which such an operation affects the security
exchange rate;

- the aggregation risk refers to transactions performed on several markets, possibly in
different countries, which can cause different problems ;
- the concentration risk (diversification) is association with the holding of a sole
security or certain instruments belonging to an unique economic sector ;
- the operational risk stems from human errors or fraudulent behaviours which lead to
the disappearance of important documents/data.
To sum up, a portfolio risk comprises two important elements:

a) systematic risk (market, non-diversifiable risk) whose causes are: inflation, the interest
rate variations, the political instability, military conflicts or generalized economic crises;

b) unsystematic risk (company, specific, diversifiable risk) is caused by events which occur
inside the company: lawsuits, strikes, success/failure of marketing actions etc. It is unlikely
that all securities belonging to a diversified portfolio would be simultaneously affected by
such a risk, the losses incurred by one of them being compensated by the gains from others.

9.7. Securities portfolio and its diversification

An investors portfolio is a collection of financial assets (banking deposits, treasury

bills, governmental bonds, ordinary shares of companies etc.) and real assets (gold, works of
art) in which they keep their fortune. Investors can manage their portfolios on their own, but,
most of the time, they delegate specialists in order to perform this operation.

Securities portfolio includes the variety of financial securities hold by an individual or

institutional investor in order to obtain an income from dividends/interests or a gain from
favourable rate exchange differences.

Diversification is an important behaviour of people who are reluctant to risk in any

field of activity.

Therefore, diversification means the diminution of the risk by combining inside the
portfolio several financial assets, whose individual incomes are independent. An investor
will not direct all his savings to one security because, in the event of a massive fall of the
security in question, his capital is compromised. Risks have to be split not only by
companies and economic sectors, but also at an internal level. But diversification does not
mean to invest less in many securities because, in this case, increases will bring only
negligible profits, but it means having always in mind the objectives fixed at the moment
when the portfolio was established big incomes, incomes security, long- or short-term

9.8. Stock indices

A stock index refers to the evolution of stock exchanges on a certain market through
the comparative analysis of capital demand and offer on the market in question. Unlike the
stock exchange which synthesizes the evolution of individual financial securities, stock
indices measure dynamic values of a representative group of shares or even of all shares
traded on the stock exchange in question.

The determination of stock indices takes into account the following elements:

a) stock index structure - includes a selective sample of companies, representative for

the general evolution on the respective market;

b) the weighting of securities included in the index can be realized in three ways:
equal weights are allocated for all securities; weights are allocated according to the amount
of dividends for each share; weights are not allocated, being taken into consideration only
securities rate exchanges.

c) establishment of the date / period chosen as a reference basis stock index for this
period is equated to 100 points, and indices for future periods reflect the modification with
respect to the comparison basis.

Chapter 10. Actual typology of the securities portfolio management

In the present situation, the portfolio management seems to be stuck in a decisive

battle between two competitive strategies: active portfolio management and indices based

10.1. Active management

Active portfolio managers buy and sell constantly a great number of common/ordinary
shares. Their task is to maintain their clients satisfied, and this means to have consistently
better results than the market so that whenever a client asks himself the legitimate question
What is the situation of my portfolio in comparison with the global market? the answer
should be positive, and the client should leave his money in the fund. In order to remain in
top, active managers try to foresee what it will happen with the shares in the following six
months and continuously diversify the portfolio hoping to obtain advantages from the
predictions made.

10.2. Passive management

On the other hand, investments based on indices are a passive approach of buying and
ownership. It involves the creation and then the maintenance of a largely diversified
portfolio of common shares, especially created to imitate the behaviour of an index of
specific level, like S&P 500 (Standard &Poors 500 Price Index).

10.3. Third way: focused investment

The worlds greatest investor, Warren Buffet underlines the fact that there is a third
alternative. This alternative is the focused investment, which involves the fulfilment of four

a) The identification of certain remarkable companies (focusing the attention on the economic
analysis of the business and the appreciation of its management, and not on the monitoring of
shares prices on the stock);

b) the concentration (focus) of the investment (purchase of a limited number of shares);

c) the calculation of the probability of occurrence of certain events and investment adaptation
thereto ;

d) the long period of time for which the investment is maintained.

Chapter 11. Markowitz model

Markowitz starts from a very simple notion: income and risk are inseparable. As an
economist, he thought that it was possible to determine the relation between the two up to a
real statistical degree and thus to determine the degree of risk necessary for different levels
of income. In his article, he presented the calculations supporting his conclusion: no investor
can have above-average benefits without taking an adequate risk. In order to quantify this
risk, he used the standard deviation. The deviation can be considered to be the difference
with the average. According to Markowits, the greater is the risk, the bigger is the difference
with the average.

We could believe that the risk of a portfolio, as it was defined by Markowitz, is merely
and simply the average of standard deviations of individual shares from a portfolio. But, in
this way an important point is omitted. Although the deviation can offer a measurement of
an individual share risk, the average of two deviations (or of a hundred deviations) will offer
very few information about the portfolio risk formed of the two shares (or a hundred shares).
What Markowitz did, was to find a way to determine the risk of the entire portfolio. This is
considered to be his greatest contribution.

He named it covariation based on the formula already determined for the variation of
the evaluated sum. Covariation measures the tendency of a group of shares. We say that two
shares have an important covariation when their prices, irrespective of the reason, tend to
move in the same sense. On the contrary, the weak covariation is when two shares move in
opposite directions. According to Markowitz, the risk of a portfolio is not given by the
variation of individual shares, but by the covariation of all shares. The more they vary in the
same sense, the greater is the possibility that economic changes lead to their simultaneous
decrease. Moreover, a portfolio composed of risky shares can be in fact a standard selection
if the individual shares price has different senses. Anyway, the diversification is the key.
According to Markowitz, the step an investor has to take is to identify the level of risk he is
willing to accept and then to build a diversified, efficient, portfolio, made of shares with
weak covariation.

The portfolios theory developed by Markowitz is built around the following main
ideas : the two relevant characteristics of a portfolio are the forecast income and its risk;
rational investors will choose the holding of efficient portfolios which are those maximizing
forecast gains at a certain level of its risk or, alternatively or equivalently, minimizes the risk
at a given level of the forecast gain; it is possible to identify efficient portfolios through a
thorough analysis of information for each security (forecast gain, forecast gain variations,
relations between the gain for each security and other securities earnings); the existence of
one computer program which uses as inputs the financial analysts calculations (necessary
information for each security in order to build an efficient portfolio). The program indicates
the weight of investors financial resources which would have to be allocated to each
security in order for the portfolio to be efficient (earnings maximization to a certain risk
level or risk minimization to a certain earning level)

A portfolio earning is the weighted sum of component securities earnings, the

weight of each security being the percentage of portfolios total value which is invested in
that security.

Portfolios dispersion (risk) is calculated by using the following formula:

X i
j j


X i weight invested in security i

X j weight invested in security j

i2 Security i forecast earning dispersion

2j Security j forecast earning dispersion

covij = codispersion between forecast earnings of values i and j

In the case of n val securities, the formula becomes:

n n


Co-dispersion between i and j is closely linked to the correlation between i and j, being
calculated by multiplying the correlation ratio (p) with standard deviation of i and j. It is
difficult to correctly appreciate the absolute value of the co-dispersion because it depends

ij p
cov ijij

both on the correlation between i and j and on fluctuations amplitude of i and j. Thus, the
co-dispersion formula becomes:


p 1

2ji - security j forecast earnings dispersion (after taking into consideration the reaction with
the security i forecast earnings) or that part of the total dispersion attributed to deviations
from the line of regression.

2j - total dispersion of security j forecast earnings or deviations from the average.

Chapter 12. Sharpe model

Sharpe stated that all securities are connected to a certain basic factor. This factor can
be the stock index, the national gross product, or another price index, as long as it has an
important influence on the evolution of the financial security price. Using Sharpe's theory, an
analyst will only have to measure the link between the security and the dominant basic factor.
Markowitz' mathematical approach is thus considerably simplified.

Let us briefly analyze common shares. According to Sharpe's theory, the basic factor
for shares' prices the only one which has a great influence on their behaviour would be
shares' market itself. (Equally important, but with less influence would also be the industrial
branch, as well as the specific characteristics of the share itself). If the share's price is more
volatile than the private market as a whole, the share's holding will make the portfolio be
more variable and risky. Otherwise, if the share's price is less volatile than the market, the
share's holding will make the portfolio be less variable, less risky. So, the variation
(volatility) of the portfolio can be simply determined by quantifying the average variation of
individual securities forming the portfolio.

The name given by Sharpe to the measurement unity of the volatility (variation) is
beta factor. Beta is defined as the correlation degree between price movements of the market
and individual security movements. Shares which decrease or increase in value directly
proportional with the market are attributed a beta factor equal to 1. If shares increase or
decrease in value twice as fast or faster than the market, then their beta factor is equal to 2; if
price modifications of shares represent only 80% of the market modification, then their beta
factor is equal to 0,8. Basing only on this information, we can quantify the average value of

the portfolio beta coefficient. The conclusion is that any portfolio with a beta superior to 1
will be more risky than the market and any portfolio with a beta inferior to 1 will be less

One year after the publication of its work referring to the portfolio's theory, Sharpe
presented a revolutionary concept, the Model of capital assets evaluation (CAPM). This
concept represented a continuation of its unifactorial model referring to the creation of
efficient portfolios.

According to CAPM, shares bear two different types of risk. The first type of risk is
the one to be on the market, that Sharpe named systematic risk. Systematic risk is beta and it
cannot be diversified. The second type of risk, named unsystematic risk, is the risk specific to
the economic position of the company. Unlike the systematic risk, the unsystematic risk can
be diversified through the simple acquisition of more types of shares.

The line of the capital market described by Sharpe correlated the forecast earnings of
an efficient portfolio with the interest rate for the risk free security and the forecast earnings
of the market:

M f
R ) R

p p

where E(Rp) portfolio's forecast earnings

Rf forecast earnings of risk free security

E(RM) market forecast earnings (index)

p - portfolio's standard deviation

M - market's standard deviation

As this relation is valid only for efficient portfolios, it cannot be used for describing
interdependencies between individual securities' earnings (or inefficient portfolios) and their
standard deviations.
According to the model of capital financial assets (securities) of Shape, the forecast
earnings of each security (or portfolio) depends on the forecast earnings of the risk free
security and the whole market forecast earnings. Therefore:

) R

where E(Ri) security's forecast earnings (portfolio); Rf risk free security's forecast earning;
E(RM) market's forecast earnings; (coefficient
a forecast earnings security to the market evolutions.

This equation is similar to the line of the capital market. Between the two relations of
calculation there is no equality, the right of the market capital being valid only for efficient

deviation. In the case of efficient portfolio, the two relations are equivalent. By definition, the
risk of efficient portfolios is determined exclusively by market evolutions and their forecast

Chapter 13. Efficient market theory (E. Fama)

Fama's message was very clear: shares' prices cannot be predicted because of the fact
that the market is too efficient. On an efficient market, whenever information becomes
available, a great number of intelligent people (Fama named them profit-maximizing people)
apply this information in a certain way, leading to a spontaneous adjustment of prices before
anyone is able to obtain profit. Estimations regarding the future cannot be made on an
efficient market because the shares' prices adjust too fast.

Fama admitted the fact that it was impossible to empirically test the idea of efficient
market. The alternative, he thought, was to identify transaction systems or traders (brokers)
who could overtake the share market on the whole. If such a group existed, this would mean
that the market would be inefficient. But as no one had the skills to beat the market, we can
say that prices reflect all available information and that the market is efficient.

Chapter 14. Investment and portfolio management Buffet model

14.1.Market principle: business evaluation and intrinsic value update

The determination of intrinsic value of a company the first and the most important
step during the decision-making process of Buffet is a combination of skills and science. The
science in question involves a pretty simple part of mathematics.

In order to calculate the current value of a business, one has to start from estimating
cash flows expected to appear during a business and then bring everything in present, using
an adequate rate of update. If only we could see, when analyzing a business, future input and
output cash flows between the business and its owner for the next 100 years or at least until
the business disappears and then we could update them to an adequate interest rate, then this
rate could offer us an amount of the intrinsic value, stated Buffet.

Some people think it is easier to compare this process to the one used for the
evaluation of a bond. Mathematically speaking, it is the same thing. Instead of cash-flow,
bonds have coupons, instead of unlimited period; they have a limited period to reimburse the
invested capital to their owners. It would be as if we considered a bond as a whole bunch of
matured coupons in a hundred years, explained Buffet. Also, business has coupons which
are bound to extend in the future. The only problem is that these are printed on a document.
Therefore, it depends on the investor to estimate which these coupons will be.

Estimating the earning of these coupons, they depend afterwards on two values: future
probable earnings and update rate used in order to obtain those future earnings at updated
values. For the second value, the update rate, Buffet uses in general as current rate, the long-
term governmental bonds rate. Because it is sure that the USA government will pay the
interest over a period of thirty years, we can say that we deal with a risk close to zero. As
Buffet also says, We use zero risk for the mere purpose of comparing an investment to

14.2. Financial principle: added economic value or not?

Buffet has a measurement instrument for the added economic value of a company. He
measures the limit rate of a company by means of his skills (aptitude) to raise the market
value of a company with a rate at least equal to the value of undistributed earnings. For each
dollar withhold by the company, the company should raise its market value with at least a
dollar, argues Buffet.

14.3. Managerial principle: how managers are evaluated?

Warren Buffet applies three principles concerning the management of a company:

rationality, candour, resistance to the institutional imperative.

a) Rationality

As we have already seen, if a company generates high yields for its own capital, the
duty of the management is to reinvest these earnings back into the company, for the benefit of
the shareholders. Nevertheless, if earnings cannot be reinvested at high rates, management
has three options: ignore the problem and continue to reinvest under the average rate, to buy
raise, to give back the money to the shareholders, who subsequently can have the opportunity
to reinvest their money somewhere else at higher rates. In Buffet's opinion, only one choice is
rational and this is the last option from the abovementioned.

b) Candour

After rationality, we should focus on the management candour. In time, each

company makes big or small mistakes. Too many managers have the tendency to report
excessively optimistic results than to provide an honest explanation.

This is really admirable, specific to managers, who, with courage, discuss about
companies' failures with its shareholders. Buffet's conviction is that the manager who
discusses his mistakes, he will correct them.

c) Institutional imperative

Independently thinking and choosing a direction based on rationality and logic, it is

more acceptable to maximize company's profits than a strategy which is better described by
the expression follow the leader.

Chapter 15. Investments' mathematics

15.1. General consideration regarding probabilities theory

The statement that the stock exchange is an uncertain universe is a strong

simplification but not an exaggeration. In this universe, there are hundreds, even thousand
singular forces which interact and generate prices, all of these being in a permanent change,
any of them being able to have a strong impact on the other ones, none of which being
foreseeable with an absolute certainty. Investors' task is to reduce the uncertainty area,
identify and eliminate what offers the greatest uncertainty and concentrate on what provides
less doubt. This is an exercise of probability.

Whenever we are not sure concerning a situation, but we want to keep arguing our
opinion, we often start with: Chances are that... or Probably... or It is unlikely that....
When we go further and try to quantify these general expressions, we deal with probabilities.
Probabilities are the mathematical language for uncertainty.

15.2. Probability subjective interpretation

Whenever we come across problems dealing with uncertainties, it is clear that we will
never be able to make sure predictions. Anyway, if the problem has been well defined, we
could make a list with all the results that could be obtained. If an uncertain event is repeated
often enough, the outputs' frequency has to be reflected in the probability of different possible
results. The difficulty increases when we come across an unrepeatable event.

How can we calculate the probability, without having repeated tests in order to carry
out the frequencies' distribution ? We cannot. When there is no possibility to make sufficient
duplications for a certain event, in order to obtain an interpretation of probabilities based on
frequencies, we have to base on our instinct.

Like Bayes' theories, if you believe that your assumptions are reasonable, it perfectly
acceptable to consider the subjective probability of an event certainly equal to the
frequency's probability. You should consider subjective probabilities as an extension of
frequencies probability method. In practice, in many cases, subjective probabilities are over-
evaluated, as this approach allows you to bear in mind operational problems instead of
depending on long series of statistical regularity.

Whether they admit it or not, all decisions investors make are exercises of probability.
In order for them to succeed, it is necessary that they combine their series of probabilities
with the most recent available information.

15.3. Kelly optimization model

Kelly optimization model, often called optimal growth strategy, is based on the
concept that if you know the probability of success, you bet on the fraction of your account
which minimizes the growth rate. It is expressed as the following formula:

2p 1 = x

where twice the probability to win minus 1 is equal with the percentage from an account
which should be bet. For example, if the probability to beat the betting shop is of 55%, you
should bet 10% of your account in order to reach full growth of earnings. If the probability is
of 70%, you should bet on 40%. And if you know that your winning chances are of 100%, the
model will say, bet your entire account.

Kelly's formula is optimal due to two criteria: minimal waiting time for reaching a
certain level of earnings and a healthy maximal growth rate.

15.4. Probability's theory and the focused investor's market

The judgment is the following:

a) Probability calculation. As focused investors, you should concentrate on a limited

number of shares because you know that on a long term, this is the best chance to win better
than the market. So, whenever you want to buy a new share, it is important to be sure that
choice you made will overtake the market. This is the probability that concerns you: What are
the chances that this share, in time, will generate a bigger profit than the market?

Using the frequency, if possible, and subjective interpretations if the frequency cannot
be used, you will make the best possible estimations. You will make the most complete
collection of information about the company. You should compare these principles and
transform the result of the analysis into a number. That number represents how obvious it is
for you the fact that the company in question is a winning one.

b) Adaptation to new information. Being aware that you will wait for the chances to
be in your favour, be very careful to anything your company does. Does the management
start to act irresponsibly? Financial decisions start to change? Has anything happened which
changes the competitive landscape where your business functions? If so, probabilities are
likely to change.

c) Decide how much you will invest. From the entire sum available for the investment
on the market, what will be the proportion allocated to this purchase? You should begin with
Kelly's formula, then adapt it, probably reducing it to half.

d) Wait for the best chances. Chances of success will be in your favour when you
have a safety margin; the more uncertain is the situation, the bigger the safety margin has to
be. On the capital market, this safety margin is offered by a reduced price. When the
company you are interested in is sold at a price below its intrinsic value (that you determined
during the probabilistic analysis process), this is the signal to act.

It is obvious that this process is a continuous cycle. Once circumstances change, the
probability changes; in case of new probabilities, you will need a new safety margin and thus
you will have to adapt the meaning to what best chances mean..

Chapter 16. Investment psychology

16.1. Behavioural finances

Behavioural finances represent a study aiming to explain the inefficiency of the

market by using psychological theories. Noticing the fact that people make mistakes and
illogical assumptions when it comes to their businesses, scientists, started to thoroughly study
the psychological concept in order to find an explanation for irrationalities of human
thinking. It is, as we have said, a relatively new field of study, but what we learn is both
fascinating and useful for intelligent investors.

a) Overestimation

Several psychological studies have shown that judgment errors occur because people
generally have an exaggerated confidence in themselves. Ask a large number of people, how
many of them consider having above average driving skills and an overwhelming majority
will answer that they are excellent drivers which leave with no answer the question about
who are the bad drivers. When they were asked, 90% of the doctors believed that they could
diagnose pneumonia when in reality only 50% of them were right.

Self-confidence is not a bad thing. But the overreacted self-confidence is another

thing and it can be even harmful when it comes to our financial businesses. This type of
investors not only that they make wrong decisions for them but they also have a strong
influence on the market as a whole.

Investors are usually very confident. They think they outsmart anyone else and can
choose winning shares or, in the worst case, they can choose the brightest financial
administrator who could beat the market. They tend to overestimate their skills and
knowledge. Typically, they choose the information confirming their beliefs and ignore
contradictory information. In addition, their minds work to find ways to evaluate even if
information is already available, instead of looking for this information themselves.

What proof do we have in connection to this overreacted confidence of investors?

According to the efficient market theory, it is alleged that investors have to buy and to hold
financial securities; we have noticed that transactions have grown in number over the last

years. Richard Thaler thinks that investors and financial administrators live with the belief
that they hold the best information and can have an advantage over the other investors.

The overreacted confidence explains why so many financial administrators take

wrong decisions. They have too much faith in information they manage, and believe they
have more rights than they really have. If all players believe that their information is correct
and that they know something the others don't, the result is a good business to trade.

b) Overreaction

There are several recent studies that have shown how people put too much faith in a
few chances, thinking that they caught a trend. In particular, investors tend to focus on the
most recent information they received and to extrapolate from this; the last earning report will
become, in their minds, a signal for future earnings. After that, believing that they see what
the others don't, they make hasty decisions based on superficial motives.

Overconfidence is of course present in this case; people think they understand

information better than the others, that they interpret it better. But it is more than that.
Overreacted confidence is extrapolated by the exaggerated reaction. Behavioural researchers
have learned that people tend to exaggeratedly react to bad news and to slowly react to good
news. Psychologists name this overreaction caused by the influence of some factors. Thus,
if the short-term earnings ratio is not good, the usual answer of investors is abrupt, with an
inevitable effect on shares' prices.

Richard Thales describes this short-term exaggerated emotion asmyopia of

investors and thinks that it would be better for them not to receive monthly information. In a
study carried out with other researchers, he demonstrated his idea in an original way.

Richard Thaler asked a group of students to invest in a hypothetical portfolio formed

of shares and treasury securities. But firstly, they brought the students in front of a computer
they simulated the portfolio's earnings for a period of 25 years. Half of the students were
given tons of information, representing the nature of the market volatility and about every
change in prices. The other group was only given information about periodical performances
measured for a period of 5 years. Thaler asked each group to allocate their portfolio for the
next 40 years.

The group was overwhelmed by much information, a few of them inevitably leading
to loss, allocated only 40% of their money on the share market. The group which received
only periodical information allocated almost 70% of the portfolio to shares.

Richard Thaler is well known for another study in which he demonstrates the
inefficiency of short-term decisions. He analyzed all the shares on New York Stock Exchange
and classified them according to their performance for the last 5 years. He isolated the best 35
financial securities (whose prices have grown the most) and the worst 35 financial securities
(which have dropped the most) and he created a hypothetical portfolio of 70 shares. After

that, he kept this portfolio for another 5 years and observed how the losers overtook the
winners for 40% of the time. In real world, Thaler thinks that a few investors would have
had the power to resist not reacting at the first drop in the price and they would have lost the
moment when the losers took another direction.

These experiments confirm Thaler's idea about the investor's myopia which leads to
bad decisions. One of the motives for which myopia generates such irrational answers is
another aspect of the psychology: our wish is to avoid the loss.

c) Aversion to loss

According to behavioural researchers, the pain suffered from a loss is much bigger
than the joy of an earning. For a bet with 50/50 chances, most of the people would not risk
anything unless the potential earning is twice bigger than the potential loss.

This aspect is known as the asymmetric aversion to loss: the loss part has a greater
impact than the earning part and it is a fundamental aspect of human psychology. Applying
this principle to the market share, means that investors feel twice worse when they lose
money than when they win. This motivation can also be found in macroeconomic theories
which show us that during the period of economic boom, consumers increase their
acquisitions by 3,5 cents for each new dollar earned. But during recession periods, consumers
reduce their expenses by twice this amount (6 cents) for each dollar lost from the total

The impact of the aversion to the loss on the investment decision is visible and deep.
We all like to believe that we made the right decisions. In order to preserve our good opinion
of ourselves, we stick to this bad choice for a long time, hoping that things will come around.

This aversion to the loss makes the investors to be more conservative. Stakeholders to
the pension programs, whose time horizon is the decade, still keep 30 to 40% of their
invested money in bonds. Why? Only such a strong aversion to loss would make someone
place their money so conservatively. But the aversion to loss can affect you immediately,
making you irrationally hold losing shares. No one to admit they are wrong. But if you don't
sell a mistake, you can let go a potential earning that you could have by intelligently
reinvesting it.

d) mental calculation

The last aspect of the financial behaviour worth mentioning refers to what
psychologists call mental calculation. This refers to our habit to change our perspectives into
money once circumstances are changed. We tend to mentally place our money in different
accounting records, thus determining the way we think how to use it.

Once more, Richard Thaler prepared an interesting academic experiment in order to
demonstrate this concept. In his study, he uses two different groups of people. The first group
is given 30 dollar each and two options: (1) take the money and leave or (2) bet by flipping
the coin. If they are lucky, they will get 9 dollars more, but if they don't, they will lose 9
dollars. The majority of the group (70%0 will accept the bet, calculating that they will leave
with at least 21 found dollars in their pockets. The second group is offered two options: (1)
bet by flipping the coin: if they lose, they receive 21 dollars, but if they win, they get 39
dollars or (2) 30 dollars each without flipping the coin. From this second group, more than
half (57%) decide to only take the money.

Both groups can win the same amounts of money, with the same chances, but the
situation is differently perceived.

Conclusions are clear: how we decide to invest and how we choose to administrate
these investments depends on the way we look at the money. For example, the mental
calculation is considered to be one of the reasons for which people do not sell losing shares;
in their heads, the loss is not real until effective. Another aspect refers to the risk. The total
impact will be described further on in this chapter, but for now one thing is for sure: we are
more willing to take risks using found money. On a bigger scale, the mental calculation
deepens a weakness of the efficient market theory; it demonstrates the fact that market values
are determined not only by obtained information but also by the way in which people
perceive this information.

This study is fascinating. It is very interesting that this aspect plays such an important
role in the investment process, a world dominated by cold numbers and concrete data. When
we have to make investment decisions, our behaviour is sometimes strange, or contradictory,
and some other times confused. Sometimes, irrational decisions are truly illogical, and some
other times they do not fit any pattern. It happens we make adequate decisions by coincidence
and wrong decisions for apparently no reason.

What it is especially alarming and what all investors should understand is the fact that
sometimes they are not aware of wrong decisions. In order to fully understand the market and
the investment process, we now know that we have to understand our own irrationalities. The
study of wrong judgment psychology is as valuable for an investor as the analysis of a
balance sheet or an income declaration. You can be an expert in companies evaluation art, but
if you don't allow yourself sufficient time to understand financial behaviour, it will be
extremely difficult to improve your strategy and your investment performance.

16.2. Risk tolerance

In the same way a magnet strongly draws near metal objects toward itself, risk
tolerance brings together all the elements of finances psychology. Psychological concepts are
abstract; they become real through daily decisions made in order to sell or to buy shares. The
common point of all these decisions is the feeling toward the risk.

In the last twelve years, professional investors have allocated considerable funds and
energies in order to help people to evaluate the risk tolerance. Stock agents, investment and
financial advisers have been monitoring the constant changes in individual human behaviour.
When the market grows, investors boldly add shares to their portfolio, and then in case the
market falls, investors should be able to re-balance their portfolios by buying bonds. The fall
of the market in 1987 is a good example. Overnight, many investors transformed their
portfolios, selling shares and buying bonds or other fixed-income securities. The alternative
move, aggressive investor conservative investor triggered a thorough research on risk

At the beginning, financial advisers considered that the risk tolerance evaluation is
simple. Using interviews and questionnaires, they could build a risk profile for each investor.
The problem is the fact that human risk tolerance is based on emotions, meaning that it varies
with the changes in circumstances. All psychological principles found in human attitude
regarding money, also influence on the risk reaction. When the market dramatically falls,
even aggressive investors will become more cautious. On an emerging market, not only
aggressive investors but also those supposedly conservative will nonetheless increase their

Another factor is the absolute self-confidence. In our culture, the ones who take risks
are admired and the investors are exposed to the human tendency to consider themselves
more used to risks than they really are.

It has been discovered that the tendency for taking risks is linked to two demographic
factors: age and sex. Older people are less willing to take risks than the young, and women
are more cautious than men. It seems that wealth is not a criterion; having more or less
money seems to have no effect on risk tolerance.

Two character traits are linked to risk tolerance, namely personal control and
achievement motivation. Personal control refers to the possibility of people to influence both
the environment they live in as well as decisions made concerning their own life in that
environment. People who see themselves having this control are called interior. Unlike
them, the exterior ones think they have less control, being like a leaf carried away by the
wind. According to research, people willing to take risks are classified as interior.

Motivation achievement describes the degree to which people are focused on their
purpose. The ones who take risks have a precise purpose, even if a strong concentration on
their goals can lead to disappointments.

Chapter 17. International investments

17.1. Foreign investments

a) Foreign investments forms

the subject concerning foreign investments has been thoroughly debated on an

international scale, generating two forms of foreign investments: portfolio investments and
direct investments. If direct investments have existed since the great discoveries period,
portfolio investments have begun to develop since 19th century.

Portfolio investments

Portfolio investment refers to purchasing securities on the organized and regulated

capital markets, which does not involve the direct participation to the administration of a
company, in order to obtain earnings from dividends and from the favourable difference
between the selling and the buying price.

The capital market represents one of the financial market components, along with
monetary market and stock market.

The monetary market comprises relations formed at the moment of attraction and
placement of short-term placement. On this market, transactions are made using commercial
securities with maturity deadline up to one year (bill, bill of exchange, promissory note,
warranty, cheque), as well as inter-banking transactions for deposits' adjustment (demand or
time deposit). Operations are carried out through specialized institutions or persons (banks,
brokers, dealers) and aim at financing economic activity of a country by continuously and
mutually transformation of loans and short-term cash sums.

The capital market is many times mistaken to the entire financial market. Whereas on
the monetary market short-term loan securities are traded, on the capital market medium and
long-term loan securities are negotiated, especially shares and bonds.

The capital market is divided in primary market and secondary market. The primary
market deals with securities issued by companies, financial and banking institutions,
government, which is permanently looking for new financing funds. The secondary market is
the stock exchange itself, by means of which securities previously issued at prices called rate
exchanges are negotiated, determined by securities demand and offer, interest rate, political
factors, prices which can be inferior or superior to acquisition prices.

Operations which are specific to the capital market, namely the placement and the
negotiation of securities (shares and bonds), loans on loan securities (Lombard) and mortgage
loans, are carried out through stock exchanges, banks and persons specialized in selling and
buying loan securities.

Direct investment

Direct investments represent financial, material and human expenses, made in order to
purchase or to create new fixed assets and trading assets, or the modernization of the existent
ones, for subsequently obtaining a flow of liquidities, aiming at increasing the wealth
belonging to certain natural and legal persons. Unlike portfolio investments direct
investments suppose the investor's participation to the company's management.

As regard to foreign direct investments forms, one can distinguish: the creation on an
empty place (greenfield) of a company or opening a branch of the existent one in a foreign
country; the acquisition of a foreign company or the merging with such a company; the
participation with investment capital to the creation of a mix company (joint-venture).

Understanding the foreign direct investment concept is connected to the definition of

the notion of multinational company or international production.

Foreign direct investments are international complex flows including financial,

technological, managerial and organizational resources, around which the interest of an
investor company of a natural person for the purpose of performing economic activities
outside the country where the natural or legal person in question live.

Foreign direct investments can often considered new markets conquering methods,
the first step in this direction being realized through export.

The multinational company is the promoter of a foreign direct investment, being in

the same time the owner of assets created abroad and manager of industrial production.

The international production comprises the totality of managed production unities and
which generate effects on the economy where they were implemented.

b) Foreign investments implications

Foreign investments have a growing role in an economy which rapidly goes toward
globalization. In this context, it is possible to analyse implications that new investments
(greenfield investments) have and the investments through acquisitions and foreign
companies merging on national economies and global economy.

New investments not only do they bring a financial and material resources, but they
create in the same time production capacities and new jobs.

The visible part of globalization is represented by mergers and foreign companies

acquisitions. Political discussion are concerned with the inputs of foreign investments by
taking over internal companies, which are seem to be suspicious, because they can show
certain disadvantages too.

Foreign acquisitions do not add new productive capacities but they constitute just a
simple property transfer from the intern to the international, being often accompanied by

employees' redundancy or closing some productive or functional activities, being considered
as an erosion of national sovereignty.

Although initially foreign investments inputs by means of acquisition transactions or

mergers offer an unfavourable image, on the long-term, as well as new investments, bring
many benefits for the countries where they are performed.

On the one hand, foreign companies mergers and acquisitions are usually followed
by sequential investments of new owners, most of the time of considerable dimensions. Thus,
on the long-term, foreign investments through companies takeovers can lead to enhanced
investments in production, as well as new investments.

In the same time, foreign companies mergers and acquisitions are often followed by
new more efficient technologies (including managerial and organizational techniques),
especially when taken over companies are restructured in order to enhance operative

On the other hand, mergers and acquisitions can generate in time new jobs whereas
the company develops through investments in new activities.

In addition, foreign investments have implications on the capital quantity and use and
technology generation.

17.2. Multinational companies

a) multinational company concept

Multinational companies are recognized as being one of the fundamental components

of the international economic environment. Their name is disputable UN organizations use
the term of transnational companies and most of the specialists and economic dictionaries use
the term of multinational companies.

Opinions are also divided when it comes to define multinational companies. Certain
definitions start from structural criteria such as: the number of countries where the company
operates, the shareholding structure, managers nationality. Other definitions emphasize
performance criteria, such as: absolute or relative value of profits, production, sales, foreign
assets, number of employees involved in the international activity of the company.

Multinational company will refer to a companys expansion beyond its own countrys
boundaries, thus forming a large assembly comprising a main company, mother-company and
a number of branches created in different countries.

b) Reasons for multinational companies creation

Multinational companies invest abroad because for the same value of the investment,
they expect to gain more than the local firms. By investing, multinational companies take

risks and implicitly additional costs related to the distance, time difference, informational
gaps, nationality, culture and other aspects common to a foreign environment which do not
affect national firms. Of course, these additional costs have to be compensated through bigger
earnings than those of local competitors. But, superior technology, entrepreneurial and
managerial skills, a global organizational structure are the advantages of multinational

Therefore, making a decision to extend a company beyond its own countrys

boundaries needs that advantages be much more than disadvantages resulted from insufficient
knowledge of foreign market.

Both multinational and local companies equally benefit from a series of advantages
offered by the host country. One of these advantages refers more specifically to certain
industrial sectors presenting common characteristics to many countries or elements specific
to that country (a large number of investors, adequately qualified labour force, and easy
access to capital).

It can be distinguished a series of factors influencing the exploitation of these

advantages by multinational companies, such as: marginal cost of accessing a foreign market
(difference between export and direct investment) has to be inferior to the marginal income
obtained from this operation; the existence of several conditions making the creation of a
branch less expensive than the exportation of the same product or justifying the export as the
only alternative; indigenous production abroad has to be more profitable than the licensing of
a foreign firms advantages.

Product life cycle theory shows that productive activity localization of a multinational
company evolves during a product life cycle and mainly explains the USA dominant role as
main innovator, exporter and investor in the global economic circuit during after war period.
Product life cycle determines the shift of multinational companies from export to direct
foreign investments.

According to this theory, multinational companies invest abroad in order to absorb

externalities existing on the market; economies of production and marketing scale, property
and public characteristic of knowledge and market restrictions imposed by governments.
According to this theory, the multinational company represents an institution meant to
create and exploit national markets advantages.

17.3. Payments balance

Payments balance has two components: current account and capital account.

a) Current account

According to IMF methodology, the current account (CA) comprises in the first place
the commercial balance, namely export and import of goods and services.

In reality, a countrys export is only very rarely equal to import. The ratio between
goods and services export and import is known as commercial balance (CB):


Whenever a countrys import surpasses the export, that country has a deficit of
commercial balance. A country has a surplus of commercial balance when its export exceeds
the import.

Secondly, the current account comprises the incomes balance (IB incomes and
external payments under the form of dividends, interests, salaries, etc.) and unilateral
transfers balance (TB transfers of economies, donations, remedies or reparations).

General balance of these balances represents the current account balance, that is:

CC = (EX + inputs BV + inputs BT) (IM + outputs BV + outputs BT).

b) Capital account

There are two explanations for the fact that the current account is very important for
GDP. The first one refers to the fact that changes in current account can be associated with
changes in production and the degree of employment of that country. The second one refers
to the fact that a current account measures the dimension and the direction of the countrys
external loan.

When a country imports more than it exports, it finances the current account deficit
through external loans, accumulating an external debt. Similarly, if a country exports more
than it imports, the resulted surplus fuels the deficit of importing countries, by giving them
loans. These moves of capital are recorded in the capital account balance (CA). A current
account deficit (CC) has to have a correspondent an input in the capital account (CA), and a
surplus in the current account has to correspond to an output in the capital account.

External wealth of a surplus country grows, because loans granted to deficit countries
will be reimbursed with interest. On the contrary, external wealth of deficit countries
decreases. It can thus be said that the current account balance is equal to net exchanges of
external wealth.

A surplus country uses less than it produces. A deficit country, on the contrary, it uses
more than it produces. Surpluses and deficits are adjusted through external loans, which are
identified as inter-temporal trade. A deficit country which borrows, imports present
consumption and exports future consumption. A surplus country granting a loan exports
present consumption and imports future consumption.

As it has been mentioned before, in a closed economy investments have to be equal to

the accumulation. In an open economy, the accumulation and investments be different. S = P
C G; BC = EX IM; then, S = I + CC.

As one part of a countrys economies can be loaned to another country, which

increases its capital stock, a current account surplus of a country is often called to be an
external net investment. It becomes obvious that the country using the investment came from
the outside, has to allocate a part of its obtained income to the loan reimbursement and its
interest. Internal and external investments are two ways by which the surplus country can use
its current account surplus for a future income.

According to the same IMF methodology, the capital account show capital moves on
the short-term up to one year (loans, assets repatriation) and medium and long-term capital
moves (direct investments, portfolio investments).

c) General table of balance of payments

As we have already seen, balance of external payments keeps the records of all
payments and incomes of a countrys foreign relations. Any transaction resulting in a foreign
income is recorded in the balance sheet as income and registered with a positive sign (+). A
transaction resulting in a foreign payment is registered in the balance of payments with a
negative mark (-).

In the balance of payments (BP) are recorded in fact two types of international
transactions: goods and services export and import, which enter the current account balance
(CAB), assets sales and purchases, which enter the capital account balance (CpAB). By asset
we understand any form in which wealth can be hold: money, shares, plants, land, stamp
collection etc. When an American buys a castle in France, the transaction is registered as
payment in the capital account of the payments balance of USA and as income in the capital
account of the payments balance of France.

Any international transaction enters payments balances twice: once as income and
once as payment. This accounting principle of the balance of payments is explained by the
fact that the transaction has two parts. If something is bought from a foreigner, the same thing
has to be paid. At his turn, the foreigner has to use the income, spend it or deposit it.

Payments balance should always to be balanced. A deficit in the current account has
to be covered by an input in the capital account through an external loan or the diminution of
the international official reserve. A surplus in the current account need to correspond to an
output from the capital account, through granting an external loan or increasing the
international official reserve.

Basic scheme of external payments balance

Incomes Payment

Current account balance (CAB)

Export X

Import X

Balance +

Capital account balance (CpAB)

Active sales X

Active purchase X

Balance +

International official reserve balance +


Total = =

In some countries, the external payments balance shows separately the countrys
international official reserve balance (RB), which comprised stock and gold reserves. When a
CAB deficit cannot be fully covered by CpAB surplus, the difference is covered from RB,
which thus decreases. The other way around, when a CAB surplus is not fully placed abroad
through CpAB, the countrys international official reserve increases.

As a synthesis of countries foreign economic relations, external payments balance

shows how healthy each country is. On this basis, a series of indices can be calculated:

d) Country risk

Health indices of the economy in international economic relations

Index Calculation Meaning Optimal level

Degree of openness Comparative As high as possible,
of the economy advantage depending on the

toward the exterior exploitation and country dimension
competitive between 20% and

Degree of import Country capacity to As close as possible to

coverage through produce competitive 100%, but not through
export goods and services on import reduction
an international scale

Total of contracted The bigger it is, the Inferior to the export

imports guaranteed smaller is the volume with respect
by the State both countrys capacity to to the annual export
from the other produce competitive level
External debt
countries and goods and services
organizations and
from the private
capital market

Matured payments Country solvability Payments obligations

and outstanding to honour its debts at related to the export
interests in a year their maturity should not exceed
External debt service 20%. If a percentage
of 25 is reached, the
country can enter
cessation of payments

Stock of currencies Country wealth and It has to cover imports

freely convertible and power, without being for a period of at least
Official reserve level gold hold by the a purpose in itself 5 to 6 months
central bank

Economys health diagnose cannot be established on the basis of one or several of

these indices, but through their combined analysis. For example, an economy can be
considered healthy although it has a degree of imports coverage through exports only of
70%, if it has substantial inputs in CpAB from dividends of national companies realized from
foreign investments. In the same way, an economy with an external debt exceeding the
annual export can be appreciated as healthy if it has an official reserve covering the import
for a whole year.

Chapter 18. Portfolios performance evaluation

18.1.Financial securities performance

It is widely accepted that performances evaluation has to be carried out by means of

two dimensions: earnings and risk.

It has been appreciated that for a true image, earning should reflect changes in market
value of securities and in the amount of dividends, received interests. Thus, most of the time,
the recourse to the accounting value of securities is unnecessary. In certain cases, it has to be
made a clear distinction between gross and net earnings. Surely an investor will be interested
in net earnings. Since earnings from different sources are imposed to certain categories of
taxes and charges, these have to be separated in order to allow a precise interpretation of
main taxes. Also, living beneficiaries and heirs have to be treated with impartiality by the
legal representatives of their funds who have to choose those types of investments whose
total earnings will be distributed in a rational manner between the two categories of
beneficiaries with divergent objectives.

Internal earning is calculated in order to determine the mature yield of bonds, being
the discount rate of cash flows related to an investment so that their algebraic sum is zero.
Internal earning quantifies the initial investment performance, assuming that any future
investments will have the same earnings. Most of the portfolios managers and investors are
interested in this index.

Nonetheless, internal earning does not evaluate the professional competency of

portfolios managers, being influenced by a series of random factors which cannot be
controlled by them, such as accounts funding intervals and funds withdrawal by investors.

In order to eliminate these deficiencies, it has been introduced the notion of time
weighted earning. Logically speaking, this notion is equivalent to the earning of a mutual
fund unity purchased and redeemed at the net unitary value of the mutual fund assets. The
earning of an investment into a mutual fund is given by the purchase price, the amount of
incomes, and the price of the unity at the end of the period. The earning of an individual
investor is not influenced by acquisitions and redemptions of other investors or by time
intervals when these funds move occur.

18.2. Risk

Investors do not take all the same degree of risk and thus their earning will be
different. It is wrong to appreciate portfolio managers professional skill only through
effective earnings without taking into consideration their different risk-taking. Earnings
fluctuations have to be attributed both to essential factors (market evolution) and random
factors (managers professional skills). During a certain period of time, if constant earnings
exist, differences in effective earnings for two portfolios can be attributed to the way of
portfolios administration. Since risk estimation is often based on earnings variability, a
distinction between essential factors and random factors has to be made.

In order to establish the risk, it is recommended to use general dispersion (total) of

time weighted earnings. This index is much more stable than the standard deviation. In order
to determine the risk, market models use beta coefficients indicating the volatility of
portfolios earnings with respect to markets evolutions, rejecting thus the use of the total
variability. William Sharpe in his famous theoretical article argues that risk premium depends
only on systemic risk (sensitivity to market evolutions). If all investors hold perfectly
diversified portfolios, Sharpes theory would be valid. In addition, if all portfolios are
perfectly diversified, the risk determined by means of beta coefficient is equivalent to the risk
determined on the basis of the standard deviation or general dispersion. However, not all
investors have perfectly diversified portfolios. This is the reason why earnings fluctuations
cannot be attributed only to the evolutions of the market, but also to its total variability

Portfolios performances evaluation by means of general dispersion reflects not only

the ability of managers to choose winning firms, but also their capacity to efficiently
diversify. In case the risk is appreciated only on the basis of its volatility related to the
market, performances evaluation depends only on the managers skills to choose those
securities having higher earnings than those registered under the conditions of similar levels
of systemic risks. Normally, total risk is higher than systemic risk. This is why, during the
periods of time when market earning exceeds zero risk securitys earning, it is not
recommended to evaluate the risk by means of total dispersion. On the contrary, during
periods when market earning does not exceed zero risk securitys earning, portfolios
managers should evaluate by means of total dispersion.

18.3. Performance criteria

Most of the investors are interested in knowing professional performances of

portfolios managers. For this purpose, it is necessary to use performance criteria.

Firstly, one can choose that portfolio presenting a risk almost equal to the one of the
existing portfolio. This methodology is frequently used in economic sciences and in
meteorology. In economic sciences, making presumptions based on the assumption that the

next year will be similar to the present one or that the next year will be different from the
present one with the same variation percentage of the present year in comparison to the
previous one. The theoretical basis of such a criterion is the price model of capital financial
assets developed by Sharpe which indicated the earning for each level of risk that is bound to
be obtained in average by combining zero risk securities with groups of risky securities.

The average performance of comparable portfolios is found by applying the second

selection criterion. For this purpose, it is right to appreciate the performances of every mutual
fund which has as an objective the appreciation of the capital with respect to the average
performance of all the other funds from this category. In Jensens study, the regression line
reflects relations between funds risk and earning.

18.4. Portfolios components evaluation

One of the fundamental hypotheses of Markowitz model is that the choice refers to
portfolios and not to individual securities and the performance has to be appreciated at the
level of the portfolio and not of individual securities or groups of securities. Although the risk
and earning appreciation of different types of securities is a current practice, its purpose is to
diagnose different types and not to make an overall evaluation of the portfolios management.
Such appreciations can contribute to the identification of causes leading to an inferior or
superior performance.

These appreciations ignore the relations established between different types of

securities. One of the fundamental postulates of the portfolios theory argues the
impossibility to correctly quantify the risk of an individual security or a group of securities
independently from the other securities included in the portfolio. The extreme example is
offered by those securities or groups of securities negatively correlated to the portfolio. Being
separately appreciated, it can be assumed that such securities are very risky and thus they will
involve a major risk premium. By relating to the other component parts of the portfolio, it
results that these securities can contribute to the decrease in risk and this is why they will
receive a reduced risk premium, maybe even negative.


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