Essentials of Corporate Finance
To run a business, you need to know about capital – without money, operating a business becomes an impossible task. When it comes to knowing where, when and how to get the capital and perhaps more importantly, how to allocate the capital and make use of it, you must learn about corporate finance.
So, what are the essentials of corporate finance? Let’s examine the concept in a nutshell, study its core concepts and understand its relationship with investment banking.
CORPORATE FINANCE IN A NUTSHELL
When it comes to learning about things and understanding issues, you first need to know the value of the information. You need to know the meaning of what you are trying to comprehend.
Essentially, you need to ask yourself why the essentials of corporate finance matter to you. The quite simple answer is that you can’t run a business without corporate finance.
Every single corporation and business out there will involve itself with corporate finance because it is all about the different financial activities a company is required to perform for operating. Corporations need corporate finance to operate and more specifically to create value.
Whether your business is small or large, you most likely have a dedicated person or even a department to oversee the financial activities – to look after the corporate finance of the organization and ensure the business is not failing due to its financial handling.
What kind of issues does corporate finance deal with? Some of the typical questions you could deal with include answering things like:
- Should the company invest in the proposed investment?
- Should the company make payments with equity or debt, or a bit of both?
- Should the shareholders receive dividends on the investments they make in the company?
The final example above points out to a crucial aspect of corporate finance, which deals with shareholders and the value they receive. The actions and activities of corporate finance are indeed primarily focused on maximizing shareholder value, either through long- or short-term financial activities.
The idea is to plan and use strategies that ensure this value creation is effective and appropriate. Therefore, things like capital investment and investment banking are part of corporate finance essentials.
To recap the above, the primary function of corporate finance is to:
Increase and maximize shareholder value.
Due to the primary function, corporate finance deals with:
The different sources of funding and the capital structure of the corporation in question, as well as the actions managers take to increase the value.
Furthermore, corporate finance essentials include:
The tools and actions, which are utilized in allocating the financial resources of the organization, and the strategies taken to achieve the ultimate function.
Before I start outlining the main concepts of corporate finance, it’s crucial to note how the concept can have slightly different meanings depending on the countries it is being talked about. The finer meaning of the word ‘corporate finance’ is approached and understood differently depending on which country you are based in.
For example, in the US, the concept has a much broader definition than in the UK. The US definition deals with different financial activities and techniques that can be used in reference to company’s finances and capital. On the other hand, the UK definition of the concept is much narrower and tends to be linked with transactions that help raise company’s capital and in which the capital is used to create, develop, grow or acquire businesses.
This post will focus on the broad essentials of corporate finance and the main concepts used around the world.
THE MAIN CONCEPTS OF CORPORATE FINANCE
Corporate finance essentials can be divided into two main categories: investment analysis or capital budgeting, and working capital management. What are these concepts?
Investment analysis/capital budgeting
Investment analysis or capital budgeting has at its core the aim of adding value to the long-term corporate finance projects. These are projects, which relate to the investments that are funded through capital structure.
In other words, corporate finance first studies how the company deploys its long-term capital, i.e. where it is spending or investing its money.
So, how do corporations get their hands on capital and then how do they invest it? First, let’s examine the different capital structures of the company and the basis of corporate finance.
Corporate finance is interested in increasing the shareholder value and in order to do so, it generally has to invest in order to expand and to grow. In order to be able to invest, the organization must find ways to finance this growth and investment. There are generally two different ways of financing corporate activity:
- Self-generating capital (i.e. selling products and services)
- Issuing new debt and equity
Furthermore, the capital structure usually consists of a combination of the following sources of capital:
- Debt capital – which is often borrowed funding, either as debt capital or credit.
- Equity capital – which refers to the money companies raise by selling shares to investors.
- Preferred stock – which is a hybrid version, including both an equity and a debt instrument.
The organization’s role is to find a balance between these different options for sourcing capital and creating a sustainable capital structure. Generally, this means using different capital sources to ensure there isn’t an over-reliance on a single source or capital model. You can find out more about capital structure from the introductory video below:
Investment and project valuation
After a business has dealt with the capital structure, the focus of corporate finance moves to capital investment and budgeting. The process of capital investments, of deciding where the money should go in order to attract long-term value, is determined by capital budgeting. For this, the organization must consider investment and project valuation.
The valuation process is essentially determining how maximize the benefits, i.e. profits, and to minimize risks and costs. The most common calculation related to investment and project valuation is the discounted cash flow (DCF) valuation. This determines the cash flow expected from the investment and therefore, shows whether it is worth it.
To calculate DCF, the organization needs to implement concepts such as time value of money to determine the present value of future cash flows. The sum of the different present values will provide the net present value (NPV), which shows whether the investment is worth the costs. Other key ways to measure the investment value as part of corporate finance include:
- Discounted payback period
- Equivalent annuity
- Rate of return
Furthermore, project valuation requires an understanding of flexibility. This refers to accounting for uncertainty in terms of the project in question. This could be about considering the right growth rate for building the additional factory and the rate of growth at which this wouldn’t happen.
This way, when calculating future cash flow, the company can account for both situations: the stage at when the factory is built and when it isn’t. Since most organizations are faced with these situations of uncertainty, the investment and project analysis has to involve plenty of quantifying uncertainty analysis. This typically means assessing the sensitivity of a specific occurrence, or the so-called stress testing.
Capital investing is the most crucial aspect of corporate financing. By budgeting capital to the right projects and investments, the organization identifies where it can make money and where it is spending money. The budgeting will help understand things such as future cash flows, comparison of planned investments and their proceeds, and the projects that are worth investing in.
Therefore, this part of corporate finance is often considered the most serious in terms of business implications. If you get capital investments wrong, you might end up with a non-functioning business. Essentially, bad capital budgeting and investing will lead to either over-investments or under-investments, which in turn can damage the financial competitiveness of the organization.
Getting this part of corporate finance right is a must-do for organizations. Furthermore, the concept of capital financing, i.e. finding the balance of sourcing capital either in the form of debt or equity, is crucial.
If the organization sells stocks too quickly, it can lead to unsustainable levels of earnings, although relying on debt can increase the default risk of the organization. Therefore, there must always be a balance between how capital financing works in order to meet the capital needs of the investments.
Working capital management
The second major concept of corporate finance is working capital management. This is about the day-to-day process of running the business and therefore more focused on the short-term growth of the business.
So, whereas the capital budgeting looks at the long-term investment and growth, capital management refers to managing the relationship of short-term assets and liabilities. The idea is that through proper working capital management, the business has the right kind of capital to fund the long-term investments and keep the organizations long-term finances in great check.
What is working capital? The term working capital refers to the funds that are required for the day-to-day business operations before the organization receives payments on products and services it has delivered to customers.
It is essentially the money the organization needs to have at hand to produce goods and services, keep employees and offices running, before anyone pays the company for these said services and goods. The amount is calculated by analyzing the difference between current assets (the resources in cash) and current liabilities (cash requirements).
The difference here in terms of the above calculations of cash flow is the focus on present. The capital considered is always current instead of a predicted sum, for example. The criteria applied in working capital are as follows:
- Cash flow and liquidity
- Profitability and return on capital
How is working capital managed? Considering the information laid out above, working capital management has important functions as part of the corporate finance process. Some of the most important functions include the following:
- Cash management – Which is about identifying the balance you need to have to meet day-to-day expenses while reducing the cost of holding on to large amounts of cash.
- Inventory management – Identifying the right level of inventory, which guarantees uninterrupted provision of goods and services, while reducing the cost of investment in the raw materials of the production of such goods and services.
The aim of the above functions is to manage the current assets of the organization (cash, inventory and debtors), as wells as the short-term financing (cash flow, returns) and ensure the short- and long-term growth of the organization is acceptable and leads to the ultimate objective of corporate finance: enhancing shareholder value.
Working capital management is often referred to in this context as short-term liquidity, as the process is about ensuring the organization has enough liquidity to finance the on-going operations. If the company can’t meet the current liability obligations, the long-term growth will suffer.
The trick is to find the right type of capital financing, which ensures there is enough short-term liquidity, but also focus on creating long-term investment opportunities for the organization to grow further.
Corporate finance in action
Let’s examine corporate finance and the above concepts through an example of how it operates in real life.
Consider you own a Business A that makes shoes. You are thinking about adding a new manufacturing plant in order to respond to increasing demand and to provide more value for shareholders.
What does it require to open a new factory? Well, you need to consider the finances of it – how will you finance the plant? Will it provide enough value? In short, you’ll need to negotiate with investors or banks to deal with the financing and understand how the short-term liquidity of your existing business is affected by the plan.
The finance department of your business will use the above concepts to determine the best capital structure to fund your venture. It will also do cost calculations in order to determine the cash flow predictions of adding the new product facilities, as well as ensure you don’t have another way of going about growth.
Perhaps you don’t need a completely new factory, but just an additional product line? Finally, you’ll use the corporate finance expertise of your finance department to ensure the plans have as little disruption to your current day-to-day operations as possible.
RELATIONSHIP WITH INVESTMENT BANKING
Like I mentioned at the start, corporate finance has slightly different meanings in different countries. Just like the UK, some countries and people associate corporate finance with investment banking as well. This is due to its close nature in terms of increasing or maximizing shareholder value.
If you consider the main purpose of an investment bank, it’s often about evaluating a specific company’s financial needs and then raising the appropriate amount of capital to meet those needs.
With that and the above in mind, the terms ‘corporate finance’ or ‘corporate financier’ relate to these types of investment banking transactions that are aimed growing, creating, developing, or acquiring businesses, and therefore, increasing the shareholder value.
The typical transactions linking investment banking with corporate finance include a broad range of actions and strategies. Below is an overview of some of these transactions:
- Raising seed, start-up, development or expansion capital
- Raising capital view issuing of equity or debt, or other related securities
- Raising capital through special corporate investment funds, including private equity and venture capital
- Raising capital through real estate and infrastructure funds
Mergers, acquisitions and demergers
- Merging with other organizations
- Acquisitions of other of businesses
- Demerging with pars of the corporation
- All of the above can include both private and public deals or public-to-private deals
Buy-outs or buy-ins
- Management buy-outs or buy-ins
- Buy-outs or buy-ins of similar divisions or subsidiaries, generally backed by private equity
Equity issuing and financial joint-ventures
- Flotation of companies on the stock exchange
- Secondary equity issuing, either through private placing or further stock releases
- Financing of joint-ventures, including infrastructure finance, project finance, and public-private partnerships and privatizations
Raising and restructuring debt
- Raising debt to fund above ventures
- Restructuring debt to fund above ventures or other financial transactions of the corporation
As the above show, there are a wide range of transactions that relate to corporate finance, which might be dealt with by an investment bank. Furthermore, corporate finance involves a number of financial roles from financial advisors to corporate accountants.
Corporate finance is also an area that relates broadly with financial risk management. This is due to the financial risk influencing corporate value directly and therefore, by monitoring financial risk, you can better understand the value implications of certain actions and strategies for creating more value for the shareholders.
Due to the broad inclusion of these different financial sectors and concepts, the essentials of corporate finance are important to know for anyone working in the finance sector or being involved in the management of a company. To recap the above, check out this introductory video to corporate finance and why companies need to understand it by ICAEW:
Corporate finance is as essential to running a business as money is for keeping the company running. Essentially, that is what corporate finance is about: attracting, allocating and advancing capital.
The focus point of corporate finance is to identify and understand how shareholder value can be enhanced – to provide investors and shareholders a better return. As the above has shown, corporate finance needs to do this by examining both the short- and long-term allocation of capital.
The focus is on understanding which projects and investment provide the organization the best long-term benefit to keep going, but also how to manage capital in the short-term to keep the business’ day-to-day operations running smoothly.
Corporate finance is therefore crucial for the survivability of the organization – big or small. While there are certain differences in how broadly the concept is defined, with investment banking and risk assessment included under the umbrella of the concept in some countries, the essence of the term remains the same in most situations: the analysis of business activities related with the organization’s financial decisions.
To understand the business and to improve the business, you must understand corporate finance.