A Guide to Understanding Corporate Finance
Finance is the science of funds management, and there are three general areas of finance which consist of corporate (business) finance, personal finance, and public finance. Corporate and business finance are discussed here for the purpose of informing managers and owners of businesses. As managers and owners, we must make intelligent financial choices or run the risk of being overrun by competition. With some knowledge of financial terms and concept you will be well on your way to a responsible and informed manager or owner.
Corporate finance planning is intrinsically connected company or strategic planning. If you plan on working in management or owning your own business, you will need to understand corporate finance to some degree in order to manage risk.
Risk- Financial risk is a broad-based term referring to any risk associated with financing. The risk most often refers to the difference between actual return and expected return.
Strategic Planning is defined as planning strategy which determines where an organization is going by coinciding projects with mission and vision statements. Strategic planning utilizes resources in a manner which is intended to maximize the potential for success of a company project. For instance, if a company is planning to expand into a foreign country, part of the strategic plan might include human resources as a means of finding the right staff with special skill sets for this endeavor, e.g., language understanding, culture knowledge etc…
Financial planning differs from strategic planning (although it is often a segment of it) in that it solely plans for projects through financial means via budget requirements and money allocation. Financial planning is however an extremely important segment of strategic planning in that it determines the monetary resources needed to accomplish projects. There are many barriers to the success of strategic plans, including financial problems. For instance, the resources that might be needed for expansion might not be available and this is where financial planning must determine whether extending credit is a viable option or if waiting until money can be saved is more economical for the company.
Intrinsic to both financial and strategic planning is what is known as breakeven point or breakeven analysis as this is used to make financial and strategic decisions.
What is the breakeven point & how does it impact decision making?
The break-even point is the level of sales at which revenue equals expenses and net income is zero, sometimes this study is referred to as a cost-volume-profit relationship or break-even analysis. Breakeven analysis is an important part of a company’s planning process, helping managers to predict how their decisions affect sales, costs, and net income. It is important to remember by altering on factor in the breakeven analysis other factors can be changed which can cause an undesired effect. Often underperforming companies use break-even analysis to determine how to make cut backs in order to lower expenses. For example, companies will often lay off workers or reduce hours of labor in order to increase profit. This often is the case but this can affect other factors in the breakeven analysis such as not being able to meet deadlines. On solution is to raise prices in order to compensate for loss. In other cases, companies might look to reduce the cost of other resources such as switching to less expensive materials or to cut back on power consumption where available.
Breakeven analysis is one of many tools used by managers and business owners for predicting actions and also for ensuring efficiency in operations and in finance. Understanding efficiency is extremely important to financial decision making.
Efficiency & Working Capital
Working capital is defined as a measure of a company’s efficiency and its short-term financial health. Working capital is measured by the ratio of current company assets’ ability to cover the current liabilities.
Capital- Capital is cash or goods used to generate income either by investing in a business or a different income property. Capital also refers to the net worth of a business; that is, the amount by which its assets exceed its liabilities and this can be confused with working capital. Capital also refers to the money, property, and other valuables which collectively represent the wealth of an individual or business.
When the assets do not exceed liabilities, then the company has insufficient working capital. This is a problem because it means that the company does not have the ability to pay short term debts. Organizations attempt to increase working capital mainly by increasing cash-flow. This can be done in many different ways but essentially collecting receivables faster increases the amount of money on hand a thereby creates more working capital.
Cash flow- Cash flow is the movement of cash into or out of a business. Cash flow is measured across a specific time period such as a month or week. Increasing cashflow increases working capital in most instances.
Some of the ways that companies speed up collections is by offering discounts on early payments or by decreasing billing periods such as net 30 to net 10. In this way working capital makes the company more efficient by having more money on hand for other projects.
Another technique for increasing working capital is to borrow less money. Many companies use lines of credit to purchase goods but these lines of credit albeit convenient, increase long term debt.
Debt- Debt is that which is owed. In finance debt represents the amount of money owed by a company. Debt reduces the value of a company.
By limiting the amount of credit used increases the working capital. This can also make the company run more efficiently because the company has less accounting work.
Along with measures of efficiency and working capital, there are other ratios to be aware of in corporate finance. Financial Ratios & Liquidity
The ratios that are used to measure a corporation’s liquidity include:
1. Current Assets — Current Liabilities
2. Current Assets/Current Liabilities
3. Current Assets — Inventory — Prepaid Assets/Current Liabilities
The problem with using these ratios is the problem of time. The ratios only take into account short-term or current values and this can be misleading over the long term. For instance, long term debts do not appear in these ratios and this can give a distorted view of the financials. Often companies face short-term liquidity issues mostly due to cash flow problems. This does not mean that the company is bad shape it is simply a reality that often companies collect receivables slower than their payouts on liabilities. As well, these ratios do not take into account long-term liabilities such as bond payouts or loans coming due. These factors could make a person see the company as being very healthy without having knowledge of these numbers. One would need to be careful to not use only these ratios for judging a company’s health.
In the way that financial ratios and liquidity can be used for determining operational functions and efficiency other ratios can be used for large expenditures such as expansion. This is known as capital planning.
Capital planning is the strategy used for determining a company’s capital expenditures. These are expenditures that are paid over a period of more than one year. These expenditures include the acquisition of assets which improve or increase the current assets of the company. For example, the purchase of a new building is a capital expenditure which must be planned for. This expenditure will increase the value of the company over time and will likely increase the profitability of the company also by expanding its size.
The Internal Rate of Return (IRR) is important to an organization by determining individual rates of return such as on projects and actions within the company. Companies can then gauge whether particular processes are actually profitable or not. The Net Present Value or NPV can be defined as the criteria for capital budgeting decisions. This measure gives an indication of the net value of an investment or project proposal. Companies use this as a method for determining whether to accept or reject a project. If a project’s net value is greater than or equal to zero, the project is accepted. When it is less than zero project is rejected. The use of IRR is common because it is easy to use and easy to explain to other managers or project leaders.
Capital planning requires a more detailed approach involving capital budgeting. When capital budgets are needed, this necessitates identifying the optimal cost of capital for the organization.
The Optimal Cost of Capital
The optimal cost of capital for an organization is the required return necessary to make a capital budgeting project worthwhile. The cost of capital is optimized when the cost of debt and the cost of equity are calculated and this can show that the cost of capital will provide a rate of return over time. There are many factors which can be used to find the optimal cost of capital including tax, stock equity, bond issuance ROI, and even market factors. These different factors provide the organization a means of calculating the optimal cost. In its simplest form for an investment to be worthwhile, the expected return on capital must exceed the cost of capital. In this way the cost of capital is comparative in that the rate of return the capital could possibly earn in an alternative investment is compared with the ROI of the capital expenditure. For example, if a company desired to build a new manufacturing facility, the cost of this expenditure would be weighed against the investment of the same cost in an index or money market fund. In this way the company can judge whether the cost of capital is better or worse than a stable investment. It should be noted that there is a subjective element associated with this calculation in which companies must gauge whether the risk of the capital expenditure is worthwhile.
Another method of determining cost of capital is through the weighted average cost of capital.
The Weighted Average Cost of Capital
The Weighted Average Cost of Capital (WACC) is used in finance to measure a firm’s cost of capital. The WACC is the value of its equity plus the cost of its debt. Through the averaging all of the capital costs of an organization, the Weighted Average Cost of Capital (WACC) is calculated. can be determined. Several key factors in WACC included sources of capital, such as preferred stock, bonds, and common equity.
The WACC is a more appropriate discount rate when doing capital budgeting because it uses the after-tax costs of the resources used for project financing. This is a more accurate view of the actual resources of available and because the WACC fluctuates over time as expenditures and assets change, this allows for a view of financing that is accurate and proportional. As well this allows the organization to have a clear view of the rate of return that must be achieved in order to satisfy creditors and investors.
The use of WACC is very important to assessing a company’s financial health. It can be used both internally for capital budgeting and externally for evaluating investment markets. The WACC allows companies to see the cost of their financing as well as a decision tool for investment decisions.
The cost of capital and capital planning help manage corporate finances but when corporations raise money they don’t always borrow. Often they use the financial markets.
What are financial markets?
Financial markets are institutions and procedures that facilitate the trading of financial securities. These transactions include the purchasing and selling of stocks, bonds, and commodities. Financial markets perform the function of raising money for public and private industry. Without these financial markets, industry and government would be slow and, in some instances, would not be able to function. For instance, the lending market would be vastly smaller because banks would not have capital from securities to lend to customers.
Are financial markets good for the economy?
The economy would be worse off without financial markets for several reasons. Investors would not be able to earn a return on their investments and in many cases, there would be no investing in things like corporations. Individuals would not be able to receive loans and therefore incapable of making capital purchases such as homes and cars. This would stunt business growth and the economy would slow tremendously since industry would be incapable of expanding due to lack of funding.
Money and Capital Markets
Money Markets facilitates transactions using short-term financial instruments, whereas Capital Markets facilitates transactions using long-term financial instruments. A money market is a market for short term debt securities such as commercial paper, repossessions, negotiable certificates of deposit, and Treasury Bills with a maturity of one year or less and often 30 days or less.
Security- A security is a debt issued by government or corporation that may be traded. The holder of the security is a lender to a buyer. By owning the security, the owner is entitled to interest at maturity, or dividends. This right of ownership can be transferred through the sale of the security.
Money market securities are generally very safe investments which return a relatively low interest rate that is most appropriate for temporary cash storage or short-term time horizons. A capital market is where debt or equity securities are traded. Typically, capital markets pay larger returns. For example, a home could be considered a capital investment. Over the life of a mortgage an investor will realize hundreds of thousands of dollars in return.
Efficient market- An efficient market is a market in which securities prices reflect all available information. In an efficient market, securities are traded with the correct value given the available data. This is also known as “information efficient.”
Capital markets are comprised of the primary and secondary markets.
Primary market- The primary market is the market in which new securities are issued and sold on the exchange. The primary market is how companies raise financing through the sale of securities. This market is comprised of underwriters and investment banks which set the price of the security being sold and are responsible for the sale. The most common securities sold in this market is stock and bonds.
Stock- The stock of a business represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors. Stock entitles holders to dividends and decision-making votes based upon the equity of their stock.
Bond- 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 later, termed maturity. A bond is a formal contract to repay borrowed money with interest at fixed intervals.
When stock is initially offered in the primary market, this offering is referred to as the initial public offering or IPO. An IPO allows an organization to grow financially by allowing investors to purchase stock in the company. This offering increases company revenue and capital in order that the organization can now invest in larger projects. The stock is based upon the value of the company and the rate of return is determined by the financial strength of the company. Often IPO sales send the stock prices of a company soaring during the initial sales, but then the stock often rests at a much lower rate. Even in the secondary market the price of stock can often rest much higher than its actual value. This is often referred to as intrinsic value and it is based not on the worth of the company but on the value investors place on the stock. Both markets also have the inefficiency caused by speculation and volatility of investors. A negative news story about a company could cause the stock to plummet but this is not always an accurate depiction of the company. This type of capital raising is best when a company has a strong financial health.
Secondary market- The secondary market, also called aftermarket, is the financial market where previously issued securities and financial instruments such as stock, bonds, options, and futures are bought and sold after being offered in the primary market. Most trading takes place in this market.
Investing in markets is a complex activity requiring research and strategizing. Some key terminology used in market investing include:
Yield- The income return on an investment. There are two different yields “cost yield” and “current yield”. The cost yield is what the ROI will be at the date of maturity such as on a bond. The current yield is what the security is worth at the moment.
Rate of return- In finance, rate of return (ROR) is the ratio of money gained or lost (whether realized or unrealized) on an investment relative to the amount of money invested.
Return on investment- Is essentially the same as ROR also known as return on investment (ROI) also known as the rate of profit or sometimes just return.
The Benefits of an Organized Security Exchange
Organized security exchanges provide a means for corporations to raise capital for any number of uses such as expansion or investment. Through stock exchange the corporation can lessen its risk of borrowing and lessen its short-term debt payments. The security exchange also provides a place where the corporation can attract other investors such bond investors. For the individual investor, the security exchange provides a place where the person can make substantial returns by directly investing in companies and government entities. The purchase of stock can often mean larger returns than the interest on savings accounts through banks. However, the risk for individual investors is much higher than those who invest through banks.
The securities exchange also provides a place where individual and corporate investors can analyze the market and economy. The exchange gives investors a view of the economy through the activity that is taking place and this can help with deciding whether to purchase certain goods or not. For instance, if a particular computer company is not performing well perhaps one would be wise to not invest in that company or buy its products.
The benefit of securities exchanges are global in implication and have been one of the driving forces in globalization. What is globalization & why has globalization become such an important issue?
Globalization is the worldwide spread and integration of business, communications, and economics. Globalization has been made possible through technological advancements such as the internet and computers. Because of the World Wide Web business has been able to expand across borders and into virtual environments. A great example of globalization is the ability for businesses to sell across borders into other countries without having brick and mortar stores. As well, globalization has also expanded companies through outsourcing of jobs, such as having IT professionals working in other countries where labor is less expensive. Globalization has many benefits but also has many negative aspects and both have made globalization an important issue.
The loss of jobs to outsourcing and the conducting of business across borders are both problems today. As well, the growth of the global economy is beneficial to developing countries where jobs are created but without financial regulation the market can become unbalanced. There are security issues and the process of globalization has created diversity issues within the workplace because of cultural differences. Along with these diversity issues, there are legal problems in that different countries have different labor laws and business laws. This creates another issue of corporate citizenship and responsibility. The necessity for dealing with these issues is paramount to being able to successfully run most large organizations today.
How Globalization Impacts Corporate Financial Management
Globalization is changing the financial management of companies dramatically. Because of the rapid growth of the world market isolated markets have almost been eliminated. This fact means that there is an increase in the competition, not only between companies within a country but between international companies. Along with increased competition there is also an increase in corporate finance options. Today is far easier to access financial resources from international investors and this makes expansion easier.
There are also problems concerning day to day financial management such as exchange rates and market volatility. Exchange risk is a serious problem especially for companies lending, borrowing, or selling and buying across borders. Timing is a serious issue when dealing with these issues especially when purchasing goods that might take time to sell. If the exchange rate changes by the time the good is sold large amounts of money can be lost in the transaction. There is also market volatility. Stock exchanges can be accessed by people across the world and this means that current events can create massive movements in the exchange. For instance, when the recent unemployment statistics were released the market fell hundreds of points. This affect has been made worse by globalization. Solid financial management is necessary for dealing in these volatile markets which increase foreign exchange risk.
What is foreign exchange risk?
Foreign exchange risk is defined as, “The risk of an investment’s value changing due to changes in currency exchange rates. The risk that an investor will have to close out a long or short position in a foreign currency at a loss due to an adverse movement in exchange rates. Also known as “currency risk” or “exchange-rate risk.”
There many problems that foreign exchange presents in companies. First that multiple currency handling can be confusing and requires an exact measurement otherwise profit can be lost between the exchange of goods and services. Simply speaking if the dollar is lower in value than a different foreign currency being exchanged then the dollar is not being maximized on that day. Currencies vary daily in value and these need to be considered in all foreign transactions.
Every country has different legal requirements and without understanding the laws in foreign countries one can lose money. For instance, foreign markets do not place the same value on investor dollars as America does. The positioning of money into bad investments often leads to losses with no means of recovery. This leads into institutional restrictions such as investment into foreign companies. It is important to understand that other markets are not as liberal as the United States and they often do not allow foreigners to invest beyond certain amounts of money. When dealing with these problems on a global scale a company needs to have strong internal controls in order to manage across borders. These controls must take into account these factors involved in the international financial market.
The Importance of Finance
Understanding corporate finance will help you as a manager save money and provide the means for achieving goals such as budgeting and defining operational needs. Not understanding finance places managers at a disadvantage especially when dealing with predatory lenders whose intention is to make companies pay high interest rates. You don’t need to be a finance expert but you do need to have a grasp of finance to protect your company.
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Mayo, H. B. (2007). Basic finance: An introduction to financial institutions, investments, and management (9th ed.). Mason, OH: Thomson.