Corporate Finance Fundamentals – A Comprehensive Guide
Corporate Finance, in a nutshell, is the domain of finance that determines the various facets of the corporate structure of an organization. This entails understanding and analyzing the different sources of finance, the budgeting, forecasting investment opportunities, and the maximization of the value of the organization to turn it into a brand. Corporate finance requires a thorough knowledge of the financial markets and tools and applications that help facilitate the process of growth to meet the company’s goals and objectives.
It also takes into account risk factors and short-term expenses for the smooth running of the business. It is a complex domain that deals with several factors related to funding and finance, the main vision is increasing the value of the corporate organization.
So let’s delve into the complex world of corporate finance and try to decode the various terms, jargon, and components intrinsic to this corporate finance domain.
We will cover the following concepts today in this article
- 3 Main Areas Of Corporate Finance
- Role of Corporate Finance
- Elements of Corporate Finance
- Corporate Finance Functions
- Principles of Finance
- Job Profile of a Corporate Finance Analyst
- FAQs on Corporate Finance
Main Areas Of Corporate Finance
Here we are looking at the main areas of Corporate Finance that help to make judicious business decisions for the expansion of the business.
The first component we cover in corporate finance is capital budgeting. Now, what do we mean by capital budgeting?
Capital budgeting is the step-by-step process of analyzing projects and making investment decisions for the business in long-term assets. This essentially means that capital budgeting enables the corporate houses to understand whether an investment in a certain project will reap benefits in the long run or not.
Here the corporate executives weigh the pros and cons of greenlighting a certain project taking into account whether the rate of return on investment (ROI) will be greater than the cost of the project. They will have to ascertain whether the investment will result in fulfilling the long-term strategies and business goals of the organization.
Some of the key decisions and capital budgeting includes the following
- Buying new or replacing existing machinery or doing both
- Launching new products, and services and creating a branding strategy
- Expanding the business geographically
- Merger and Acquisition Decisions
Capital budgeting decisions are made by taking into account a few essential components. These determine whether investing in a project is viable or not.
These components are as follows
- The Payback Period
- Net Present Value
- Internal Rate Of Return
- Profitability Index, among others
The payback period simply put is the number of years that the company will take to recover the initial cost of the investment. As a general rule, any project that provides the quickest payback time is the one preferred by the company. The reason is that the payback period can determine the liquidity of a business. Therefore to resolve any liquidity issue, a short payback period is desirable for the company.
The Payback Period is calculated as follows:
Primary Cash Investment/ Cash Flow (Annual)
Net Present Value
Net present value is another method by which capital budgeting is done for an investment. The net present value is the difference between the value of cash inflows in the present time and the value of cash outflows in the present time calculated over a period of time. It is one of the primary methods to analyze the benefits of investing in a project and whether it is going to be favorable in the long run.
NPV is calculated by the following formula
Net cash flow/ (1+discount rate)^t
where t is the time period
Internal Rate of Return
An internal rate of return is a situation where the net present value of the investment is zero. This happens when the cash flow is equal to the cash outflow. In such a scenario an investment is approved if the internal rate of return is greater than the average cost of the capital.
We may also be interested in our article On Guide to Financial Modeling Fundamentals and how it can help businesses in making prudent investment decisions.
The profitability index as the name suggests is the present value of the cash inflows divided by the initial investment made. When the value is lower than 1 it means that the cash inflows a lower than the initial cost of the investment. When the cash inflow is greater than 1 that denotes the cash flow generated is healthier and the company would profit from expecting such a project.
Methods of Capital Budgeting
- Analyzing Investment Options
- Evaluating Proposals To determine Best Projects
- Selecting a Project
- Planning and Implementing Budget For The Project
- Auditing and Monitoring Progress
This is essentially a performance review where you analyze whether the project is behaving as expected or if there are roadblocks that need to be ironed out. This also means that you have to pull up the estimated outcomes and compare them with the actual performance to get a clear idea of whether your presumptions about the project were correct.
Factors Determining Capital Budgeting
- Accounting Norms of The Business
- Capital Returns
- Working Capital
- Structure Of Capital
- Government Rules Regulations & Policies
- Taxation Policies
- Project Requirements
- Working Capital
- Economic Value Of The Investment Earnings
- Financial Institutions
- Conditions For Lending
Every company has assets and runs operations successfully. Have you wondered where the funding comes from for all the operational activities and the assets that a company chooses to acquire and invest in? That’s right, it is the capital structure of an organization that determines all these factors and how much is to be allocated for assets and expenses. Capital structures specifically mean the mix of debt and equity that is used by a company to run its business.
The capital structure comprises debt and equity and a judicious combination of the two can help in the optimum performance of the business. It is the responsibility of the business management to decide how much debt or equity to use to carry out their financial task. This is dependent on the weighted average cost of capital (WACC).
The weighted average cost of capital (WACC) is the cost of equity plus the cost of debt.
The capital structure of a business is determined by several factors such as the size of the company, mergers, and acquisitions, company operations, government policies, and management decisions.
Working Capital Management
Working Capital Management is the management of the current assets and current liabilities of the organization for the smooth running of the short-term business goals and objectives.
Current assets include cash, inventory, debtors, investments for the short-term bank balance, etc. Current liabilities include creditors, outstanding expenses, loans (short term), etc.
Anything that is a liquid asset is considered a current asset that helps to run the expenses and operations of the business.
Role of Corporate Finance
Corporate finance is one of the most vital departments in an organization and its role in the growth of the business is multifaceted.
Elements of Corporate Finance
Operating Cash Flow
Operating cash flow is an important financial metric that helps to understand how well the business is performing and what should be the future course of action based on the data available from operating cash flow results.
Operating cash flow is the assessment of the cash generated by the business with its normal operational activities. It defines whether a company is sufficient in generating positive cash flow through its different operations or whether it needs external financing to expand the business activities to fulfill the goals of the organization.
Some of the ways in which you can gauge the amount of operating cash flow are the sales of your product and service in the specified time, the ease with which you can handle payouts to employees, and payment to suppliers.
Types of operating cash flow
Direct cash flow method
The direct cash flow method is assessed by subtracting the operating expenses from the total revenue. It is an apt determinant for the operational performance of the business.
Indirect cash flow method.
The indirect cash flow method presents a picture of the earnings in expenses incurred in a specified time by mentioning the different sources. In this type of calculation, any changes in assets and liabilities are added or subtracted from the net income. After that, any non-cash expenditure is added to the value to determine the operational cash flow.
Invested Capital in simple terms is the total of investments made by shareholders and bondholders. Here it becomes imperative to delineate the difference between a shareholder and a bondholder of a company. A shareholder owns stocks of a company whereas a bondholder is issued should bond by the company. The basic difference between the two is that a bondholder is a creditor of the company whereas the shareholder is the owner of the company.
The invested capital is calculated as follows:
Total debt (Short term+Long term)+ lease+ total equity + non-operating cash and investments.
Cost of Capital
The cost of capital is calculated as the minimum return that will be compulsory in order to take up an initiative like financing a significant capital budgeting endeavor. The cost of capital is the sum total of the cost of debt and equity that is used to finance any business organization.
This is a prerogative of the business and they might choose to fund an entire capital budgeting project through debt, equity, or a combination of both. Cost of capital can also be an assessment of the return on investment compared to its cost and risks associated with it. Any organization’s investment calls should be made keeping in mind the return that should exceed the firm’s cost of capital that is used to finance that investment opportunity.
Return on Investment Capital (ROIC)
Return on invested capital is a financial metric that helps to understand the return that a company earns on any investor capital. It is a performance ratio where the percentage is calculated to determine how efficiently the investment opportunities yield positive results for the business and the investors.
Fundamental Corporate Functions
This is the first step in corporate finance where you create a detailed financial plan to ascertain the finances of the organization. This entails evaluating investment opportunities, planning how much finance is required to green-light those investment opportunities, what the sources will be, how the investment ratio is going to be, and the return on investment expected from such endeavors.
The next part is of course determining the means of raising the capital required for investment. There are various methods of raising capital like selling shares, bank loans, issuing bonds, and debentures. There has to be proper implementation of a financial plan to enable smooth short-term operations of the business and manage capital for long-term investment projects.
Capital budgeting is a crucial decision for management. People in the financial department analyze and implement finance models to consider the feasibility of investment and whether it is going to yield profitable results in the long run.
Any capital expenditure requires a huge amount of funding, therefore, considering all possibilities before going ahead with investment is the primary task to accomplish. Once you make such a huge financial decision, the nature of it being long-term, you cannot undo it. Therefore, all the complexities of such investment decisions have to be taken into account. This is capital budgeting in a nutshell.
Corporate governance is just as important as any other function of Corporate Finance since the entire growth of the business is dependent on careful governance and allocation of duties and responsibilities after well thought-out strategic decisions.
This requires shareholders to decide who the best people are to make key decisions for the business. Corporate governance entails that you have insightful individuals at the helm who understand the nitty-gritty of running a business. Evaluation of the performance of the business from time to time, and never losing sight of the purpose, mission, and vision of the business are vital elements of running a successful business.
Just as mentioned above, capital budgeting is a huge responsibility that requires a massive amount of Finance to be pumped into the investment decision. Hence meticulous planning and monitoring are required to understand whether the investment is performing as expected. Since these are long-term investments, persistence is the key. Factors like market trends, fluctuation in prices, government rules, and regulations pertaining to the investment decision are vital aspects.
Similarly, risk management also entails taking prudent decisions on the future course of the business. For example, corporate finance analysts have to consider whether mergers and acquisitions are going to be profitable, whether equity or debt is the way to go and how to strategically grow the business through different activities that the business can undertake. They have to keep in mind operational tasks and the short-term goals of the business. This is important because liquidity is a requisite to run the short-term goals and expenses of the business. lack of sufficient current assets can hamper the short-term plans of the business.
Job Profiles in Corporate Finance
Corporate finance is a field in the Finance department that deals with capital investments, capital financing, and capital structure to efficiently handle a business.
This requires people with impeccable analytical skills and a problem-solving mentality that will help to tide over any adverse situation. Some of the job roles in corporate finance are financial analysts, investor relations analysts, cost analysts, and tax experts, treasurers, corporate accountants, auditors, financial modelers among others.
These job designations include the following tasks:
- Creating viable business plans and investment proposals to catapult the business to greater success and prosperity
- Ensuring that financial statements are analyzed and audited before making major business decisions
- Coordinating with other finance professionals in the department to identify challenges and work upon it
- Making sure that the dissemination of pertinent information is done to the shareholders without any ambiguity
- Studying and assessing business trends, looking for new investment opportunities, and creating viable financial models to provide an overall understanding of the performance of the business
- Implementing the best practices in corporate finance to develop investment opportunities
- Ensuring proper preparation of important documents such as annual reports financial statements, and financial models, and collating historical data to interpret the correct financial health of the organization
- Ensuring research and development are carried out to support important business decisions so as to maximize return on investments
- Most importantly corporate finance professional analysts should have superior communication and interpersonal skills to be able to disseminate information effectively with different concerned parties
1. How important are financial statements in corporate finance?
Financial statements denote an organization’s activities, and its financial standing, and help to understand how the company has performed in the previous years. Whether it is the return on investment, assets liabilities, cash flow, equity, debt, or operational activities, all of it can be summarized in financial statements. This enables managers, financial modelers, and executives of the organization to take important decisions regarding the future of the business and the steps to take for its prosperity.
2. What are IPOs?
IPO or initial public offering is the phenomenon by which private companies go public by offering shares of the company to investors. This activity is undertaken by investment banks. IPO helps in getting huge capital for the business for its expansion and investment goals.
3. What is the significance of corporate finance?
Corporate finance is an essential part of running a business successfully. Whether it is predicting the outcome of an investment, forecasting financial gains, budgeting for projects, or managing and minimizing risk, corporate finance is of the utmost importance.
Companies have to keep up with the trends and best practices and have to innovate to remain at the top in the minds of the consumers. For this reason, it is important with they carry out regular research and development activities that include feedback from customers, and market analysis to understand what works with the customers and what doesn’t.
All of this requires diligent financial planning and it can only be achieved if there is significant financial support available to carry out these important tasks. Thus, corporate finance help in activities starting from the functioning of the organization to making suggestions and decisions with respect to investments and capital.
4. What are the core skills for corporate finance?
Some of the core skills to secure a job in corporate finance are as follows:
- You should have a formal degree in finance and accounting from a recognized Institute.
- You should be well versed with accounting terms, concepts, and glossary.
- Decision-making, keen financial intellect, analytical skills, and risk mitigation are some of the scales that corporate finance professionals should have in plenty.
- In this digital age, it is become compulsory to be well equipped with knowledge of digital tools that help in financial calculations and problem-solving.
- You have to be well versed with internet tools that help to minimize manual labor so that you can concentrate on other crucial decision-making in corporate finance for the business. You have to be fluent in communicating important points to the management regarding the financial position of the business. You should also start developing management skills to be able to make key decisions regarding operations in the business.
5. Who can apply for jobs in corporate finance?
Corporate finance job is ideal for anybody with an inclination in financial mathematics, accountancy, statistics, and such subjects. You have to possess acute business mathematics skills, quantitative skills, and core knowledge of Business economics. Keeping all of these traits in mind people coming from the educational backgrounds of Business economics, business mathematics, Business administration, taxation, mathematics, statistics, economics, chartered accountancy, and company secretaryship is well-suited for a job in corporate finance.
So here you have all the details that are pertinent to corporate finance. Hopefully, this article has helped you to glean Fundamental knowledge of the components that make up the corporate finance structure and framework of an organization. Remember the financial world is vast and you will only be able to gain in-depth knowledge by implementing your knowledge on practical tasks. Whether it is capital budgeting, determination of capital structure, IPOs, or exhaustive learning of stocks and bonds, the key to comprehensive learning is to imbibe the knowledge and to use it to solve real-world issues of organizations.
As a fresher one of the best approaches would be to go over the corporate and financial structure of companies, to get hold of annual reports of organizations, and to study the various analyses and deductions made in these reports. They provide clarity and a 360-degree understanding of the structure of corporate finance.
Practice, dedication, and a whole lot of practical work will help you become a pro at corporate finance.