Corporate finance is an exciting field with many different facets. Understanding how corporations fund their activities can give entrepreneurs and other businesspeople a window into the workings of large companies and inform their activities.
Leslie Haoen Shen, an experienced financial executive from Toronto, ON, discusses the three main areas of corporate finance and shares how each one fits into the overall picture.
1. Capital Budgeting
Through capital budgeting, corporate finance executives attempt to predict how much money the company will need in the future. Businesses look at the potential for major investments or projects like constructing a new plant or investing in a major outside venture. Before these projects are approved, finance experts must put them through the capital budgeting process.
Capital budgeting may consider the lifetime accumulation of profit and cost, determining the expected returns. This part of the process is also known as investment appraisal.
Finance experts use several established methods to examine capital budgeting issues. These methods include payback, discounted cash flow, and throughput analyses. Payback involves calculating the time it takes to recover an investment’s cost or the time it takes to break even. Discounted cash flow means projecting the amount of money that an investment is expected to make in the future. A throughput analysis takes the project’s impact on the entire corporation into effect.
People who engage in capital budgeting must have strong skills in projecting how a company’s activities will progress over the coming years and how much money they will need to accomplish each task. Capital budgeting is the backbone of corporate finance because companies would not know how much money they need to raise to fulfill their obligations without it.
Capital budgeting is a long-term activity. It examines the company’s parts that make money and how much capital they should receive each year. Understanding how to allocate revenue to each department is a complex process, and corporate finance professionals must have a great deal of knowledge and experience to accomplish this task.
2. Capital Structure
Capital structure applies to the distribution of equity and debt that comprises a company’s finances. Capital structure is generally expressed as a debt-to-capital or debt-to-equity ratio. Financial managers need to know how to allocate debt or equity to pay for projects. They must strike a balance that keeps the profitable company while properly allocating its assets and efforts.
The weighted average cost of capital is calculated by averaging the cost of debt and the cost of equity. Finance experts use this figure to determine how much money a company is retaining depending on its budgeting activities.
Each industry has its typical cash flow. Some industries like insurance and banking run heavily on leverage, requiring large volumes of debt. A small private company may have to run itself using mostly equity investments because debt is too expensive and must be personally guaranteed.
3. Working Capital Management
Working capital management is the process of allocating capital to provide a balance between profitability, liquidity, and growth. Working capital can be thought of as the difference between a business’s debts and assets. This figure can measure a company’s efficiency and financial stability.
Many companies use the working capital ratio, dividing current assets by current liabilities, to gauge how they are doing and whether their cash flow is adequate to keep them running.
Companies need a positive cash flow to stay in operation. They need to purchase materials and supplies, make payments on various expenses, and cover their costs. When working capital is managed well, companies operate smoothly.
Other aspects of working capital management that are sometimes overlooked include inventory management, accounts payable, and accounts receivable.
Other working capital management measurements include the collection and inventory turnover ratios. The collection ratio is the period it takes to recover outstanding accounts receivable. It is calculated by dividing the total receivables by the average daily sales. The inventory turnover ratio refers to the number of times a company has replenished and sold its stock on hand over a specific period.
Companies want to spend as little as possible on maintaining their working capital while increasing their returns on their current investments.
When a company does not have enough working capital, it could be subject to insolvency or bankruptcy. The company may find a buyout necessary to get an injection of cash and keep its operations going.
Managing Corporate Finance
Corporate finance departments are filled with experts who keep track of these three aspects of their field. No matter how large or small, each company should pay close attention to its corporate finance activities. Leslie Haoen Shen believes that without fully understanding how money is acquired and spent, companies cannot run properly.
Leslie Haoen Shen encourages people interested in working in finance to study these fields and find a specialty. Corporate finance jobs pay well and are always looking for talented personnel.
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