Corporate Finance

How do companies decide when to open a new factory or enter a new market or maybe even acquire another business? What guides the company on how much debt is enough, or where should it raise funds from most efficiently? What should a company do with its profits — distribute it among shareholders or invest in a new project?

These are a few of many questions that every company has to come across. What are the guiding principles/factors? Well, the financial calculations that go behind these decisions are governed by Corporate Finance. Any decision that financially impacts the business and involves the use of money is said to be a Corporate Finance decision. The ultimate aim of corporate finance is to make the most efficient and effective utilization of available financial resources and incur the least possible expenditure.

To formally define Corporate Finance, According to Investopedia,

“Corporate finance is the division of finance that deals with how corporations deal with funding sources, capital structuring, and investment decisions. Corporate finance is primarily concerned with maximizing shareholder value through long and short-term financial planning and the implementation of various strategies.”

This definition brings out three terms, namely funding sources, capital structuring, and investment decisions. So let’s have a look at them:-

1. Funding Sources / Capital Financing — As trivial as it may sound, it determines the options for a company to source resources to finance a need, program, budget, etc. On a broader basis, we can categorize the sources of funding into two parts — Debt and Equity. We will discuss them later in great detail, but here it prompts us to go to our next term capital structuring.
2. Capital Structuring — is the optimum management of a particular combination of debt and equity(sourced funds). Capital Structuring depends upon a variety of factors including but not limited to the current economic climate, industry, and business’s life cycle stage.
3. Investment Decision / Capital Investment — It is essentially an investment in a business, project, product, etc, to generate future benefits. It is done through Capital Financing.

I hope we are clear about the grounds of corporate finance. Now we are going to elucidate some very basic but very important terms in corporate finance. Whole corporate finance dwells on these basic terminologies.

Assets — Assets are the economic resources owned or controlled by a company that will provide probable future economic benefits to the company. Examples of Assets include Cash, Inventory, Building, etc. Simply stated, Assets are what the company owns.
We see that assets include items with varying liquidity. So how do companies report the current value of an asset? Well, that is a whole new topic and depends on Accounting Standards followed by the country of domicile of the company. But briefly, this can be done in three ways

. A. Report at current market value. E.g., Cash.

B. Net realizable value. I.e., the amount that the asset is expected to yield.

C. Historical Cost. e.g., building, land, equipment, etc.

Assets are generally divided into two parts:-

1. Current Assets(Short-term Assets):- Assets that are expected to be used within one year. The most common current assets include Cash, Accounts receivables, and Inventory.
2. Non-Current Assets(Long-term Assets):- Assets that are expected to be around next year. Examples include Investments, Property, Plant, Equipment, and Intangibles.

Notes and Relevant Definition:-

1. Inventories — Goods held for sale in the normal course of business.

2. Account receivables — represent the expectation that you are going to collect money from people in the future based on contracts that exist in place now. (usually collected within 10–60 days.

3. Cash Equivalents — Financial instruments like certificates of deposits that will mature in the very near future.

4. Prepaid Expenses are assets — Payment in advance for business expenses like insurance and rent.

5. Intangibles — An intangible asset is an asset that is not physical in nature e.g Goodwill, Brand recognition etc.

6. Generally, the Company’s Book Value < Market Value. Because many assets are recorded at purchase cost. Moreover not all economic assets are included e.g. employers, suit of software, installed user base, etc.

Liabilities — Liabilities are the obligations that are satisfied through payment or providing services to someone else in the future. e.g., of Liabilities include Bank loans, unearned revenue, lease obligations, etc. Simply stated, Liabilities are what the company owes.
Similar to Assets, liabilities are current and noncurrent. Let’s have a glance at that:-

A. Current Liabilities — Obligations that are expected to pay within a year. Examples include taxes, wages, accounts payable, short-term loans, unearned revenue.

B. NonCurrent Liabilities — Obligations that are not expected to be paid or otherwise satisfied within a year. Examples include Traditional loans, bonds, lease obligations.

Notes and Relevant Definition:-

1. Unearned revenue — Company’s obligation to provide service to customers who have paid for a service that they have not yet received. E.g. Future Subscription given by the company.

2. Contingent liabilities — Potential obligation that may occur depending on the outcome of an uncertain future event. E.g. cosigner’s obligation on a loan.

3. Estimated liabilities — Definite obligation with only the amount of obligation in question and subject to estimation at the balance sheet date. E.g pensions, warranties, deferred taxes, etc.

Owner’s Equity / Shareholder’s Equity — Owner’s Equity is the owner’s investment in the company with no obligation for the company to repay that investment. The changes in owner’s equity are attributed to retained earnings, Treasury Stock, and Accumulated other comprehensive income.

Notes and Relevant Definition:-

1. Paid-in Capital — The amount of money directly invested in the company.

2. Retained Profits — Profits/earnings kept in business after paying off the dividends.

3. Treasury Stock — A company’s repurchase of its own shares of stock.

4. Accumulated other comprehensive income — Market-related gains and losses that are not included in net income computation. E.g changes in the value of derivatives, changes in the value of investment securities, etc

With this all being stated, we are in a perfect position to define “The Accounting Equation”.

Assets = Liabilities + Owner’s Equity

This is perhaps the most fundamental and the most important equation in accounting which is hidden in its deceptive shortness. The whole of accounting revolves around this paramount equation.

LHS tells us about a “Business’s economic resources” while RHS tells us about “Claims against those economic resources”.

With all that being discussed, let us review some crucial concepts and basics of accounting.

The current system of accounting, Double-entry bookkeeping, is widely used and is based on Debit and Credit. We introduce the terms debit and credit.

According to Wikipedia,

‘In double-entry bookkeeping, debits and credits are entries made in account ledgers to record changes in value resulting from business transactions.’

Double-entry bookkeeping is based on the concept of double-entry, which states that every financial transaction has equal and opposite effects in at least two different accounts.

In accounting, you have mainly five different types of accounts.

Assets, Liabilities, Equity, Revenue, Expenses.

Let us give you some examples of each type of account.

• Assets- (Items that provide future economic benefit to the company) Cash, Accounts Receivable, Inventory, etc.
• Liabilities- (Obligations that the company is required to pay) Accounts payable, Loans Payable, etc.
• Equity- (Company’s non-operational assets after the liabilities have been paid) Stocks, Bonds, etc.
• Revenue- (Accounts related to income earned from the sale of products and services, or interest from investments) Sales Revenue, Service Revenue, etc.
• Expenses- (Charges related to the day to day operation of a business) Rent, Interest, etc.

Now, how do you record a transaction as debit or credit?

First of all, you should remember that credit and debit are always equal to each other for a given transaction. Also, debit is always recorded on the left side of the account ledger, and credit is always recorded on the right side of the account ledger.

The general rule is that debits increase assets and expenses, and decrease revenue, liabilities, and equity. Credits do the reverse i.e., they decrease assets and expenses and increase revenue, liabilities, and equity. Let us show you a simple example to make things clear.

Suppose a company sells a product worth Rs.1000 to a customer. This transaction will lead to an increase in the company’s revenue by Rs.1000 and also an increase in the company’s cash by Rs.1000.

Since cash, which is an asset account, is increasing, you simply record this as an increase in the asset as a debit( on the left side of the account ledger).

Also, since the revenue is increasing, you record this as an increase in revenue as a credit(on the right side of the account ledger).

Here you see that credit and debit amounts are equal (which is Rs. 1000).

Now, with that being discussed, it is high time to introduce you to the financial statements. These financial statements are essentially a collection of all important financial data of the company and provide critical insights about the company’s performance, operations, and cash flows. Let us learn about financial statements.

The three core financial statements that are used to evaluate a business or a company’s financial health are the Balance Sheet, the Income Statement, and the Cash Flow Statement.

Let’s see them one by one.

1. The Balance Sheet

The Balance Sheet of a company shows its assets, liabilities, and shareholders’ equity( at the end of a particular time period).

One important thing to keep in mind here is that the equation (The balance sheet is constructed in accordance with the Golden Equation of Accounting)

Assets=Liabilities+Equity is always satisfied.

In simple terms, this means that the balance sheet shows how much a company owns, owes, and how much shareholders have invested in it.

In the balance sheet, under assets, you will find current assets and long term assets.

Current assets usually include cash, cash equivalents, accounts receivable, etc. and long-term assets include land, machinery, intangible assets, etc.

Under liabilities, you will find current liabilities and long term liabilities.

Current liabilities usually include accounts payable, interest payable, etc. and long-term liabilities include long-term debt, etc.

Under Shareholders’ Equity, you will usually find retained earnings, common stock, etc.

The Income Statement

The income statement, also known as the profit and loss statement of a company, reports its revenue, expenses as well as the profit or loss for a given reporting period.

The expenses are from many sources, like the cost of goods sold, depreciation, impairment of property, etc.

It essentially has four components.

• Revenue — How much money a company made over a specific period of time.
• Cost of goods sold(COGS) — This is how much it costs to manufacture the product.
• Operating Expenses — These are indirect costs associated with the business, which include salaries, wages, marketing expenses, R&D, etc.
• Net income — This is the “bottom line”, what the company has earned after deducting all expenses from revenue.

Profits(or losses) are also represented in different ways like EBIT(Earnings before interest, tax), EBITDA(Earnings before interest, tax, depreciation, and amortization), etc.

Note —

Income statement captures the financial performance of a company for a period of time, while a Balance sheet is a snapshot of a company’s financial position at a specific point of time.

The Cash Flow Statement

The Cash Flow statement of a company reports its cash inflow and outflow during a specified time interval, or in other words, it reports the amount of cash and cash equivalents leaving or entering a company during a specified time interval.

Similar to the Income statement, the Cash flow statement captures a period of time.

The cash flows that are reported can be classified as:-

• Cash flow from operating activities means the cash flow generated by a company’s main business activities.
• Cash flow from investing activities includes cash flow generated due to a company’s investments in other ventures.
• Cash flow from financing activities includes cash flow generated due to the issuance of securities or due to repayment of loans, dividend payment, etc.