This is a research paper on the foundation of corporate finance and its most basic elements. That is corporate finance and its three main areas: Capital budgeting, capital structure, and working capital management.
Large corporations are very different from small businesses. A large corporation can have thousands of employees, even hundreds of thousands across the globe. On the other hand, a local business may have a few hundred employees at the most. Small businesses provide services and products to a small radius and a certain amount of people living within that radius. Contrastingly large corporations provide services and products to entire states, nations, and even around the world. Owners of small businesses can be intricately involved in the business where they make every decision ranging from day-to-day activities to very important, business altering decisions. They are free to do that because their expanse is not too wide and they can be informed of every little detail.
Large corporations are very different from small, local businesses. They have a completely different organization and structure. They are not owned by one person or a partnership. Instead, the owners of the firm are the stockholders. These stockholders own one or more shares in the company and are considered the “owners.” The firm has to make their decisions which align with the will and the allowance of the stakeholders. The goal of every stakeholder is to make profit. That is the same goal of any firm. Businesses, small and large alike, have the common goal of growth and make more profit to run the business more effectively and in turn make more profit and capital for themselves. Firms have CEO’s (Chief executive officer) that make the managerial decisions. Firms also hire a CFO (Chief Financial officer) who is at the top and takes care of the financial functions of the company.
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The corporation hires managers to represent and work on the owners’ interests and make decisions on their behalf. In a large corporation, the financial manager would be this manager. Financial managers have a lot of responsibility. They look after the financial health of the corporation. They develop financial reports and according to them, work on strategies and plan the long-term financial goals of their organization. The Financial managers have to tackle with three questions upon which the corporation relies. I call them the ‘Big Three’. According to the text book “Fundamentals of corporate finance, 12th edition”, the financial manager must be concerned with these three basic questions:
- What long-term investments should the firm take on? (Capital budgeting)
- Where will we get the long-term financing for the investment? (Capital structure)
- How will the everyday financial activities of the firm be managed? (Working capital management)
Capital Budgeting
The first question concerns the firm’s long-term investments. The process of managing and planning a firm’s long-term investments is called capital budgeting. The main goal is to find as many investments opportunities as possible and to make more profit and generate more capital for the future of the firm. The value of the cash generated by an asset must exceed the cost of the asset. The kinds of investments that would be made depend in part on the type of firm it is. For a large retailer such as Walmart, their capital budgeting decision could be to open another store. Another example for a software company such as Apple, developing a new application program would be a capital budgeting decision.
Capital budgeting is the cause of a corporation’s growth. If a company has the ability to invest more, it has the potential to grow more. A good, strong capital budget is an example of a growing corporation. It is a simple law of nature that healthy things grow. If a firm is staying in the same shape and size for decades, with the same capital structure and no steps are being taken to expand the firm’s boundaries, we can say that the firm is not healthy because it is not growing. This is how large corporations think. Their goal is to grow and gain more profit, and one cannot expect to make profit when they are not willing to invest. This is a simple law of nature and human psychology. If someone cares about something, they would not neglect it. Instead, they would want to invest time and energy into it. It could be anything like relationships, athletic skills, even growth and expanse of a multi-national company.
Retailing giant-Walmart, is one of the best examples of growing corporations that spends a huge amount of labor, money and planning to increase their capital budget because their main goal is more profit and to grow their sales, services, popularity and in turn their company. If growth is not a goal, a firm cannot last long. Executive vice president of finance and treasurer of Walmart, Charles Hollev says, “Our financial priorities of growth, leverage and returns drive our decisions on capital investment, we are positioning our company for the next generation Walmart, which means that we will grow internationally and in the United States. We believe our capital strategy strikes the right balance between growth and return on investment.”
Financial managers must be concerned with when they expect to receive the cash and how likely they are to receive it, not just on how much cash they expect to receive. Capital budgeting is all about evaluating the size, timing, and risk of future cash flows. An investment should be pursued if it brings in cash and increases the value of the company. Capital budgeting is essential because it creates measurability and accountability.it is because of capital budgeting that a company can hope to stay active and competitive in the growing world economy. A business needs to be able to sustain itself in challenges and still grow in popularity. The businesses that do not budget themselves and plan ahead are very prone to be overcome or sold. Capital budgeting is also important if cash flow in a business varies during the year.
Capital Structure
The second question for the financial manager deals with the way in which the firm obtains and manages the long-term financing it needs to support its long-term investments. A corporation’s capital structure is the mixture of long-term debt and equity the firm uses to finance its operations. Capital structure is how a firm finances its overall operations by using different sources of cash and funds. A company that shows a lot of growth in a considerable short amount of time has a very effective capital structure. A great example of this is Amazon. Amazon’s sales have skyrocketed in the last ten years and this is because they spend a lot of resources and time making their capital structure. They are ready for surprises if there is an access of demand for specific products. Good capital structure promotes growth in the corporation. Debt comes in the form of bond issues or long-term notes payable, while equity is comes as common stock, or retained earnings. The financial manager has two questions that need to be answered in this area- “How much should the firm borrow?”, “What are the least expensive sources of cash for the firm?”
Capital structure can be a mixture of a firm’s long-term debt, short-term debt, common equity, and preferred equity. When analysing capital structure investors are referring to a firm’s debt-to-equity ratio. This tells them how much risk is involved in investing in that particular firm. A company that relies more on debt has a more aggressive capital structure. It shows more risk is involved for the investors. But this risk may be the main source of a corporation’s growth.
Debt is one of the most common ways companies raise capital for themselves in the capital markets. When companies take debt, they have advantages on taxes. Interest payments are tax-deductible. Debt also gives the company more control. Through debts, corporations get capital without having to give up ownership. Unlike stakeholders, who are owners of the company, issuing debt does not mean the lenders get the ownership of the company. The firm can still make its decisions on its own. Equity is more expensive than debt. However, equity does not need to be paid back if sales and profits decline. Equity is the claim on the future earnings of the company. Debt has to be paid even if the company goes through a loss. But equity need not be paid the same way as debt because they are not the same. Shareholders bear the loss as an owner of the company.
Equity and debt are both on the balance sheet. Companies that use debt more than equity to buy assets have a higher leverage ratio and an aggressive capital structure. A company that uses more equity than debts to pay for the assets has a low leverage ratio and a conservative capital structure. Lower leverage ratio results in low growth rates, high leverage ratios can lead to high growth rates. In addition to deciding on the financing mix, the financial manager has to decide exactly how and where to raise the money from. The expenses related to raising long-term financing can be a lot, so different possibilities and scenarios must be carefully evaluated and considered. Corporations borrow a lot of money from a lot of lenders in many different ways. Choosing how and who to take the finances from is the job of the financial manager.
Working Capital Management
The third question concerns working capital management. The term working capital refers to the combination and usage of a firm’s short-term assets, such as inventory, and its short-term debts and liabilities, such as money owed to creditors and suppliers. Working capital is a day to day activity that makes sure that the firm has enough resources to continue its operations and keep away from costly mistakes and interruptions. Some questions that must be answered when talking about working capital management are, “How much cash and inventory should the firm keep on hand?”, “Should the firm sell on credit? If they do so, on what terms will they sell? To whom should they sell?”, “How will the firm obtain any needed short-term financing? How and where should they do it?”
Working capital management refers to a company’s managerial accounting system designed to monitor the two components of working capital- current assets and current liabilities. To ensure the company’s effective financial standing working capital management must be utilized. The main goal of working capital management is to make sure that the company always maintains sufficient cash flow to meet its short-term operating costs. Working capital management mostly involves monitoring cash flow, assets, and liabilities. Through the ratio analysis of operating expenses, including the working capital ratio, and the inventory turnover ratio working capital management turns out to be very important as the firm relies on it every day. Efficient working capital management helps maintain the smooth running of the company (the minimum amount of time required to convert net current assets and liabilities into cash). Working capital management also helps to improve the company’s profits. Management of working capital includes inventory management and management of accounts receivables and payables. The formula of working capital is as follows:
Working capital = Current assets – current liabilities.
A signature of good business management is the ability to utilize working capital management for a good balance between growth, profitability and liquidity. The balance sheet organizes assets and liabilities in order of liquidity, making it very easy to recognize and calculate working capital. Most current assets and liabilities are there for operating activities (inventory, accounts receivable, accounts payable, etc.) and are primarily in the operating activities section of the statement of cash flows under a section called “changes in operating assets and liabilities.”
After computing the net working capital, if the amount is positive, it means that the company has enough current assets to meet its current liabilities. A high net working capital is a good sign for the company. However, excessive current assets may not be too good since they could have been invested in more productive assets (i.e., non-current assets). For better analysis, the net working capital should be compared with road marks such as past performances.
Conclusion
The three basic areas of corporate financial management- Capital budgeting, Capital structure and Working capital Management are critical to the understanding of corporate finance. Without the understanding of these, one cannot learn more about corporate finance. Capital budgeting is the process of planning and managing a firm’s long-term investments. Capital Structure is the mixture of debt and equity used by the firm to finance its long- term operations. Working Capital Management is the management of the firm’s short-term assets and liabilities and day to day management of the firm. Financial managers are responsible for the financial health of an organization. Any financial manager in any corporation, business, or company must have a complete thorough understanding of these basic foundational blocks of Corporate Finance.
References
- Ross, S. A., Westerfield, R., & Jordan, B. D. (2019). Fundamentals of corporate finance. New York, NY: McGraw-Hill Education.
- Walmart Announces Capital Strategy to Drive Global Growth; Next Year’s Capital Spending to Increase Slower Than Sales. Retrieved from https://corporate.walmart.com/_news_/news-archive/investors/walmart-announces-capital-strategy-to-drive-global-growth-next-years-capital-spending-to-increase-slower-than-sales-1482363
- Council, F. A. (2017, February 03). Forecasting And Budgeting Can Improve Your Company’s Fiscal Performance. Retrieved from https://www.forbes.com/sites/forbesagencycouncil/2017/02/03/forecasting-and-budgeting-can-improve-your-companys-fiscal-performance/
- Journal, W. S. (2000, September 01). Working Capital. Retrieved from https://www.wsj.com/articles/SB967830960880747145
- Kenton, W. (2018, December 13). Working Capital Management (WCM). Retrieved from https://www.investopedia.com/terms/w/workingcapitalmanagement.asp
