Corporate Finance Definition Principles Examples Types

Corporate Finance Definition

Key Takeaways

Corporate finance is the process of obtaining and managing finances in order to optimize a company’s growth and value for its shareholders. The concept focusses on investment, financing and dividend principle. The main functional areas are capital budgeting, capital structure, working capital management and dividend decisions. For example, judging whether to invest in debt or equity as a medium to raise funds for the business is the primary focus of capital structure decisions. Going over the risk-return aspect of investment alternatives, ensuring working capital management, etc. are some aspects of this branch of finance.

How does Corporate Finance Work?

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Corporate finance emphasizes the desire to maximize the financial soundness of a company and its stockholders. The departments working under this branch of finance primarily manage a company’s financial activities. They take crucial decisions regarding organizational budgeting, investments, and capital allocation.

For example, in a real estate investments company, the department computes capital requirements to acquire assets. They will also focus on finding efficient sources of capital for asset acquisition using appropriate calculations. Such decisions determine an organisation’s capital structure, i.e., whether to finance by debt or equityDebt Or EquityDebt refers to the source of money raised from loans on which the interest is required to be paid. Thus it is a form of becoming creditors of lenders, whereas equity means raising money by issuing shares of a company. Shareholders get returns on such shares from the company’s profit in the form of dividends.read more or a combination of the two. Another aspect of this segment includes ensuring optimal working capital management.Working Capital Management.Working Capital Management refers to the management of the capital that the company requires for financing its daily business operations. It is important for the company in order to maximize its operational efficiency, manage its short term liabilities and assets properly, avoiding the underutilization of the resources and avoiding the overtrading, etc.read more

Decisions around how much profit to retain or distribute amongst the shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company’s total shares.read more are also an important element. All these essential decisions have the underlying tone of ensuring profit maximization. Hence, corporate finance jobs are in huge demand, with many institutes offering courses to enhance the required skills. For example, the average annual salary of a corporate finance executive in New York is $1,24,212.

Sometimes, the difference between corporate finance and corporate accounting can be confusing. However, the main distinction between the two is that the finance team focuses on strategy formulation, planning, directing and executing the financial strategies of an organization. Majorly, they provide a blueprint for future performance.

In contrast, the accountingAccountingAccounting is the process of processing and recording financial information on behalf of a business, and it serves as the foundation for all subsequent financial statements.read more domain typically focuses on analyzing, recording, tabulating and reporting on the business’s finances. That is, it measures past performance.

Corporate Finance Principles

Let us take you through some central principles guiding this concept.

Investment Principle – Investment principle urges on the significance of investing in the suitable options by assessing the risk and return. The evaluation of an investment proposal should be based on a predetermined hurdle rateHurdle RateThe hurdle rate in capital budgeting is the minimum acceptable rate of return (MARR) on any project or investment required by the manager or investor. It is also known as the company’s required rate of return or target rate.read more that serves as a return analysis benchmark. It is important to ensure that cost of acquiring the capital is not offsetting the expected returnsExpected ReturnsThe Expected Return formula is determined by applying all the Investments portfolio weights with their respective returns and doing the total of results. Expected return = (p1 * r1) + (p2 * r2) + ………… + (pn * rn), where, pi = Probability of each return and ri = Rate of return with probability.
read more.Financing Principle – Financing principles influence the selection of financing methods to ensure the extraction of maximum value from the investment. The most crucial question here is whether to use debt financing, equity financingEquity FinancingEquity financing is the process of the sale of an ownership interest to various investors to raise funds for business objectives. The money raised from the market does not have to be repaid, unlike debt financing which has a definite repayment schedule.read more, or a combination of both. Many factors affect the capital structure such as business structure and goals, cost of financing, interest rate and access to the equity marketEquity MarketAn equity market is a platform that enables the companies to issue their securities to the investors; it also facilitates the further exchange of these stocks between the buyers and sellers. It comprises various stock exchanges like New York Stock Exchange (NYSE).read more.Dividend Principle – The dividend principle of an entity explains whether to streamline surplus towards business growth or shareholders in the form of dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more.

Central Elements

Corporate finance major focus areas include capital budgetingCapital BudgetingCapital budgeting is the planning process for the long-term investment that determines whether the projects are fruitful for the business and will provide the required returns in the future years or not. It is essential because capital expenditure requires a considerable amount of funds.read more, capital structure, working capital and dividend decisions.

#1 – Capital Budgeting

The capital budgeting process discloses the viability of investment proposals and helps invest in profitable projects. The goal is to maximize the growth and profitabilityProfitabilityProfitability refers to a company’s ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company’s performance.read more of the business. As part of capital budgeting, financial analysts go over various investment alternatives. They conduct a comparative analysis of investments’ present and future value to interpret their risk-return aspects concerning organizational goals. Only the most suitable projects are given a chance.

#2 – Capital Structure

The capital structure tells us the method of financing used by the entity. The capital structure, for example, might include equityEquityEquity refers to investor’s ownership of a company representing the amount they would receive after liquidating assets and paying off the liabilities and debts. It is the difference between the assets and liabilities shown on a company’s balance sheet.read more, retained earningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company.read more, and debts. In the perspective of investors, a combination of too much debt or equity is unappealing. They want a well-balanced combination of debt and equity funding instead. Consequently, the proper financial decision produces an optimum mix of various types of funding and enhances the company’s value.

#3 – Working Capital

Working capitalWorking CapitalWorking capital is the amount available to a company for day-to-day expenses. It’s a measure of a company’s liquidity, efficiency, and financial health, and it’s calculated using a simple formula: “current assets (accounts receivables, cash, inventories of unfinished goods and raw materials) MINUS current liabilities (accounts payable, debt due in one year)“read more refers to the capital for day-to-day business operationsBusiness OperationsBusiness operations refer to all those activities that the employees undertake within an organizational setup daily to produce goods and services for accomplishing the company’s goals like profit generation.read more. Efficient financial management can ensure an adequate cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more in line with business policies. In this way, maintaining the liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more of the organization can save them from going bankrupt.

#4 – Dividend Distribution

Public companiesPublic CompaniesPublicly Traded Companies, also called Publicly Listed Companies, are the Companies which list their shares on the public stock exchange allowing the trading of shares to the common public. It means that anybody can sell or buy these companies’ shares from the open market.read more hold answerability to their shareholders. As a result, they often wonder how much of the business profit they should distribute as dividends. If they reinvestReinvestReinvestment is the process of investing the returns received from investment in dividends, interests, or cash rewards to purchase additional shares and reinvesting the gains. Investors do not opt for cash benefits as they are reinvesting their profits in their portfolio.read more surplus as retained earnings, it must be backed with a strong conviction that the sum will generate business growth. At the same time, a certain amount of dividend distribution is also essential for many companies to serve their shareholders better.

Types of Corporate Finance

The two chief types include –

Equity Financing – Companies can raise finance through equity issuance or obtain from retained earnings. Equity comes in the form of common stockCommon StockCommon stocks are the number of shares of a company and are found in the balance sheet. It is calculated by subtracting retained earnings from total equity.read more, preference stockPreference StockA preferred share is a share that enjoys priority in receiving dividends compared to common stock. The dividend rate can be fixed or floating depending upon the terms of the issue. Also, preferred stockholders generally do not enjoy voting rights. However, their claims are discharged before the shares of common stockholders at the time of liquidation.read more etc. A company can sell its shares by getting itself listed on a stock exchange or through over the counterOver The CounterOver the counter (OTC) is the process of stock trading for the companies that don’t hold a place on formal exchange listings. The broker-dealer network facilitates such decentralized trading of derivatives, equity and debt instruments.read more (OTC) exchanges. Too much equity dilutes shareholders’ voting rights and reduces dividend share.Debt Financing – Debt financing refers to obtaining the finance required through loans, usually from financial institutions, or through bond issuance, etc. Debt financing attracts the cost of regular interest payments and repayment of the principle at the end of the loan tenure. Too much of debt induces the risk of defaultRisk Of DefaultDefault risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other factors.read more or going bankrupt in case of non-repayment of the debt.

Examples of Corporate Finance Activities

Corporate finance jobs entail managing the interaction between corporations, assets, markets, investors, government, financial institutions and intermediaries. Following are some examples of such activities –

Financial modeling: Financial modelingFinancial ModelingFinancial modeling refers to the use of excel-based models to reflect a company’s projected financial performance. Such models represent the financial situation by taking into account risks and future assumptions, which are critical for making significant decisions in the future, such as raising capital or valuing a business, and interpreting their impact.read more helps to analyze the value and risk associated with investment options.Bank loan: Taking a loan from a bank to meet business needs and associated due diligence to analyze the cost of loan and repayment capacity.IPO: Initial public offeringInitial Public OfferingAn initial public offering (IPO) occurs when a private company makes its shares available to the general public for the first time. IPO is a means of raising capital for companies by allowing them to trade their shares on the stock exchange.read more (IPO) generally helps to raise capital through equity financing.Refinancing and renegotiating all debts and payments: As the market changes, corporations may strategically negotiate to update the terms of loans or other payment agreements.Dividend distribution: Dividend distribution depends on the policy set by the management. It can be regular or irregular.

Why is it Important?

Corporate finance aims to obtain finances through the right sources to manage day-to-day and long-term financial activities. It strategizes how a company uses and manages capital to maximize value. Planning appropriate capital budgeting and structures is vital for balancing risk and profitability.

A company’s management evaluates future cash flows from investmentCash Flows From InvestmentCash flow from investing activities refer to the money acquired or spent on the purchase or disposal of the fixed assets (both tangible and intangible) for the business purpose. For instance, the purchase of land and joint venture investment is cash outflow, while equipment sale is a cash inflow.read more through capital budgeting tools. They find the least expensive fund sources or the right mix of debt and equity in the capital structure. For short-term needs, working capital requirements are paid attention to.

Hence, we can say that these strategies ensure the going concern conceptGoing Concern ConceptGoing Concern concept is an accounting principle which states that the accounting statements are formulated with a belief that the business will not be bankrupt or liquidated for the foreseeable future, which generally is for a period of 12 months.read more of the organization. Moreover, it improves the statistics on financial statementsFinancial StatementsFinancial statements are written reports prepared by a company’s management to present the company’s financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more. Consequently, it will maximise value, or more specifically, the maximization of stock price.