Corporate Finance: Definition, Importance & Sections

KEY TAKEAWAYS

• Corporate finance is how businesses fund their operations to maximize profits and minimize costs
• It is concerned with monitoring cash flows, accounting, taxation, and preparing financial statements
• Corporate finance deals with the day-to-day operations of a business’s cash flow and long-term financing goals.

What Is Corporate Finance?

Corporate finance is the process of dealing with the capital structure of a corporation. This includes the company’s funding and any processes that are put into place to increase the value of the company. If the return on capital exceeds the cost of capital, then the value of the business is raised. 

Corporate finance is involved with the process of maximizing shareholder value. This is done through short and long-term financial planning. That means that it is often used to deal with the day-to-day operations of a business’s cash flow and planning for the future with long-term goals. 

It is a subfield of finance. It mainly concentrates on the process of how corporations deal with funding sources, capital structuring, and capital projects. It also addresses investment decisions and accounting. These decisions can include whether or not to pay for investment with equity or debt, or in some cases with both.

Why Is Corporate Finance Important?

A business’s capital structure is a vital part of making the value of the business as high as possible. The capital structure tends to be a mixture of long-term and short-term debt, as well as common and/or preferred equity.

Corporate finance also helps a business maintain liquidity. i.e. the ability to pay for bills and expenses when they come due. This could be through a line of credit or overdraft facility or some other means.

The ratio that is between a firm’s debt and its equity is normally used as a basis. This is for determining how well-balanced, or risky, the company’s capital financing is. 

A business will be considered to have a more aggressive capital structure if they are heavily funded by debt. It would therefore potentially hold a higher level of risk for stakeholders. That being said, taking risks is quite often the main reason for the growth and success of a company. 
The importance of corporate finance can be highlighted using four main areas:

1. Planning Finances

This is where the finances of a company can be determined. Decisions need to be made on how much financing or cash flow a company needs, and where it will get it. The company also needs to figure out how it will be invested, and what anticipated profits will be. The company’s leaders would then need to decide on a strong plan of action.

2. Capital Raising

This is one of the most vital stages and it highlights the importance of corporate finance. The decisions here involve the assessment of any company assets to fund investments. In order to raise enough capital, a company may do a number of things. These may include:

• Selling shares of the company
• Issuing debentures and shares
• Taking a bank loan
• Asking creditors to invest capital

This shows the serious financial implications on profit and liquidity. Especially when related to short-term funding, and managing plans of the company in order to finance long-term investments.

3. Investments

An investment can either be on fixed assets or working capital. Fixed capital is used to finance the purchase of things such as:

• Machinery
• Infrastructure
• Buildings
• Technological upgrades
• Property

Working capital on the other hand is required for day to day activities. This may include:

• The company’s running expenses
• Raw-material purchases
• Salaries
• Overheads
• General bills

There is a large amount of foresight and analyzing of data required before a company should raise or provide capital. Businesses should only raise funds when they have a well thought out investment plan with a good return on investment. This is a vital stage of the process as it directly impacts the company’s overall financial position, health, and performance.

4. Financial Monitoring and Risk Management

Once an investment has been made, it needs to be constantly monitored in order to reduce and mitigate the risks that are associated with investments. It forms a part of a continuous monitoring process.

Businesses utilize complex tools and technologies to provide a thorough analysis and assessment of their investments. This includes:

• Monitoring of prices 
• Monitoring the fluctuations
• Risk assessment
• Market trends
• Monitoring of debtor positions
• Monitoring of creditor positions
• Monitoring interest rates or broader market conditions

The 4 Sections of Corporate Finance

There are four activities that make up corporate finance. They are as follows:

1. Capital Budgeting & Investments

Investing and capital budgeting is the planning of where a company should make long term capital investments. This is to generate the highest returns that have been risk-adjusted.

A capital budgeting project concentrates on deciding whether to pursue any particular investment opportunity. It is achieved through extensive financial analysis.

2. Capital Financing

Capital financing includes decisions on how to finance capital investments. These capital investments can be achieved through using debt or equity financing, or both.

Long-term funding for capital investments or major capital expenditures is vital for businesses. The capital can be raised by selling stocks, or getting a bank loan. This is done through investment banks in the relevant market.  Large publicly traded companies or governments might also issue bonds to raise capital. 

It’s important to closely manage the two sources of funding. This is because having a large amount of debt can increase the risk of defaulting on repayments. Depending too heavily on equity may reduce earnings and the value for original investors, and can increase the risk of losing control of the company.

3. Dividends and Return of Capital

This requires corporate managers to make a decision on whether to retain a business’s excess earnings or distribute the earnings or cash to shareholders. If it is retained it can be used for future investments or any other business need. If it is distributed to shareholders it can be done by paying through the form of dividends or share buybacks.

Retained earnings that aren’t distributed back to shareholders can be used to fund a business’ expansion efforts. This is often the best way to use these funds as it doesn’t incur any additional debt.

4. Short-Term Liquidity

Short term finance management is also a part of corporate financing. The goal here is to make sure that a business has a high enough amount of liquidity to carry out their operations. This form of short-term financial management works around a business’s current liabilities, assets, operating cash flows, and working or current capital.

When a company’s liability obligations are due, they must be able to meet them. This means that they have to have enough current liquid assets to avoid disruptions to the company’s main operations. A company may get additional credit lines or issuing commercial papers as a backup for their liquidity. This would be organized via short-term financial management.

Examples of Corporate Finance

There are a number of examples of activities that can be counted as corporate finance. Here are some of the most popular examples:

Financial Modeling

To help a business analyze the risk and value that is associated with investment options, they can use financial modeling. This is the process of figuring out the financial performance of a project. It works by taking all relevant factors such as growth and risk into account, then figuring out the impact.

Initial Public Offering (IPO)

An IPO is when a company initially offers their stock to the public market. It helps to raise capital through what’s known as equity financing. This means that the business’s stock can be sold off and bought at the current market share price, and can be publicly traded on a stock exchange.

Bank Loans

A business can take a loan from the bank to meet their business needs. This is known as debt financing. They first have to analyze the cost of the loan and what their capacity is for repayment. While business debt from bank loans can be considered good debt, taking on too much can financially cripple a company. 

Refinancing

Most businesses will have a number of debts and repayments currently in play. But as the market changes, a company can renegotiate their financing options for their loans. This means that they can refinance a loan with a lower interest rate, which will reduce your debt payments, therefore saving money, opening up cash flow, and improving your financial position. 

Mergers and Acquisitions

Mergers and acquisitions involving private companies are a classic form of corporate finance activity. By merging two smaller corporations, you can combine the wealth and resources to create a much bigger company. If done properly, this will inevitably lead to higher profits and put the company in a strong capital position. Higher profits in a consolidation can also come from economies of scale.

Summary

Corporate financing is a vital part of running a business. It’s the main way that you can maximize the value of your business by structuring your long-term and short-term debt. 
The debt-to-equity ratio gives investors a well-balanced idea of how much risk would be involved, and allows them to make well-informed business decisions. This is if they wanted to invest in your business.