In its most basic form, Corporate Finance is concerned with the Capital Structure of the company. The Capital Structure reflects how the company is funded. Sources of funding are diverse and consist of Share Capital, Preferred Share Capital and Debt. In other legal entity forms, like in a small business, that is not incorporated, the capital is reflected by Owner’s Contribution, or, for a Partnership, Partnership Interest. A small business being operated in a registered legal entity form (incorporation) may also depend on Shareholder Loans as a common feature of funding. In such instances, many owners incur expenses on behalf of the business and therefor need a mechanism to reflect how they fund the business, especially during the early years in the life of a company.
Within the Debt space a magnitude of different sub-funding sources exists too, namely, and not limited thereto only, Convertible Debt, Term Loans, Interest-Only Loans, Mezzanine Debt, Debt structures modeled on the principles of Zero-Coupon Bonds, etc. The combinations are endless and develops through Financial Engineering and Structured Finance. Project Finance specifically combined with Structured Finance instruments have paved the way in innovation when it comes to optimized funding. For instance, Sculpted Annuity Payments or Indexed- or Inflation-Linked Debt.
Sources of funding comes at a funding cost. Share Capital too has a cost associated with it, although many believe that not to be the case. Dividends being paid is compensation to the holders of Shares for investing in the Share capital. The other part of the cost of Equity is the risk-free rate of return plus a margin that equites to the required rate of return for Share Capital. Corporate Finance is also concerned with understanding how these differences in funding costs impacts a range of different, but very important, Financial-, Cover Ratios, Return Ratios, Cash Flows, Profitability and Earnings Ratios. When planning funding and raising capital, it is important that the detailed financial planning, forecasting and analysis reflect adequately on the different options being considered. A comprehensive Corporate Finance Model reflects on a detailed Profit & Loss, detailed Tax calculations, detailed Cash Flow run-off and a detailed Balance Sheet that can be updated seamlessly with different assumptions and credit-stressing (“break” the model through aggressive stresses and still meet the required return profile). Each funding source and the cost attached to each type of funding source, further has Income Tax and Sales Tax implications. Sometimes providers of funding sources will reduce the cost of funding (the rate of annual interest or required return) but include a capital raising upfront fee. Obviously, this would impact what is referred to as the Effective Cost of the funding source. In start-ups, Venture capitalist and Angel Investors want to earn a Royalty attached to an exit mechanism and/or convertibility. Paying a Royalty off the top-line Revenue is the cost of having raised the required capital. Treat this and evaluate same as you would with a bank loan. In other words convert that cost into an annual finance charge rate to compare with other offers.
When evaluating funding sources, investment decisions impact the ultimate funding source. This is where Corporate Finance, proverbially, “marries” investment opportunity for funders and investors with financing for the business or company.
The cost of funding further impacts the value being created for shareholders. Through Corporate Finance one would aim to maximize Shareholder Value through financial- planning and engineering, and the implementation of various strategies. Corporate Finance then becomes strategically important in its function of relating Strategy to the most suitable funding source. This is where Corporate Finance is extremely dynamic, creating that link between Strategy, Thought Leadership and Capital. It aims to explain the behaviour in the numbers behind the Strategy to facilitate growth and increase Shareholder Value. Corporate Finance activities range from Capital Investment decisions to Investment Banking. Corporate Finance require to also have a deep understanding of applicable Securities Laws and Regulations. Not all funding sources are equally available to all businesses and legal entity forms. Securities Laws and Regulations are primarily designed to protect investors. It lays down the minimum requirements from an Issuer perspective. Selling restrictions give effect to Securities Laws and Regulations in achieving the ability to protect Investors. This is akin to, for instance, understanding the credit granting rules and requirements of banks. Banks in return must hold regulatory capital and are regulated to protect investors in banks against reckless lending practices and credit default by borrowers. In the same indirect fashion, banking practice weighs-in on the type and level of bank-related funding a business can apply- and qualify for to use as capital (working capital and/or long-term capital).
Capital Investment within the sphere of Corporate Finance deals with Capital Budgeting. Capital Budgeting is concerned with evaluating and choosing projects that add value to the business. Evaluating projects is important as it provides insights as to which project produces the better sustainable returns accompanied with an assessment of the best funding source. Projects compete for capital. The projects that add the most value, are those that has a higher Economic Value Added (EVA). EVA evaluates the Return on Capital Employed against the Cost of Capital. In this evaluation one is also concerned with Payback Period, IRR, NPV etc. Typical Project Finance aspects feed into the evaluation process in Corporate Finance.
Investment Banking within Corporate Finance deals with matters concerning underwriting of debt funding, the selling of securities (equity and debt instruments a company is looking to issue to raise capital with) to the investing public, and facilitate Mergers and Acquisitions.
Because Corporate Finance deals with the evaluation and analysis of funding, capital and projects & assets, that will add the most value to the business and organization, the value of the business comes into question. Various valuation models are leveraged to reflect on the valuation under given circumstances. It’s important to assess value from how a new project or new funding source adds value and creates further value. Its important to reflect on all Valuation methods. Not all methods will provide the same Valuations. For that reason, one would need to know what the Value Drivers are. Value Drivers tie-in with Strategy. Strategy is implemented to increase value for shareholders and Corporate Finance relates to all the financial matters and metrics to articulate the value to be added and created through a specific strategy.
Corporate Finance expertise and experience take many years to develop. It’s not something one wake up one morning with, and decide that you are becoming a Corporate Financier. A strong Corporate Financier can with their eyes closed, relate all the financial pieces described above in a matter of minutes and seconds. It’s three-dimensional financial thinking. You have to be wired to understand the deep underlying connections. It starts with a strong background in Accounting and Financial Modeling. When in discussions, a strong Corporate Financier will see a few steps ahead, just like a Tennis Player planning one or two return-hits ahead in expectation of what type of ball-hit the Tennis opponent fires off. It’s not Financial Management, its not Working Capital Management either, nor is it Capital Analysis in isolation. Although, Financial- and Working Capital Management disciplines are key supporting environments, Corporate Finance analysis “pulls” the various financial sub-parts together. One need to understand how different scenarios, articulating growth, strategy and funding, impacts the implementation thereof and the impact on Cash Flow. Cash Flow is the key “golden thread” that ties the different finance components together. It’s therefore, understandable that Investors want to see that the Corporate Finance model underpinning a project, a growth strategy and a funding strategy, reflects as closely a possible, the reality.
Many companies and businesses fail dismally to tie all things together. How many times do we observe Net Income After Tax reflecting a 45-degree inclination upwards to the right over a number of years? It’s good to point out that Corporate Finance modeling requiring the proper treatment of both Sales Taxes, Taxable Income and when tax payments fall due under certain assumptions (the timing of tax payments) too. Get it wrong and it can create havoc with Cash Flows and guess what, Valuations too. In many instances Income Tax is calculated as a percentage of Net Income Before Tax, for a specific accounting period being forecast. What about likely Tax Assessed Losses, and Deferred Taxes? When do they run out, thus moving the business into tax-paying status? Things like this are regularly left out. A definite “no-no” when measuring and modeling Cash Flow since Cash Flow is the “golden thread” that binds together all financial components. The best approach is to model Corporate Finance using granular details and assumptions. The more details to work with, the closer to reality one would be able to forecast and project. Do a poor job on modeling and you will fail to raise your required capital. I am grateful for the years that I have spent developing detailed Project Finance and Structured Finance models that helped me developing the talent to capture and weave-in important legal, regulatory and credit related aspects.
In addition to the above, it is important to derive the correct financial ratios that underpin Credit Risk. Yes, you may ask how does Credit Risk reflect on Share Capital and Equity? Shareholders are last to be repaid in a liquidation. Investing in Equity is the riskiest portion of the Capital Structure. As an Equity Investor you stand last in line to receive any money back in a liquidation. As such, the credit metrics underpinning the business are vastly relevant and it does matter. In my 20+-years I have seen many situations where businesses and companies are only concerned with measuring profitability and treating same, with adjustment for Depreciation & Amortoization, as the same as net cash flow. That is so wrong. How about the changes impacting Working Capital, Fixed Assets and Capital? Don’t those movements impact Cash Flow too? Of course they do. To help size-up credit risk, SWOT analysis is a valuable tool to gauge how different risks impact the business and organization.
I combine Corporate Finance principles by weaving-in my detailed experience, stemming from having worked intensely in Structured Finance with International Credit Rating Agencies.
As you can derive from the aforementioned, there is passion and love within me for Corporate Finance having developed such skills from diverse angles within Finance. I capitalize on these great experiences to develop sufficiently enough Corporate Finance artifacts that will help you to better articulate positioning your business and company in front of funders and Investors.
Ahead by a Century.