Understanding Corporate Finance: Analysis, Ratios, and Value

Posted on Mar 6, 2025 in Finance

Corporate Finance: An Overview

Corporation: A virtual or fictitious entity created by the state. It possesses its own rights and liabilities, enabling it to enter into contracts, buy, sell, or own property, pay taxes, face prosecution for legal violations, and initiate lawsuits. Corporations offer owners protection through limited personal liability.

Objective: To conduct business activities that enhance corporate profit and shareholder gain. This must be done in accordance with the law, with ethical considerations, and with a reasonable allocation of resources to public welfare, humanitarian, educational, and philanthropic purposes.

Financial Analysis

Financial Analysis: The process of selecting, evaluating, and interpreting financial data, along with other pertinent information, to formulate an assessment of a company’s present and future condition and performance.

  • Market data
  • Financial disclosures
  • Economic data

Four basic principles for preparing public financial statements:

  • Objective
  • Unambiguous
  • Conservative
  • Cost-effective

Cash Flow and Financial Statements

Cash Flow Production Cycle: Cash returning from the working capital cycle and investment cycle should exceed the beginning amount. Profits do not equal cash flow. Financial statements are an important window on reality. Financial statements include the balance sheet, income statement, and cash flow statement.

Income Statement

Income Statement: The operating statement reports the results of the company’s major, ongoing activities. It records the flow of resources over time. The non-operating segment summarizes all secondary activities.

Depreciation and Amortization

Depreciation: Represents how much of an asset’s value has been used up. The method should reflect the pattern of benefits provided. To calculate, you need to know the original value/cost, useful life, residual value, and depreciation technique.

Straight Line: Allocates the amount to be depreciated evenly over the useful life of the asset. Formula: (cost – salvage value) / useful life.

Reducing Balance: Applies a fixed percentage rate of depreciation to the carrying amount of assets each year.

Depreciation of Intangible Assets: Called amortization. The approach is generally the same as for tangible assets. Valuation problem:

  • Infinite useful life / impairment value – total profit, cash flow, or other benefit expected to be generated by that specific asset is periodically compared with its current book value.
  • Assumed residual value of 0

Revenue Recognition Criteria

  • The amount can be measured reliably.
  • Sufficient probability that money will be received.
  • Ownership and control of the item should pass to the buyer.
  • Moment of placing an order, collection of the item, or payment for the good.
  • Long-term contracts.
  • Expenses associated with particular revenue must be considered in the same reporting period as that in which the item of revenue is included.

Balance Sheet

Balance Sheet: A financial snapshot, taken at a point in time, of all assets the company owns and the claims against those assets. The basic relationship is: Assets = Liabilities + Equity.

Assets

Meet four requirements:

  • A probable future benefit must exist.
  • The business must have the right to control the resource.
  • The benefit must arise from some past transaction.
  • The asset must be capable of measurement in monetary terms.

Current Assets

  • Held for sale during the business’s normal operating cycle.
  • Expected to be sold within the next year.
  • Held principally for trading.
  • Are cash or near equivalents to cash, such as easily marketable, short-term investments.

Liabilities

Liabilities: Represent the claims of all individuals and organizations other than the owners.

Corporate bond:

  • Face value – the price tag of this particular bond.
  • Maturity – the time when it should pay.
  • Coupon rate – the interest you get each year from the company.
  • Price to pay.

Current Liabilities

Current Liabilities: Are expected to be settled within the business’s normal operating cycle.

  • They are held for trading purposes.
  • Are due to be settled within 1 year.
  • No right to defer settlement beyond a year after the date of the relevant statement of financial position.

Equity

Equity: The claim of owners against the business.

Forms of Revenue and Expenses

Forms of Revenue:

  • Sales of goods (e.g., a manufacturer)
  • Fees for services (e.g., a solicitor)
  • Subscriptions (e.g., a gym)
  • Interest received (e.g., an investment fund)

Forms of Expenses:

  • Cost of sales or COGS (buying or making)
  • Salaries & wages
  • Motor vehicle running expenses
  • Insurance
  • Printing & stationery

Financial Analysis Tools and Ratios

Financial Analysis Tools:

  • Graphics
  • Regression
    • Direct relationship
    • Inverse relationship
    • No relationship between 2 variables

Financial Ratios: Express one number in relation to another. Standardized financial data in terms of mathematical relationships expressed as percentages, time, and days. Facilitate comparisons of trends and companies. Are interrelated. Analysis encompasses computation and interpretations.

Categories of Finance Ratios:

Activity ratios, Liquidity, Solvency, Profitability, & Valuation

Common-Size Analysis:

Expresses financial data, entire financial statements in relation to single financial statement items or base.

Horizontal Analysis:

Uses the amounts in accounts in a specified year as the base, and subsequent years’ amounts are stated as a percentage of the base value. Useful for comparing the growth of different amounts over time.

Vertical Analysis:

Uses the aggregate value in a financial statement for a given year as the base, and each account’s amount is stated as a percentage of the aggregate. Balance sheet = aggregate amount is total assets. Income statement = aggregate amount is revenue/sales.

Operating Cycle

Operating Cycle: The length of time from when a company makes an investment in goods/services to the time it collects cash from accounts receivable.

Net Operating Cycle: The length of time from when a company makes an investment in goods/services, considering the company makes some purchases on credit, to the time it collects cash from accounts receivable. Gives information on the company’s need for liquidity. Longer = greater need for liquidity.

Asset-Based vs. Cash-Flow Based Lending

Asset-Based Lending: Lenders use the assets of the company as collateral for the loan. These assets will be taken by the bank to cover the money lent.

Cash-Flow Based Lending: Lenders use the cash flow of the company as collateral for the loan. The lender has access to cash in the bank account and repays the debt. They don’t use goods (assets), but use cash.

Aggressive vs. Cautious Debt Policy

Aggressive (High Debt) / Cautious (Low Debt) Policy:

  • High/Low & relatively stable/unstable level of operating cash flows in relation to size
  • High/Low corporate tax rate environment
  • Low/High interest rate environment
  • Low/High potential bankruptcy costs (high value of tangible assets)
  • Few/Many potential conflicts between managers & owners
  • Few/Many potential conflicts between equity holders & debt owners
  • Low/High level of influence by industry regulators

Creating Shareholder Value

Creating Shareholder Value: Competition among companies to raise capital to finance growth creates pressure for performance. Growing importance of institutional investors and globalization of capital markets. Decreasing protection of independence.

Stakeholders

Stakeholders: Government, Employees, Community, Consumers, Owners

Creating Value for Stakeholders: Shareholders recognize they have a residual claim on the total value created by the company. They will try to protect their interests by aligning management incentives to ensure that this residual claim provides an adequate return on their financial investment.

Financial Flexibility

  • Excess cash
  • Unused borrowing capacity (sell shares that you have in other companies)
  • Ability to issue equity on reasonable terms (open credit line in the bank, you can reach for it if you need money)
  • Possible divestitures (possibility to sell assets that I don’t need to receive cash)
  • Room to adjust business plan

Dividend Policy

Dividend Policy: If a company cannot earn cost of capital rates on new investments, it should distribute dividends (investments, not dividend policy, primarily create or destroy shareholder wealth). As companies and industries mature, it becomes more difficult to find value-creating investments for all of the cash flow that is being earned. So, mature companies start to pay dividends to their shareholders. Companies are generally advised to develop stable and predictable dividend policies (dividend payments stable or rising gently over time to satisfy the tax and consumption preferences of their equity investors). Dividend decisions have information content (the stock market often reacts negatively to dividend reductions and unexpected extraordinary dividend payments).