Corporate finance deals with the allocation of a company’s financial resources and the management of their value. This involves decisions about where to invest, how much debt or equity to use, and how to balance risk and profitability.
Companies need to be able to show investors, shareholders, and others that they have the right mix of capital–debt and equity–in order to encourage support for their business. It can also help them attract and retain the best talent.
Definition
Corporate finance is the process of obtaining and managing funds in order to maximize organizational value and profit. It focuses on investments, finances and dividends as well as the capital structure of the company.
A capital structure is the combination of debt and equity that a firm uses to finance its operations, assets and investments. It is typically expressed in terms of the debt-to-equity ratio, which tells investors how risky a business’s financing practices are.
A firm’s capital structure can have a positive or negative effect on its value. The Modigliani-Miller theorem states that a firm’s capital structure has no effect on its value if it is financed with cash or debt in a perfect market.
Sources of Capital
Various sources of capital are required for a business to meet its short term and long-term financial needs. These sources of capital include equity, debt, and retained profit.
Equity capital is money raised by selling a company’s shares to shareholders. This is the most common source of capital for companies that trade publicly on a stock exchange.
Debt capital is the other main type of business funding. This is usually obtained by borrowing from banks and other financial institutions or issuing bonds to the public.
Retained profits, which are the excess earnings left over after all expenses and liabilities have been deducted, are another low-cost source of capital.
Aside from these two sources, businesses can also get finance by utilizing their own assets. For example, a retail store can sell the extra clothes from last season at a discounted price to raise cash.
Leverage Ratios
Leverage ratios are financial measures used to assess the ability of a company to meet its debt obligations. These include long-term debt (interest payments and final principal payments) and short-term liabilities (current liabilities due within one year).
A company’s leverage varies depending on the industry and business model. For example, an internet company is less likely to use leverage than a car or truck manufacturer.
Regardless of the type of company, a high level of leverage can increase the risk of a debt default. This can have a negative effect on a company’s operations and affect its stock price.
Debt-to-Capital Ratio and Capital Gearing Ratio are both common leverage ratios that can help companies understand the amount of reliance on creditors. This can be important to management and investors alike because a sudden cut-off in external financing could have a detrimental impact on the company’s operations.
Optimal Capital Structure
The optimal capital structure is the combination of equity and debt that maximizes a company’s market value while minimizing its cost of capital. In theory, debt financing offers the lowest cost of capital because interest expense is tax deductible. However, too much debt inflicts a financial risk on shareholders and increases the return on equity that they require.
A company can optimize its capital structure by changing the mix of debt and equity. The best choice is one that balances long-term debt with short-term equity investments, taking into account the company’s cash flow profile and prevailing market conditions.
Optimal capital structures vary from industry to industry, as companies have different financing strategies and cost structures. For example, cyclical industries like mining may not be suitable for large amounts of debt because they often have unpredictable cash flow profiles. Other industries, such as banking and insurance, are more likely to use large amounts of leverage due to their business models.
