Corporate Finance For Dummies
Overview
Get a handle on one of the most powerful forces in the world today with this straightforward, no-jargon guide to corporate finance
A firm grasp of the fundamentals of corporate finance can help explain and predict the behavior of businesses and businesspeople. And, with the right help from us, it’s not that hard to learn!
In Corporate Finance For Dummies, an expert finance professor with experience in everything from small business to large, public corporations walks you through the basics of the subject. You’ll find out how to read corporate financial statements, manage risks and investments, understand mergers and acquisitions, and value corporate assets.
In this book, you will also:
- Get a plain-English introduction to the financial concepts, instruments, definitions, and strategies that govern corporate finance
- Learn how to value a wide variety of instruments, from physical assets to intangible property, bonds, equities, and derivatives
- Explore the intricacies of financial statements, including the balance sheet, income statement, and statement of cash flows
Perfect for students in introductory corporate finance classes looking for an easy-to-follow supplementary resource, Corporate Finance For Dummies, delivers intuitive instruction combined with real-world examples that will give you the head start you need to get a grip on everything from the cost of capital to debt analytics, corporate bonds, derivatives, and more.
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About The Author
Michael Taillard, PhD, MBA, is an economic consultant and professor of finance. His financial experience ranges from nonprofits to large corporations and even to small business owners. He is an often-published author, and he wrote the previous edition of Corporate Finance For Dummies. In his free time, Michael enjoys kayaking!
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corporate finance for dummies
CHEAT SHEET
Corporate finance is the study of how groups of people work together as a single organization to provide something of value to society. It’s the job of those in corporate finance to manage the organization so that resources are efficiently utilized, the most valuable projects are pursued, the corporation can remain competitive, and everyone gets to keep their job.
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General Accounting
Futures contracts are highly standardized in a number of ways: futures contracts must be for a homogenous commodity of a standardized type and quality; each futures contract must be for a standardized quantity; futures contracts must be in a single currency determined by the location of trade; and futures contracts must have a standardized delivery date
Basically, futures contracts of a single type must all be completely identical.
General Accounting
Determining how financially successful a corporation is actually provides a lot more information about the corporation than simply how well it manages money. Financial performance analyses are the way we pick apart, quantify, and measure every aspect of the success of the corporation.
Because the ultimate goal of a corporation is to generate value for its shareholders (in other words, to make money), every aspect of the corporation’s activities is assessed in financial terms.
General Accounting
How a person processes available financial data is subject to behavioral errors based on the context in which the data are presented. For instance, when some expression of judgment makes its way into the presentation of data or information, that judgment influences how others analyze and understand the information.
General Accounting
Exotic financial products aren’t entirely new; rather, they’re new and/or rare variations of existing products. The word exotic is used in finance in the sense that something is attractive simply because it’s out of the ordinary. On the flip side, “ordinary” products are popular because they appeal to a larger market.
In the world of corporate finance, you need to consider fixed-rate bonds and floating-rate bonds. Fixed-rate bonds are pretty simple. If the bond says it pays 1 percent interest plus principal, then that’s exactly what you’re going to earn. There are no changes, no fluctuations, no nothing.
The nominal cash flows of a fixed-rate bond are exactly as advertised: repayment of the principal with added interest payment equal to the percentage rate.
General Accounting
When it comes to allocating resources toward an investment to derive value from it (you can’t just buy a machine without allocating resources to the operation, maintenance, and financing of that machine), the corporation must develop a budget for that investment.
Because so much money and so many resources are being spent to generate a return on investment, ensuring that the investment is adhering to its budget is a big part of how successful executive management will consider the investment to be.
From the corporation’s perspective, investing, debt, and equity all come back to the original question of how to fund its operations and how to properly balance the amount of debt or equity that is being used to raise capital. In other words, all this information is being used to manage the corporation’s capital structure.
General Accounting
Before you can analyze any of the data that will actually help you project your corporation’s future financial performance, you need to actually collect that data. Thankfully, in the age of the Internet, this task is actually pretty easy.
If you don’t have Internet access, then you’ll be spending a lot of time collecting the required data by requesting it directly from corporations or going to the local library or financial advisor to get the information you need.
To truly understand the role that stocks play in corporate finance and investing, you need to understand the terms long and short. In the context of equities trading, tend to remain a mystery for a large number of people.
After all, stocks are always the same, right? That’s actually true: Whether you’re buying long or selling short doesn’t actually change the stock itself; it just changes the nature of whether or not you’re in possession of that stock and the periods of time that you’re in possession of it.
The most significant trend in the manner in which financial transactions take place and the financial implications of this change comes from an overlap between financial engineering and computer engineering, called computational finance. Portfolio engineering and computerization have become very closely interconnected.
General Accounting
The degrees of success being generated by corporations can be measured in many ways. There are several different methods for evaluating the success of standard capital investments as well as financial or portfolio investments.
Arithmetic rate of returns
The arithmetic rate of return on a specific asset is pretty simple.
General Accounting
Corporate analysis is one of the primary methods of determining the value of stock because the value of the underlying company contributes strongly to the value of the stock. Don’t be confused; the actual price of the stock is different from its value, and whether you prefer to watch the value of the company or the price of the stock will depend a lot on your investing strategy.
General Accounting
Corporate finance is the study of how groups of people work together as a single organization to provide something of value to society. It’s the job of those in corporate finance to manage the organization so that resources are efficiently utilized, the most valuable projects are pursued, the corporation can remain competitive, and everyone gets to keep their job.
General Accounting
A lot of people misconceive the actual role of the Federal Reserve. The actions of the Federal Reserve, however, are all quite transparent. Its reports are all available for public view, its actions are all over the news each day, and the public can even see its hearings on TV sometimes.
The Fed, as it’s often called, actually has very limited power, so some of the conspiracies that exist tend to be nothing more than fantasy.
General Accounting
Corporate finance is the study of relationships between groups of people that quantifies the otherwise immeasurable. Take a look at the role of money in the world to understand how this definition makes any sense at all.
According to Adam Smith, an 18th century economist, the use of money was preceded by a barter system.
General Accounting
Two types of comparisons utilize data from both the vertical and horizontal analyses, producing cross comparisons. The horizontal common-size comparison does a lot to help you understand changes in a corporation’s finances over time by comparing financial reports from several consecutive years. Vertical comparisons, by contrast, tell you how efficiently corporate value is being allocated and utilized.
General Accounting
The process of having shares listed in more than one equity market is called cross-listing. As companies reach out in search of capital to fund start-ups and expansion, they often look beyond their own borders for investors and lenders. Why? The three main reasons are
The domestic availability of capital is limited and can be relatively homogeneous.
General Accounting
Not all financial infrastructures work the same way. Culture plays a big role in how a nation’s government, companies, and even individual transactions operate, so if you’re dealing with a company involved in international finance, you absolutely must understand a bit about the nation(s) in which the company operates to understand the context of its overall financial position.
General Accounting
Current assets are those assets that a company expects to turn into cash within one year or, for inventories that take more than a year to turn into cash (such as buildings, vehicles, and other things that are usually expensive items), those assets a company expects to sell within one year.
The subsections of the current assets portion of the balance sheet range from the most liquid to least liquid.
General Accounting
Current liabilities are those that must be paid back, fully or in part, in less than one year. Following are the current liabilities you find on the balance sheet in order from those that must be paid in the shortest period from when they were incurred to those that can be paid off in the longest period from when they were incurred.
A forward in the world of corporate finance is an agreement between parties to perform a sale of a specific type of good in a predetermined quantity at a predetermined price at a predetermined date in the future.
Unlike options, which give either the buyer or the seller the right to participate in the transaction but do not obligate them, forward contracts are legal obligations to perform the transaction on or before a specific date.
General Accounting
After you collect all your financial data, you need to figure out what to do with it. You need to do some simple descriptive calculations of statistics and probability, which is the mathematics of uncertainty. In other words, you measure the likelihood of an event occurring using information about performance and relationships between variables.
General Accounting
You can measure the manner in which data is distributed around the average in a few different ways. Obviously, not all the numbers in a data set are going to be exactly the same as the average. Say that the average net income of a corporation is $10,000. That’s great, but it doesn’t tell you whether that number changes much.
General Accounting
Diversifying your investments means buying stock in several different companies. In an ideal world, if one of those companies did poorly, then the others would help mitigate your losses. But even this strategy can’t eliminate systematic risk (which comes from the fact that any given nation’s market constantly jumps around in different directions).
General Accounting
Because the risk of a single investment can’t be totally eliminated, corporations attempt to reduce the risk of a portfolio by picking investments that are likely to change in value in different ways or at different times. This process is called diversification. Diversification means taking advantage of differences in risk among your investments.
Portfolio engineering and investing strategy go hand-in-hand and are easily the most mathematically complicated subject in all of financial engineering. As Isaac Newton pointed out, modeling the madness of men is more difficult than modeling the movement of the planets. He was entirely correct, and portfolio engineering is an extreme example of how this is true.
General Accounting
Easily the most difficult part of investing in stocks is figuring out what they’re worth and projecting how their prices will change. There are a number of different influences on the value and price of a stock. You can measure the stock itself using any of a number of equity valuation models.
Far too many different valuation models are in use to be able to talk about each one, many of which are becoming very involved due to the increased use of computers and financial engineering.
The term Eurobonds refers to bonds in one nation that are denominated in another nation’s currency. So a Japanese-currency bond owned in Canada and subject to Canadian interest rates would be a type of Eurobond even though it has nothing to do with Europe. Specifically, this particular bond would be called a Euroyen bond because it’s a Eurobond denominated in the Japanese yen.
General Accounting
Each industry responds differently and at different times to different variables. Understanding how each sector responds to cycles and policies in economy is very important for traders and investors alike.
For example, during a recession corporations that work in consumer staples (soups, soaps, cereals, and so forth) tend to see a boost in stock prices because demand for these things doesn’t decrease greatly.
Credit is a form of loan. Corporations frequently provide their goods or services to customers on credit, which means that they expect to get paid at some later date. Extending credit is common for furniture stores, car dealerships, many businesses that sell to other businesses, and just about any company that deals in goods that are considered expensive for customers to purchase.
General Accounting
Investors have a tendency to get caught up in a stampede of other investors, believing that they’re running like the bulls on Wall Street when, in reality, they were just lemmings jumping off a cliff. As soon as some trend begins to occur, investors start to follow that trend as quickly as possible, often without even fully knowing why.
Financing refers to the process of acquiring capital to fund a start-up, an expansion, basic operations, or whatever else the company needs the extra funds for. The financing activities cash flows section of the statement of cash flows covers these types of activities.
Most of the time, changes in liabilities (the debt a company uses to fund asset purchases) and owners’ equity (the ownership purchases whose proceeds are used to fund asset purchases) impact cash, regardless of whether the company is acquiring or repaying the cash.
General Accounting
Financing institutions are kind of like banks in that they lend money, but they’re a bit different, too. First of all, they tend to give different types of loans than banks do. Secondly, they get their funding by borrowing it themselves instead of through deposits. They earn a profit by charging you higher interest rates than they’re paying on their own loans.
General Accounting
When you review historical financial data, the first thing one should do is look for trends and patterns. If you can identify trends that are occurring and any cyclical patterns that have happened in the past, you can gain important insight into what will happen in the future.
Start with patterns, for example.
General Accounting
At the core of all M&A (mergers and acquisitions) is the idea of corporate integration. Companies can make corporate integration happen in several ways that aren’t technically mergers or acquisitions.
Hostile takeover
A hostile takeover is really quite the same thing as a regular buyout or acquisition. The thing that makes such a takeover hostile is the fact that it occurs without the consent of the management of the acquired company.
General Accounting
Your financial decisions can be some of the most emotionally charged decisions you make in your life, which is why many people prefer to let professionals handle their money. They believe that professionals with no personal attachment to the money will be better able to make rational decisions.
The world of corporate finance is similar in that people are typically dealing with someone else’s (the company’s) money, so you may think emotions run low in corporate finance.
Horizontal common-size comparisons use only one type of financial statement at a time, but instead of using that statement from just one year, they utilize several consecutive years’ worth of the same type of financial statement.
For example, if a corporation were to do a horizontal analysis on its income statement, it would use the income statements for 2010, 2011, and 2012.
General Accounting
Analysts use the net interest margin to determine whether the earning assets are actually making enough money to justify the interest expense or if the company would’ve been better off just paying off its debts to decrease the interest expense.
In other words, a good way to determine whether a company is effectively using its earning assets is to look at the proportion of income that’s being generated for the value of the company’s assets.
General Accounting
A very important ratio for banks to calculate is their loans to deposits ratio. A high loans to deposits ratio means that the bank is issuing out more of its deposits in the form of interest-bearing loans, which, in turn, means it’ll generate more income. The problem is that the bank’s loans aren’t always repaid.
General Accounting
Bank analysts want to know what percentage of a company's assets are actually generating income. They determine this with the earning assets to total assets ratio. Of all the assets that a company owns (referred to as total assets), analysts want to know what percentage of them are actually generating income.
Earning assets usually include any assets that are directly generating income, such as interest-generating investments or income-generating rentals, but in some cases, they include other forms of assets that directly contribute to income, such as machinery, computers, or anything that is directly involved in producing goods and services that will be sold to customers.
General Accounting
An effective way to determine the number of times over total equity that deposits cover is to calculate deposits times capital. Deposits are the primary way a bank borrows money. A customer deposits money, and the bank must pay that money back on request with interest.
The primary difference between deposits and the loans taken by any other corporation is that deposits are loans that must be repaid on request and are often subject to cyclical fluctuations.
General Accounting
Some companies are particularly interested in the proportion of their total assets that’s comprised of equity ownership because this ratio can decrease the amount that they have to borrow in order to generate the same amount of earnings.
Maintaining a high ratio of equity to total assets provides a degree of protection against the risk that interest payments will exceed earnings, particularly for companies that generate their earnings from interest on loans or rentals.
General Accounting
Companies measure their rainy day fund by using the loan loss coverage ratio. Your “rainy day fund” is the money you set aside in case you lose your job and stop making money. A company's loan loss coverage ratio is calculated by:
To use this equation, follow these steps:
Find the pretax income near the bottom of the income statement, the provision for loan losses in the assets portion of the balance sheet, and the net charge-offs in the expenses portion of the income statement.
Unless you’re in a rare minority who live “off the grid” (secluded and self-sufficient), nearly every aspect of your life is strongly influenced, directly or otherwise, by corporate finances. The price and availability of the things you buy are decided using financial data. Chances are high that your job relies on decisions made using financial data.
General Accounting
Raising money by selling shares of equity is a little more complicated both in theory and in practice than borrowing money using loans. What you’re actually doing when you sell equity is selling bits of ownership in a company. Ownership of the company is split up into shares called stock.
When you own stock in a company, you own a part of that company equal to the proportion of the number of shares of stock you own compared to the total number of stock shares.
General Accounting
When a corporation needs money, one of the primary options it has available is to borrow some. Regardless of what the money’s for, when a corporation wants a loan, it starts by putting together a proposal.
For start-up companies, this proposal comes in the form of a business plan, but anytime a corporation receives a loan significant enough to influence the capital structure of the company (not lines of credit), it has to present a proposal for the use of the funds.
General Accounting
The cost of equity is heavily influenced by the corporation’s dividend policy. When a company makes a profit, that profit technically belongs to the owners of the company, which are the stockholders. So, a company has two choices regarding what they can do with those profits:
They can distribute them to the shareholders in equal payments per share of stock as dividends.
Both inflation and interest rates, in their ability to change the value of money over time, play a very important role in how corporations manage their liquid assets and their investments. Therefore, to have even a basic understanding of corporate finance, you must understand what the time value of money is and how it influences corporations.
General Accounting
To determine how stable a company’s dividends are, investors calculate the cash dividend coverage ratio. One way to help determine the stability of a company’s dividends is by estimating the company’s ability to meet its dividend payouts using only operating cash flows.
The use of operating cash flows helps indicate whether a company’s core operations are contributing to financial strength, which, in turn, helps investors estimate whether related metrics are stable.
General Accounting
Investors use the book value per share to determine the value of a share of stock when you take away all the earnings and investor speculation. In other words, if a company were to go out of business and liquidate everything it owns, how much would each share of stock in that company be worth? Here's what the book value per share looks like:
The following steps show you how to use this equation:
Find the total shareholders’ equity and preferred stock equity in the equity portion of the balance sheet and the total outstanding common shares on the balance sheet under the equity portion (or sometimes on the income statement).
General Accounting
Investors can estimate whether a stock is overpriced or underpriced by calculating the price to earnings ratio (P/E). Say an investor has some idea of the value of a stock but he wants to know how the price of the stock compares to its value. The first thing the investor needs to do is remember that the market, not the value of the company itself, determines the stock’s price.
General Accounting
The operating cash flows per share is a reliable measure of a company's financial strength. Although earnings per share directly measures the amount an investor makes on his shares and is, therefore, the more popular investment measure used, a more reliable measure in terms of the company’s financial strength is the operating cash flows per share:
Here’s how to use this equation:
Find the operating cash flows in the operating cash flows portion of the statement of cash flows and the preferred dividends on the income statement near the bottom.
General Accounting
Investors can use the percentage of earnings retained to evaluate how effectively a company is producing share value using retained earnings compared to other potential investments that instead yield dividends.
When a corporation earns money, it can use that money in one of two ways:
It can issue the money out to shareholders in the form of dividends (see the next section).
One of the core calculations used in capital budgeting is net present value (NPV). Net present value is calculated using the following equation, which says that you add up all the present values of all future cash inflows, and then subtract the sum of the present value of all future cash outflows:
In other words, you take the present value of all future cash flows, both positive and negative, and then add and subtract as appropriate.
General Accounting
The simplest rate of return to calculate is the accounting rate of return (ARR). This is a very fundamental calculation to determine how much value an investment generates for the corporation and its owners, the stockholders. It requires only two pieces of information: the amount of earnings before interest and taxes (EBIT) generated by the project and the cost of the investment.
Calculating the cost of debt is pretty simple. Debt includes any long- or short-term debt that is used to finance the operations of a business.
The biggest influence on the cost of debt is simply the interest rate on debt incurred, measured by using the current value of future cash flows to repay the loans. Well, you’re looking at the same thing from the perspective of corporate costs of debt rather than investor potential for debt.
General Accounting
The ability to estimate the value of something today that will change value over time is essential not only to buying and selling assets, it’s also a critical element of tracking the progress and efficiency of capital assets within an organization.
When you purchase a piece of capital like a machine you may have some estimates of the value that it will create for your organization and you may even have some projections on the returns on investment it will generate, but you can’t just sit back and assume your estimates were correct.
General Accounting
When a company earns money, it can choose to distribute those earnings out to its shareholders in the form of dividends. Investors calculate the percentage of earnings used for dividend payouts to common shareholders like this:
To use this equation, follow these steps:
Find the dividends per common share on the income statement and determine the earnings per share.
General Accounting
To determine how much money an investor really makes, you have to determine the earnings per common share (EPS). When you own a company by yourself, the amount of money the company makes is the amount of money you earn.
In contrast, when you own a share of stock, you still own a part of the company, but you have to split the amount of money the company makes with everyone else who owns stock.
General Accounting
A company's degree of financial leverage is the amount of the company that's funded using finances with fixed repayments, such as loans. Pretend for a moment that you’re deciding whether or not to buy stock in a company. Now pretend that this company has borrowed money to obtain capital.
Investors, both real and pretend, measure financial leverage like this:
Here’s how to use this equation:
Find both the EBIT and the net income on the income statement near the bottom.
General Accounting
The payback period is the number of periods it will take to pay back the initial investment on a piece of capital. In other words, it’s the number of years it will take for a corporation to break even on its new capital investment.
The payback period is a crucial calculation not only for projecting the cash flows, interest payments, and other value management techniques for the investment, but also for projecting the influence of the project on the entire corporation’s asset management and profitability.
General Accounting
Corporate debt is a big deal. In fact, it’s such a big deal that companies value their capital structure based on how effectively they manage debt. Why is debt so important as compared to, say, equity?
First, a company can have more debt than assets. Unlike equity, where the maximum equity is the value of all the company’s assets, debt can surpass assets.
General Accounting
When people talk about securities, more frequently than not they’re referring to equity securities, also known as stocks. Equity securities aren’t even close to being the only type of security out there, though. Securities include any financial investment that derives its value from an underlying asset.
So while stocks are a type of security whose value is derived from the ownership in a corporation that’s also changing in value, bonds derive their value from underlying assets, as do mutual funds and derivatives.
How do you compare different potential investments? Every investment has an opportunity cost — the loss of the next best option — so corporations really need to ensure that they’re picking the best option, and that includes, potentially, no capital investment at all.
Calculate the equivalent annual cost
Probably the best place to start is by calculating the equivalent annual cost of each potential investment.
Exactly how risk is measured is a complicated issue. Before you can begin managing a portfolio you have to look at individual investments. Originally, this task was done using a calculation called the capital asset pricing model (CAPM). The CAPM is now seen more as an unrealistic view of investing, but it’s still valid as a starting point.
General Accounting
The most common method of measuring the cost of capital that you’ll see in all the major college finance textbooks is called WACC (pronounced “whack”), the weighted average cost of capital. This particular equation takes the same basic cost of capital equation and contributes the proportions of total corporate value that each source of capital composes.
Collections of individual assets interact together to influence the overall portfolio. So when several investments are lumped together in a portfolio, every single investment has an influence on the portfolio.
Think of it like this: Envision a ring that’s held up by several rubber bands tied to it. Each rubber band acts like a single investment, so that the location of the ring in the middle is determined by the length of each rubber band.
General Accounting
The future value of an asset refers to the amount of value that you estimate something will have at any point in the future. Want to know what a machine will be worth after 5 years? Want to know how much your bank account will be worth in 6 months? You can measure both things using future value.
The vast majority of future value calculations are functions of just three things:
Present value
Rate
Time
All future value calculations are just a matter of determining how much revenue an investment will generate over a period of time at the interest rate offered by that particular investment.
You need to know how to read bonds in the language of corporate finance to understand their potential impact on your corporation. Look in the finance portion of any newspaper (for example, The Wall Street Journal) and you’ll see information about the bond market. This data about specific bonds is meant to help buyers and sellers make effective decisions regarding the potential to invest in bonds or issue their own.
General Accounting
The following ratios are of primary concern for those people who manage, own, or lend to companies that have large capital investments — companies that need things that are very expensive to operate. These companies could be part of the manufacturing industry, which usually requires machines of some sort, the transportation industry, such as airlines or buses, or utilities, such as electrical or water.
Imagine that you own equity in a company. You’d probably want to know how much value the company is making for you, the stockholder. The good news is you can calculate the amount of income a company is able to generate with the equity you have invested in it by using the return on total equity metric, which looks like this:
To put this equation to work for you, follow these steps:
Find net income after tax near the bottom of the income statement.
General Accounting
A company can use the days sales in receivables metric to calculate the number of days it takes for the company to finish collecting the money a customer owes it. When a company sells a product and the person who bought it doesn’t pay right away, the money that the company will collect in the future is called a receivable.
General Accounting
How effectively is a company using its operating assets to generate sales? To find out, use a ratio called operating asset turnover, which you calculate like this:
Follow these steps to use this equation:
Find net sales at the top of the income statement.
Find average operating assets by using the balance sheets from the current year and the previous year: Add together the operating assets of the current year and the operating assets of the previous year and divide that value by 2.
General Accounting
The accounts receivables turnover metrics are used by companies to determine whether they’re collecting the money that customers owe them. To find out exactly how well a company is at making sales that will be collected in the future and how well the company is at collecting the money that people owe it, the company can use the accounts receivables turnover metric, which it calculates like this:
To put this equation to use, follow these steps:
Find net credit sales on the income statement.
General Accounting
Companies use the acid test ratio (aka quick ratio) metric to determine whether they would be able to pay off their debts due within the next year. Some companies that sell very large or expensive items have a difficult time selling inventories.
The acid test ratio uses all current assets except inventories and divides their value by the current liabilities, as you can see in the equation that follows:
Follow these steps to put this equation to work:
Find the cash equivalents, marketable securities, and accounts receivables in the assets portion of the balance sheet and the current liabilities in the liabilities portion.
General Accounting
The strictest test of a company’s liquidity is the cash ratio. This metric utilizes only the most liquid of assets — cash equivalents and marketable securities — to determine how many times a company could pay off its liabilities over the next 12 months.
For companies that have very high accounts receivables, either because they sell expensive items that customers make long-term payments on or because they issue a lot of bad debt, this is often the best ratio to use.
General Accounting
How long does it take for a company to turn its inventory into sales? Companies can answer this question with the days sales in inventory liquidity metric. The days sales in inventory metric looks like this:
To use this equation, follow these steps:
Find the ending inventory on the balance sheet at the end of the year (the value of the inventory listed at the end of the year is the ending inventory) and the cost of goods sold (COGS) in the revenue portion of the income statement (usually somewhere near the top).
The DuPont equation was developed by the DuPont Corporation in the 1920s to take a closer look at return on equity by breaking it into its component pieces. Using the DuPont method, return on equity looks like this:
Profit margin x Asset turnover x Equity multiplier = DuPont equation (or return on equity)
If you break down the components in the DuPont method into their respective ratios, the DuPont equation looks like this:
Because net sales appears on top in profit margin and on the bottom in asset turnover, you can cancel it out.
General Accounting
A significant determinant of a company’s profitability is how well it manages fixed assets, such as production plants, properties, equipment, and other assets that contribute to the company’s potential output volume. A bigger plant may be able to handle greater production volume, but unless the company is able to turn that potential into actual sales, it’s just a wasted expense.
General Accounting
Companies can use the gross profit margin to calculate the percentage of sales that are left over to cover indirect costs. After a company figures out how much it costs to cover the direct costs associated with the making and selling of a product, it has to figure out whether it can cover the indirect costs that it must pay for but that aren’t directly associated with the product itself.
General Accounting
The number of times a company’s inventory is sold and replenished is called the inventory turnover. Here, the term turnover means that the total value of a company’s inventory has been completely depleted and recovered. A high number means that the company cycles through its inventory very quickly, while a low number means that the inventory cycles very slowly.
General Accounting
The most common measure of a company’s profitability is the net profit margin. This metric measures the percentage difference between net income and net sales. In other words, it measures the percentage of a company’s sales revenues that don’t go toward business costs. You measure profit margin like this:
Here’s how to use this equation:
Find net income near the bottom and net sales near the top of the income statement.
General Accounting
The ratio of operating cash flows to current maturities utilizes the cash flows a company generates from its operations to determine its ability to pay any debts that are maturing within the next year. This ratio is different from the other liquidity metrics in this section in two important ways:
It determines whether a company can pay debts by using the cash flows it generates rather than the assets it has on hand.
General Accounting
A store's management and investors use the operating cycle liquidity metric to determine how long it takes the store, from start to finish, to do everything it has to do to collect its money and complete a transaction
The period of time from the moment a company purchases its inventory to the moment the final payment on the sale of that inventory is made is called the operating cycle.
General Accounting
The operating income margin profitability metric measures the percentage difference between operating income and net sales. This metric differs from net profit margin in that it concerns itself only with income from operations, excluding a number of costs and revenues that go into measuring net income. You measure operating income margin with this equation:
To put this metric to use, follow these steps:
Find net sales near the top of the income statement.
General Accounting
The return on investment (ROI) is an extremely common measure that determines how well a company is using investments to generate profits. When a company raises funds, either by incurring debt or by selling equity, it invests those funds in purchasing the things necessary to make the company operate.
In other words, ROI determines whether it was worth the company’s time and efforts to raise those funds in the first place.
General Accounting
The appropriate level of liquidity varies depending on the individual company in question. But you can use the ratio sales to working capital metric to help determine whether a company has too many or too few current assets compared to its current liabilities. This metric looks like this:
Here’s how to use this equation:
Find sales at the top of the income statement.
General Accounting
In the world of corporate finance, companies use a ratio called the total asset turnover profitability metric to determine how effective it is at using its assets to generate sales. The total asset turnover metric is calculated like this:
Follow these steps to put this equation to use:
Find net sales at the top of the income statement.
General Accounting
Companies use the working capital metric to tell them exactly what their net value is in the short run. If you paid off all your short-term debts, what would the value of your remaining short-term assets be? For example, if you paid off your credit cards, would you have any money left in your bank account?
Here’s what the working capital metric looks like:
Current assets – Current liabilities = Working capital
To put this equation to use, follow these steps:
Find current assets and current liabilities on the balance sheet in the assets and liabilities sections (go figure!
A hybrid is anything that is made by combining two or more things. The idea is simple: Take two financial products and smush them together into a single product. Some work more effectively together than others; sometimes the traits of each component of the hybrid function separately, not really creating any benefit other than having two financial products rather than one.
General Accounting
Operating risk, or operational risk, is the risk of losses or costs associated with business operations. According to the Basel Accords on banking supervision, this category includes just about every possible non-value-added cost that a company can experience — from fraud and theft to negligence and stupidity to accidental events such as the acquisition of faulty equipment or the occurrence of a natural disaster.
General Accounting
Insurance companies are a special type of financial institution that deals in the business of managing risk. A corporation periodically gives them money and, in return, they promise to pay for the losses the corporation incurs if some unfortunate event occurs, causing damage to the well-being of the organization.
General Accounting
Intangible assets listed on a corporate balance sheet are things that add value to a company but that don’t actually exist in physical form. Intangible assets primarily include the legal rights to some idea, image, or form. Any assets that a company hasn’t otherwise listed in the assets portion of the balance sheet go into an all-inclusive portion called other assets.
General Accounting
The vast majority of products available for investment that yield interest offer fixed rate returns. A fixed rate return means that if you purchase an investment that offers a 1 percent annual interest rate, then you’re going to earn 1 percent annually — no more, no less.
When you earn 1 percent interest on an investment, it doesn’t matter whether interest rates go up or down during that time, nor does it matter how high inflation rates go; you still only earn 1 percent.
General Accounting
Particularly if you manage a multinational company, anticipating fluctuations in exchange rates can be an extremely important part of your company’s financial management success. So what influences exchange rates?
The International Fisher Effect says that for every 1 percent differential that a nation has in its nominal interest rates over another nation, the currency of that nation will experience a 1 percent decrease in exchange rate via inflationary pressures associated with increased interest, increased consumption, and investment speculation.
Any cash flow changes that result from the purchase or sale of investment assets belong in the investing activities cash flows portion of the statement of cash flows.
Whenever a company purchases or sells any form of investment, including large, long-term assets, the cash flows result in either a gain or loss in cash from the total cash and cash equivalents (although they could also break even).
Capital budgeting is the process by which you evaluate the financial potential for each of one or more possible capital investments. In those cases where several options are available but the corporation has enough resources to pursue only one, each option must be compared against the others in order to determine which one will yield the greatest returns.
General Accounting
The idea that whom you know is more important than what you know holds weight all over the world. In Chinese, it’s called guanxi, in Arabic, it’s called wasta, in Russian, it’s called blat, but it all means the same thing: showing favoritism based on personal relationships rather than merit or qualifications. This form of favoritism is called cronyism (or nepotism, when you’re dealing with relatives).
General Accounting
Long-term assets are those assets that will take more than one year to turn into cash or that are otherwise not intended to be sold yet (but can be sold, if necessary). The long-term assets section of the balance sheet includes three main categories.
Investments category of long-term assets
Long-term investments typically include equities and debt investments held by the company for financial gain, for gaining control over another company, or in funds such as pensions.
General Accounting
Long-term liabilities are those that must be paid back in a time period of one year or more. On a balance sheet, you might see the following categories in the long-term liabilities section.
Notes payable category of long-term liabilities
When a company owes money that it expects to pay in a time period that’s longer than one year, the value of that money goes into a category called notes payable.
General Accounting
The goal of regression is to look at past data to determine whether there are any variables that are influencing financial movements. This process now typically utilizes very advanced computer programs, such as analytics software and databases, to perform something called data mining.
Basically, data mining works by including all the data you can possibly get your hands on and letting a computer program figure out whether any correlation exists between the thing you’re trying to forecast and other variables.
General Accounting
The accounting rate of return is helpful, but it’s so simple that it’s extremely limited in its ability to provide you with information that’s useful in your attempt to manage assets, investments, and projects. For that, you have something called the modified internal rate of return (MIRR). Modified!? Yeah.
The internal rate of return (IRR) is a good equation, but it has some faults that are easily rectified, so no one really even brings it up anymore.
General Accounting
Studies in corporate finance make the assumption that people are rational decision makers. In fact, most economic models, financial and otherwise, assume that people act unemotionally and with a certain degree of competence. Here’s the reality, though: People are emotional, illogical, impulsive, and ignorant. That’s where behavioral finance comes into play.
General Accounting
Logic can be really complicated. Common sense may get you through the day in one piece, but when you’re dealing with finances, what you really want is good sense. The problem is that human brains have a tendency to try and find patterns in the world around them.
While this pattern-seeking behavior is necessary for people to function (you assume that you won’t fall into oblivion with every step you take based on the pattern that the ground stopped you from falling before), sometimes it can lead people to make incorrect conclusions.
General Accounting
Understanding how irrational financial behavior works is only half the job. You also have to determine the value of irrationality. That is to say, you must figure out how much your own inherent irrationality costs you (and your company) financially.
Consider how you might measure the cost of satisficing behavior:
One person goes to the store, intending to purchase ten boxes of cereal.
General Accounting
A merger is really a rather strange thing. A merger occurs when two companies become each other or, more specifically, both companies cease to exist and a new company is formed out of the operations of both.
The stockholders have their shares reorganized under the new company, and all operations fall under a new set of executive management, which usually consists of a combination of the management from the two individual organization prior to the merger.
General Accounting
Like all investments, the method of payment for mergers and acquisitions (M&A) plays a very significant role in whether or not making the investment at all is feasible. There are a number of methods available to pay for M&A, each with their pros and cons.
Cash: Cash is great. It’s cheap compared to other methods, it’s an instant transaction, and it’s mess-free (meaning that once it’s done, you don’t have to mess with it again).
Your company is careful. It chooses only the best customers, only the best investments, uses derivatives only to mitigate potential losses, diversifies clients and investments, and does everything right to reduce the risk associated with every single penny. You have the safest and most stable company in the entire nation .
General Accounting
So what the heck is an acquisition, anyway? An acquisition differs from a merger because it doesn’t combine two companies. Rather, in an acquisition, one company purchases the other as you would purchase a car.
Acquisitions are a bit more flexible than mergers in respect to the legal organization of each company, but the one true hallmark of an acquisition is that one corporation then owns another after the acquisition process is complete.
In essence, operating activities cash flows include any increases or decreases in cash that result from the primary functions of the company. Here are some of the most common changes in cash you may see in the operating activities portion of the statement of cash flows:
Cash received from customers: When a customer pays in cash (including via an electronic transfer made between accounts), you count that transaction as a cash increase in the operating activities cash flows.
The decision to outsource (or transfer certain operations to an outside company) is a financial one that many companies have to deal with at some point. Basically, a company has to decide whether another company could perform one or more of its operations comparably and more cheaply than it currently performs them.
General Accounting
The owners’ equity portion of the balance sheet breaks down exactly what value the company has to its owners and how that value is allocated to them. The amount of value that investors have in a corporation is equivalent to the amount of total assets the company has minus its total liabilities.
In all cases, regardless of any other variables, debtors always get their cut in a company’s assets before investors.
When you’re dealing with corporate finance, you rely on the collection and analysis of data to help you answer questions and make decisions. Even though all the data you need to make the best decision may be available, how you actually perceive and use that data can be an erroneous process thanks to the following two types of bias:
Statistical bias: This type of bias occurs when people collect data from a sample rather than an entire data set and then assume that the data they collected represent the entire data set.
General Accounting
Maybe the corporation you’re analyzing has improved dramatically over the years. Its common-size analyses make it seem like the corporation’s asset allocations are steadily improving, and a comparison of its financial metrics over the last ten years supports that by showing improved financial health. Is the corporation really doing well, though?
The goal of comparing financial metrics over time is to judge the current performance of a corporation based on the past performance of the same corporation. Instead of looking at your financial measures and metrics by themselves, you want to compare them to the previous years’ metrics and see how they’ve changed, if at all.
General Accounting
Governments and politicians seem to have an uncanny way of knowing exactly how to make your life as complicated as possible. When you’re dealing with international finance, you have to be aware of not only your own nation’s international policies but also the policies of at least one other nation, plus how each nation involved interacts with the others.
General Accounting
The buying, selling, and trading of investments within a portfolio — optimizing the returns of the portfolio by managing which investments the portfolio holds — is considered portfolio management. But the portfolio itself remains constant despite the changes of its exact contents. The portfolio itself only actually changes when the underlying investment strategy changes.
One concept that can be applied to any expenditure or investment is generally applied to evaluations of the success of investment portfolio managers. These evaluations involve (surprise, surprise) the actual returns, risk, and average market returns. As with evaluating the estimated price and value of assets compared to the market, the degree of success is also evaluated in such a manner.
General Accounting
People prefer to live their lives in a fantasy. They fear what they don’t understand and dream of what they (probably) can’t attain. You shouldn’t be surprised, then, to find out that this same view influences people’s financial decisions in a behavioral fluke described as the prospect theory, which basically says this:
When making financial decisions that aren’t certain (meaning that the outcomes aren’t certain but the probability of success can be estimated), people look at the potential for gain or loss instead of relying on rational thinking using the probable outcomes.
General Accounting
The purchasing power of a nation’s currency refers to that nation’s ability to purchase goods. Usually purchasing power is measured using a list of necessities such as certain groceries, utilities, and other requirements for daily life, but for simplicity’s sake, say that purchasing power is measured in beer.
Purchasing power by itself doesn’t really mean anything, but when used to track changes over time, it helps measure inflation.
General Accounting
You've decided that a career in corporate finance is absolutely your life's calling, so what do you do next? You need to bone-up on some essential mathematical and computer skills that not everyone warns you about when you first begin your journey into corporate finance.
Whether you're pursuing your college degree or a professional certification, these skills tend to be sorely neglected, leaving many completely unprepared for the workplace.
There are certain risks that no amount of diversification can eliminate. Specific risk is any risk associated with an individual investment and holds the possibility of being eliminated or greatly minimized through diversification. Default risk on a bond, liquidity risk on the corporation underlying a stock, and the risk of a building losing value in the real estate market are all specific risks.
General Accounting
In corporate finance, the application and measurement of what’s “good enough” is called satisficing. Remember that old saying “time is money”? Well, come to find out that people naturally apply a value to their time. This value isn’t so much about money as it is about using your limited amount of time doing things you either need to do or would rather be doing.
General Accounting
Securities firms provide transaction services related to financial investments, which are quite distinct from the services provided by traditional depository institutions. However, many commercial banks have separate departments that offer the services of securities firms, and others actually merge or partner with securities firms.
General Accounting
A number of things influence exchange rates, but in the end, how are exchange rates decided when a floating currency is involved? The process actually works a lot like buying stock. The organizations that have foreign currency and are willing to sell it for domestic currency (or another foreign currency) tell people how much of the domestic currency they want to receive for their foreign currency.
General Accounting
Of the four most common derivatives, the swap is easily the most confusing. Why? Because each swap involves two agreements rather than just one. Swaps occur when corporations agree to exchange something of value with the expectation of exchanging back at some future date.
Corporations can apply swaps to a number of different things of value, usually currency or specific types of cash flows.
General Accounting
If your company is owed money but doesn't have enough to pay the bills in the meantime, you’re a victim of liquidity risk! The most extreme form of liquidity risk, called insolvency, occurs when a company is completely incapable of paying the money it owes and must file some form of bankruptcy, sell its operating assets to make the payments it owes, or simply go out of business.
The cost of equity is a little less singular than the cost of debt. Equity is any funding raised through the selling of stock. Different people have different ways of measuring equity.
Some people prefer to simply utilize the CAPM or some other form of APT, estimating the cost of equity as an amount equivalent to the risk premium on returns paid by the corporation to its investors.
General Accounting
Derivatives are legal contracts that set the terms of a transaction that can be bought and sold as the current market price varies against the terms in the contract. Originally, derivatives were all about bringing price stability to products that can be quite volatile in their pricing over short periods of time.
General Accounting
In corporate finance, funds come in two types — hedge funds and mutual funds — and although they both have the same fundamental principles, each type has some unique traits, processes, regulations, and variations.
The following table gives you a quick look at the main differences.
Hedge Funds
Mutual Funds
Strategy
Managers have more freedom in their use of investment tools and
an ability to change strategy as they see fit.
General Accounting
After you decide that you want to buy or sell stock, you have to decide the type of buy or sell order you want to place, the price at which you want the transaction to take place, and the timing of the transaction. These factors can all be controlled by managing your transaction order.
Say that you want to buy 10 shares of Ford stock for $10 per share, and you want the transaction to take place as soon as a seller of that many shares at that price becomes available.
General Accounting
The first portion of a corporate income statement, called gross profit, seeks to calculate the profitability of a company’s operations after direct costs. Its ultimate goal is to determine the company’s gross margin.
For example, if you’re a self-employed window washer, your margin would be all the money you make for washing windows, minus the cost of the materials you used to wash those windows (for example, soap, water, and other supplies), but not the cost of your ladder because you use it over and over again.
General Accounting
The goal in the earnings before interest and taxes portion of the income statement is to account for all the costs and revenues from activities that aren’t related to the company’s normal operations. This information enables the company to make smart financial decisions on debt and so it knows how much to pay in taxes.
General Accounting
In the earnings per share (EPS) portion of the income statement, which immediately follows net income, corporations have to include the amount of earnings each individual share of stock they have outstanding has generated. Here are the two main components of this portion:
Basic earnings per share: Companies calculate the basic earnings per share by dividing net earnings by the total number of common shares outstanding.
General Accounting
The net income portion of the income statement, which lists costs and revenues, is called net income and deals exclusively with taxes and interest. A company has to pay the taxes and interest charges that appear in this section, but the amounts due are often related to the amount of money the company makes.
As a result, the company has to account for all other expenses and revenues before it can calculate these final items and determine the company’s total profits.
General Accounting
The operating income portion of the income statement takes into account a company’s costs of doing business other than the costs of goods sold. Think of it as a way of breaking down the overhead costs associated with all the standard operations without including any infrequent revenues or costs.
The overall goal of the operating income is to determine how much money a company is making after taking into consideration all the costs the company incurs during its primary and supporting operations.
General Accounting
Probability theory is pretty easy. The total probabilities of an event occurring or not will always equal 100 percent. If you have a 10 percent probability that something may happen, then you have a 90 percent probability that it won’t.
The simplest example is the coin toss. You have a 50 percent probability that the coin will land on either side because only two options exist.
General Accounting
A special type of insurance company, called underwriters, deals only with other insurance companies. They analyze applications for insurance, determine the degree of risk and associated costs with issuing insurance, and determine eligibility and price. Some insurance companies have their own internal underwriting departments, while others outsource to external companies that specialize in just underwriting.
General Accounting
According to modern portfolio theory, there’s a trade-off between risk and return. All other factors being equal, if a particular investment incurs a higher risk of financial loss for prospective investors, those investors must be able to expect a higher return in order to be attracted to the higher risk.
Be very careful in your interpretation of the preceding paragraph, because perception can be misleading.
General Accounting
At no point in a typical retail exchange do either you or the store owner have a trade imbalance, because the value of goods and money being exchanged are equal.
The store owner, having given a thing of value to you, is now in possession of a piece of paper that symbolizes the value of debt that society owes him in the form of goods and services.
General Accounting
Numerous regulatory bodies oversee corporate finances and financial institutions, and each one warrants its own book (in fact, the role and regulations encompassing each regulatory body span volumes of books of information). Armed with their names and main purposes, you can do a quick online search to find out more about the ones that interest you most.
General Accounting
Behavioral finance was developed as the result of the need to explain how corporations and the people within them behave, driving an overlap between the fields of finance and psychology. Very broadly speaking, behavioral finance looks at the actions and reactions made by people in order to determine how to better understand them and make better decisions.
General Accounting
To forecast your finances, you watch for trends, patterns, and relationships, determine the probability of these influencing a particular outcome, and use that to model your forecast.
For instance, if government indicators predict that the economy is going to grow by 4 percent next year and you’ve assessed a correlative relationship of index-predicted economic growth and sales in a ½ ratio, then you should predict that the economic growth will contribute to a 2 percent sales increase next year.
Earned value management includes ensuring that everything remains on schedule. Time is money. So anytime that there’s a deviation in the schedule regarding when a project will be completed or when it will reach certain milestones in earned value, there’s a problem.
Not only do you have a problem if you’re falling behind, which is especially bad, but you also have a problem if the project is generating value ahead of schedule to the extent that the corporation’s assets could have been managed more efficiently.
Each vertical common-size comparison uses a single financial statement from a single year. In other words, you might do a vertical comparison of a corporation’s 2011 income statement, and then another one for its 2012 income statement. These comparisons are intended to measure the allocation and usage of value within the organization by measuring the proportion of total value that is being distributed in each entry of the financial statement.
General Accounting
You may hear a lot of talk about different types of chips, caps, and sectors when stocks get brought up in financial conversations. These terms are all just different ways of classifying and lumping together different types of stocks and their underlying companies.
A cap, for instance, just refers to the size of the company in terms of its total value.
Depository institutions come in several different types. Anytime you give your money to someone with the expectation that the person will hold it for you and give it back when you request it, you’re either dealing with a depository institution or acting very foolishly. Depository institutions all function in the same basic manner:
They accept your money and typically pay interest over time, though some accounts will provide other services to attract depositors in lieu of interest payments.
General Accounting
Options in corporate finance are contracts that give the buyer the right to buy or sell a fixed number of goods at a predetermined price, but they don’t obligate the buyer to do so.
The two primary types of options are
Put options: When purchased, put options give the holder of the option the right to sell a predetermined unit quantity of some asset at a predetermined price, called the strike price, before some predetermined future date, called the expiration date.
Everything that makes up a corporation and everything a corporation owns, including the building, equipment, office supplies, brand value, research, land, trademarks, and everything else, are considered assets. Believe it or not, when you start a corporation, that company’s assets aren’t just included in a Welcome Letter; you have to go out and acquire them.
When several of a single type of asset or, sometimes, several different types of assets are grouped together and sold collectively as a single security, that’s called bundling.
Bundling has come to have a unique role in corporate finance since the start of the 21st century. The actual act of bundling involves taking several different assets and lumping them together in something called an asset pool with a nominal value equivalent to the sum of the values of the individual assets included.
Corporations are a special type of organization wherein the people who have ownership can transfer their shares of ownership to other individuals without having to legally reorganize the company. This transferring of shares is possible because the corporation is considered a separate legal entity from its owners, which isn’t the case for other forms of companies.
Financial engineering is nothing more than the creation of new and interesting financial tools, often accomplished through the use of mathematic modeling and computer engineering. Financial engineering is really where the majority of innovation is occurring in the field of finance.
Financial engineering is a bit like the science lab of the world of corporate finance, where brand-new ideas are developed and tested.
General Accounting
Macroeconomics is the study of large-scale, collective economic management. It’s usually related to the national economy or other issues involving an aggregate of smaller economic entities. Macroeconomics is a very complex subject. Following are some of the macroeconomic influences on performance, value, and price:
GDP: Gross domestic product (GDP) is the total value of all production created in a nation.
M&A stands for mergers and acquisitions. Both a merger and an acquisition are forms of integration between corporations. Mergers and acquisitions aren’t the only types of corporate integration, but the term M&A has entered the popular vocabulary, so M&A includes any of a number of corporate integration options despite the term itself referring to only two.
A buyout occurs when one corporation buys a controlling share of stock in another. A buyout is very similar to a partial acquisition. Some argue there’s no difference, which isn’t surprising because the difference is subtle at best.
Note that the primary difference between a buyout and other forms of M&A (mergers and acquisitions) is that a controlling share of stock is used, rather than a stock swap, purchase of other forms of equity, or other possibilities of acquisition.
When a company is looking to get rid of some of their operations, they will go through something called a divestiture. You’ve done awful, terrible things during your time managing M&A (mergers and acquisitions), and as a result of your incompetence, the corporation you worked for now needs to get rid of your acquisitions.
General Accounting
Corporate finance jobs aren’t just about crunching numbers all day in a hidden corner of a corporation’s financial department. A variety of employment opportunities are available within the corporate finance function, including the following:
Entry-level positions: The entry-level positions in corporate finance are typically the same as the ones you see in accounting:
Payroll: The people who make sure you (and the rest of your company) get paid
Accounts receivables: The people who process incoming payments and money owed
Accounts payables: The people who process outgoing payments and money owed to others
Bookkeeping clerks and other forms of paperwork processing: People who work on data entry; think Charles Dickens’ character Bob Cratchit from A Christmas Carol
Analysts: These people get to do a whole lot of research and analysis to derive useful information from data or otherwise yet unstudied scenarios.
Corporate finance plays a very interesting role in all societies. Finance is the study of relationships between people: how they distribute themselves and their resources, place value on things, and exchange that value among each other.
Because that’s the case, finance (all finance) is really the science of decision-making.
General Accounting
The valuation of bonds refers to the process by which you determine the value of a bond. This information is then used, in conjunction with your personal estimates of what you’re willing to pay or your other options, to determine what is considered a fair price.
For investors, these valuation methods are the manner in which the investor will figure out what they’re willing to pay, what they can expect in returns, and what their investment portfolio is worth at any given point in time.
Businesses don’t typically just advertise that they’re for sale and at what price they’re being sold. These transactions are all handled through very careful financial valuations, usually done separately by both parties who then meet to negotiate price.
For corporations, this transaction almost always includes a shareholder vote as well.
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