Corporate Finance Theory

Corporate finance helps a firm fund short-term operating needs and long-term investments.

Corporate finance is a business practice that helps a firm's top management evaluate how current operations affect short-term liquidity needs and long-term investments. A corporate finance employee typically partners with an investment banker to review a company's financial statements, detect business performance trends, such as profit and expense levels, and recommend appropriate funding solutions.

Corporation Finance Defined

Corporate finance consists of activities, tools and mechanisms that help a firm prevent liquidity problems in its operations. A corporate finance manager reviews a company's current operating data and compares it with past information to detect performance trends. A manager also analyzes a firm's financial statements to ensure that capital structure models and working capital ratios are accurate. Capital structure refers to sources of funds (stock, debt and internal funds) a company uses to finance operations. Working capital is a measure of short-term cash availability and equals current asset minus current liabilities.

Financial Statements

Financial statement analysis is pivotal in corporate finance theory because an investor, a lender or a business partner typically reviews financial reports to gauge an organization's economic robustness. Generally accepted accounting principles (GAAP) require a corporation to prepare and report financial statements that are accurate, complete and in accordance with industry practices and regulatory guidelines. Complete financial reports include balance sheet, statement of profit and loss, statement of cash flows and statement of retained earnings.

Financial Analysis

Financial analysis, also called financial statement analysis, helps an investor or a regulator learn about a company's financial position or economic activities during a period. A business partner, such as a supplier, a customer or a lender, also may learn about investments and financing activities in which a firm engages. For instance, a lender can analyze an oil and gas company's balance sheet to detect liquidity needs in the short-term. Alternatively, it could review its statement of cash flows to assess funds used in operating activities.

Securities Markets

Financial markets are the cornerstone of corporate finance theory because they affect, indirectly or directly, most funding transactions. As an illustration, a corporation seeking short-term cash can sell stocks, bonds, convertible bonds or preferred shares on securities exchanges. Alternatively, it may issue commercial papers with a maturity date of nine months or less. An example of indirect financial market impact is a private loan for which a borrower applies. The lender typically seeks funding from other private institutions or public financial markets before approving the loan.

Present and Future Values

Present and future value concepts are critical in corporate finance theory because a company's primary goal is to maximize shareholder value by increasing profits. A firm's treasury department usually manages corporate investment accounts and helps increase its financial income. Present value means the current worth of an asset, whereas future value is the asset's estimated worth in the future.

References

• Princeton University Press: The Theory of Corporate Finance
• Birbeck University of London: Lecture Notes on Corporate Finance Theory
• NYU Stern: Corporate Finance: Theory and Practice