Question

What are the three important questions of corporate finance? Please briefly explain them and indicate how they are related to the areas in the balance sheet of a company.

Answer 1

Answer:

Following are the three important area of corporate finance.

1. Capital Structure

2. Capital Budgeting

3. Working Capital Management

The concerns or questions arising from each of this areas in corporate finance are as follows:

1. Capital Structure : How to get long term financing and what mix of debt and equity should be used?

2. Capital Budgeting: What are the long term investments decisions should the company take?

3. Working Capital Management: How the company should manage its everyday financial operations and activities?

Now, let's talk about each of these areas briefly and discuss how they are related to the balance sheet of the company.

a. Capital Structure:

A company's health can be easily understood by the right mix of debt and equity. Debt constitutes short and long term borrowings, whereas equity comprises of common and preferred stocks plus retained earnings.

Capital Structure = Debt + Equity

There is no rule of thumb to define a right mix of debt and equity for a company. It depends on lot of factors such as industry and development of company. But generally, a lower debt and higher equity is considered healthy.

Company's balance sheet shows capital structure in the form Shareholder's equity and Liabilities.

b. Capital Budgeting:

Capital budgeting talks about the long term investment decisions a company need to take so as to align itself with the goal of the company. Capital budgeting can be used to assess the direction a company is moving in. Capital budgeting refers to the process of evaluating investment options. For example, whether to build a new factory or not is a capital budgeting question. To evaluate the viability of this question, companies use cash inflows and outflows, IRR and NPV calculation.

In company's balance sheet, capital budgeting decisions appear in Fixed assets.

c. Working Capital Management:

Working capital is the financing needed to run day to day activities of a company. These expenses could be the cost of materials, staff salaries etc. Net working capital refers to company's liquidity & short term financial health and it is the difference between operating current assets and operating liabilities. Current assets include cash, account receivable and inventories, whereas current liabilities include account payable, taxes payable and wages. A healthy company should have more current assets than current liabilities to function properly.

In company's balance sheet, working capital management decisions appear in Current assets and Current liabilities.