The first actual use of the term “corporate finance” was by Richard Edward Driehaus at the University of Chicago in 1948. In his paper, titled “Corporate Finance from a Capital Markets Perspective” Driehaus defined corporate finance as “the analysis and evaluation of firms that provide capital to companies as well as those that receive it.” A year later, Professor of Business at Stanford Roger W. Heawood defined the field as “the study of how corporations raise money, use it to finance their operations, and report on it to their shareholders.”
The subject is broadly defined today as an investigation into the financing of business corporations with the most common sources being equity, retained earnings, long-term and short-term debt. The financier may be a bank if the corporation has no ready cash flow to pay interest on borrowed money or to repay principal when it falls due. Generally speaking, corporate finance deals with “funds” that are liquid assets that can be used for any purpose. It also deals with “cash management” which is how companies balance their liquid assets so they know how much they actually have available for working capital purposes.
Importance of Corporate Finance
Corporate finance is important because, ideally, the financing structure chosen for a corporation should result in it having adequate cash flows in order to both service its debt and provide for future growth.
Corporate finance is an important field in finance generally because it can be used to assess the financial health of a corporation and its management. The difference between the total liabilities and total assets of a corporation forms the entity’s equity or net worth. One way to measure this is by relating it to the amount of debt taken on by the corporation. For example, if a corporation has $10 million in debt and $40 million in equity (net worth), its debt-to-equity ratio is 2:1 (i.e., $10 million/$40 million = 2:1).
Corporate finance is also used to examine how corporations manage their financial structure. One problem corporations face is deciding how to allocate their funds among several options – each with different levels of risk and return. Most corporate decisions are made under the assumption that the future will be like the past, but this is not necessarily true. Financial analysts use corporate finance to try to determine how investments will affect a company’s cash flows and overall health in the future.
Corporate finance is even used to examine the financial behavior of individuals. Individuals are often judged by their net worth, which can be thought of as the sum of all of their assets minus all of their liabilities. A person’s net worth can be used to gauge that person’s financial health and emotional stability. For example, a financially healthy individual will have relatively little debt and a large net worth compared to his or her peers. Individuals with negative net worth may not be able to support themselves for more than a few months without an additional infusion of funds from one or more sources, such as credit or additional borrowing from friends and family members.
One sub-field of corporate finance is banking and capital market research. It involves researching how corporations work, their financing methods, the capital structure of the company, and how they use this overall structure to manage cash flows.
Three Key Sub-divisions of Corporate Finance
Corporate finance deals with a wide range of activities related to the financing of a corporation and comprises three major areas: financial management, asset management and liquidity management.
Financial management is the term used to describe the management of financial assets and liabilities. It is also called “cash flow management”. Financial management is the discipline of matching payments and receipts as closely as possible, as if trading cash were no different from trading any other asset or liability — bonds, for example — on a secondary market.
Asset management is concerned with making sure that a corporation does not exceed its limits in terms of excess binding assets. More specifically, this area involves ensuring that a corporation’s net worth does not change so significantly over time that it will destabilize operations.
It can also be thought of as preventing corporations from becoming insolvent, which is bad for investors and creditors, and prevents growth of the business.
Liquidity management refers to the management of a corporation’s liquidity. Liquidity management is about ensuring that a corporation does not become insolvent or in financial distress, and that all of its assets are usable in the short term. This is done through two main aspects: cash flow and capital structure. In terms of cash flow, the corporation would need enough cash to pay all operating expenses over time, which is called net working capital or simply working capital. In terms of capital structure, companies need sufficient equity in their balance sheet so they can use it to invest in future growth rather than being restricted by debt.
Should you hire a Corporate Finance Expert?
Every business must decide how it will raise additional capital. The three basic choices are through debt financing, equity financing, or from retained earnings. Expert knowledge is often required to determine how these sources of capital will affect the total risk of the business and how suitable it is for the corporation. If a corporation is extremely risk averse and needs a very safe investment, then borrowing money is probably not going to be an effective way to raise capital. On the other hand, some businesses would require risky investments in order to force growth. In some situations especially in small companies there can be financial implications of raising finance from outside sources. Financial decisions and choices can very easily make or mar a business and therefore engaging a corporate finance expert can have a huge impact on the success of a corporation.