## Lorenzo Preve and Virginia Sarria-Allende

Print publication date: 2010

Print ISBN-13: 9780199737413

Published to Oxford Scholarship Online: May 2010

DOI: 10.1093/acprof:oso/9780199737413.001.0001

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# Corporate Finance

Chapter:
(p.3) 1 Corporate Finance
Source:
Working Capital Management
Publisher:
Oxford University Press
DOI:10.1093/acprof:oso/9780199737413.003.0001

# Abstract and Keywords

We start the chapter by presenting a basic framework of corporate finance. Next, we provide an introduction to the main financial reports: the balance sheet and the income statement. We describe both the primary individual characteristics of each financial report and the interaction between the two statements. This interaction is important as it allows one to get a more complete picture of a company's financial situation and business performance. Finally, we provide some basic measures of return. As a necessary complement, we also introduce the concepts of expected return and cost of capital.

# The Basic Corporate Finance Framework

Most businesses are started by an investor who is willing to invest his or her capital in exchange for a return on the investment. How much of a return? As financial economists would say, the riskier the investment is, the higher the expected return.

The money that the investor uses to start the firm is referred to as the firm's initial capital. This money is invested in what is called the firm's assets, which include everything from the most obvious items such as property, plant, and equipment, inventory, and cash, to less obvious items such as customers’ financing. In some cases, especially in the case of small firms, the investor makes all of the firm's investment decisions. In other cases, particularly as firms grow, other people—the firm's management—are tasked with making these decisions.

Aiming to meet investors’ expected returns, after selecting an optimal investment the business must use the investment to produce goods and/or services that will be sold to customers. In generating these sales, a firm will incur several costs, for example, materials and production costs, storage and distribution costs, employee-related costs, and taxes. What is left after collecting revenues and paying the related costs is the firm's profit, which is the basis for estimating the investors’ return on investment.

(p.4) Thus far we have focused attention on “an investor” who decides to apply his or her money to a given business. In reality, however, most businesses do not count on a single investor to finance the entirety of their assets; rather, they typically have many investors. These investors are not all alike. For our purposes here, investors can be characterized according to the type of contract they establish with the firm.

Broadly speaking, we can categorize these contracts into two basic types: debt contracts and equity contracts.1 A debt contract is one in which the firm schedules a promised repayment to the investor. The owners of the corresponding claim are called debt holders. An equity contract, in contrast, is a contract in which the firm assigns to investors what can be considered the firm's residual profit, that is, the profit that is left over after the firm covers its operating costs and its obligations to debt holders. The owners of the latter type of claim are named equity holders. Figure 1.1 illustrates this framework.

To summarize, a firm's main business activities consist of identifying optimal investments, arranging appropriate financing to sustain the investment, and using the selected investments to generate revenues from which operating expenses, debt obligations, and equity holders’ returns are paid. These activities are summarized in a firm's financial statements, which are the set of documents that collect and organize this information. We discuss the two most basic financial statements next.

# Financial Statements

A firm's main business activities as described previously are recorded in two basic financial statements: (1) the balance sheet and (2) the income

Figure 1.1. The Basic Corporate Finance Framework

(p.5) statement. In the following paragraphs, we describe both the primary characteristics of each financial report taken separately and the interaction between the two statements. This interaction is important as it allows analysts to get a more complete picture of a company's financial situation and business performance.

## The Balance Sheet

The balance sheet provides a snapshot of the firm at a given moment in time. This report has two main parts: the left-hand side, which presents the assets of the firm, and the right-hand side, which shows the corresponding liabilities. The assets represent the investments made by the firm, whereas the liabilities characterize the way those assets have been financed. It is easy to see that both parts of the balance sheet reflect two sides of the same coin: one cannot be affected without altering the other, and both have the same size (i.e., the assets are equal to the liabilities). For example, if we make a new investment, it is either because we have obtained new financing that allows for it (increasing both assets, reflecting the investment, and liabilities, reflecting the financing), or because we have funded it with the proceeds of a divestiture of a previous investment (leaving the total amount of assets and liabilities unchanged). Similarly, if we obtain new financing, we can accumulate cash or buy goods or equipment (increasing both assets and liabilities), or we can use the money to cancel some previous claim (leaving the total figures unchanged).

The items reported on a balance sheet are presented in an order that follows convention. In particular, assets are organized by liquidity (i.e., the ease with which a given asset can be converted into cash), and liabilities are organized based on exigibility (i.e., when each liability is due).2 On the asset side, items are sorted by descending liquidity, with the most liquid assets at the top of the list and the least liquid ones at the bottom.3 According to this rule, a firm's assets could plausibly be ordered as follows: cash, bank accounts, marketable securities, trade receivables, inventories, and, at the very bottom, property, plant, and equipment (PPE). Note that these assets are grouped into two broad categories: short-term or current assets, which are expected to become liquid within one year, and fixed or noncurrent assets, which are expected to take more than a year to become liquid. Short-term assets often include items such as cash, banking accounts, trade receivables, and inventories, and typical noncurrent assets include PPE and goodwill.

On the liabilities side of the balance sheet, the accounts are classified based on exigibility, with the most exigible claim (the claim due soonest) presented at the top and the least exigible claim (the furthest-dated claim) (p.6) listed at the bottom. The least exigible claim consists of equity, since equity holders receive their part after all other obligations have been satisfied. Long-term debt is listed above equity, and before long-term debt are the different sources of short-term financing. Typically, the first type of obligation listed is commercial credit, which consists of obligations the firm has with suppliers who sell their goods or services to the firm on credit, as such obligations are usually due within a number of days. Wages and other obligations due to employees in exchange for labor and managerial services are often listed next, as such payments are usually made on a monthly basis, with employees effectively extending short-term credit to the firm. Also included among the short-term liabilities are taxes owed to the government, which are accrued based on profit generation but only exigible on a monthly or quarterly basis, and payments owed on financial debt such as short-term bank loans or commercial paper.

Figure 1.2 provides an example of a representative firm's balance sheet.

As we mentioned earlier, the balance sheet provides a snapshot of a firm's investments and corresponding financing at a given point in time. One can take such snapshots on a monthly, quarterly, yearly, or other periodic basis and then compare these snapshots to analyze the evolution of the firm's investments and financing over time. When analyzing a firm's investments, we care about not only the size of total investments but also their main drivers—the inferences we draw about what is happening to a firm that is showing an increase in its trade receivables might be dramatically different from those we reach about a firm that is

Figure 1.2. The Balance Sheet

(p.7) observing an increase in inventories. Similarly, when analyzing the evolution of, say, a growing firm's financing, it is important to look at whether the growth has been financed with (short- or long-term) debt or equity, as the financing choice will significantly impact a company's performance and risk exposure.

The previous discussion suggests that analysis of a firm's balance sheets can reveal extremely rich and interesting insights on the firm's performance. However, in order to have a more complete understanding of the firm's evolution, we need to have information on what has happened between consecutive reports. For example, changes in inventory across balance sheets are linked to how much the firm has bought and sold between report dates, and changes in equity financing are related to the amount of net income the firm has been able to generate. Information on firm activity between balance sheets can be obtained by looking at the second basic financial statement, the income statement, which is also called the profit and loss statement, or the P&L statement for short. One can think of the income statement as the movie that tells the story of the company between each pair of balance sheet snapshots.

## The Income Statement

The income statement is a representation of a firm's normal business operations between two consecutive balance sheet statements. In particular, it records the firm's total sales and costs incurred over the period, from which the firm's net income (or profit) is calculated. As is the case for balance sheets, the income statement can be prepared for any desired period of time (a week, a month, a quarter, a year, etc.). Typically, a one-year interval is used for tax and most legal purposes, but many firms also use quarterly or monthly income statements for different types of supplementary analysis. Later in the chapter we discuss the various components of a firm's income statement and then turn to the derivation of net income (profit).

The first item reported on an income statement is the firm's total sales, which is computed by adding all the invoices generated over the period. It is important to notice that at this stage we do not take into account whether these invoices have been paid or are still outstanding; we will consider this distinction in a subsequent chapter.4

Next, the income statement records the costs of the goods sold over the period. This item includes, among other things, those expenditures directly related to producing the goods that have been sold over the period, for instance, the raw materials used to produce these goods. Note that expenditures incurred over the period that are related to goods that were not sold but that are stored as inventory (either as raw material or as (p.8) intermediate or final goods) are not counted as costs in the income statement; instead, these expenditures are recorded as assets, since they are regarded as an investment that will allow the firm to generate future sales.

To illustrate this distinction, consider the case of a firm that produces dining room sets. Assume that in the period under analysis, say a month, the firm produces and sells 5 dining room sets, each using 40 pounds of wood. The firm's total sales for the month will equal the 5 dining room sets sold over the month times the price per dining room set sold, and the firm's cost of goods sold will equal 40 pounds of wood times the cost of the wood per pound times the 5 dining room sets that have been sold. No problem so far, as we are making the important assumption that the firm bought the exact amount of wood needed to produce the items sold over the period. What happens, however, if we relax this assumption? Imagine now that the firm purchased enough wood to produce 10 dining room sets, but continued to produce and sell only 5 dining room sets. In this case, the firm would show the same total sales and the same cost of goods sold as before, but would now also show an increase in wood stored in inventory. The expenditure associated with this surplus wood is recorded an asset, as this wood will allow the firm to produce more dining room sets to be sold in the future. Note that it does not matter whether this surplus wood was acquired intentionally as an investment in future production capabilities or unintentionally as a result of weaker sales than expected—the accounting implications for the cost of goods sold and inventory are identical.

Other costs recorded in the income statement include the costs of keeping the company operational. Some of these costs vary with the level of production, whereas others are independent of production levels and are said to be fixed. Regardless of whether variable or fixed, these operating costs are recognized on the basis of their relation with the sales and other business activity generated during the period, not on the basis of whether they have been paid during the period. Other financial reports, as we will see when we turn to sources and uses of funds, concentrate on actual cash flows.

We are now ready to discuss the derivation of a firm's net income. The first two lines of the income statement present the firm's total sales and corresponding cost of goods sold (CGS), which includes raw materials, labor, and variable operating costs. Subtracting CGS from sales gives the firm's gross margin, which is the income obtained before deducting any fixed costs.5 Subtracting fixed costs from the gross margin gives earnings before interest and taxes (EBIT), and subtracting interest expenses from EBIT yields earnings before taxes (EBT). After deducting taxes, we get the firm's bottom line, that is, its net income or profit.

(p.9)

Figure 1.3. The Income Statement

The sample income statement shown in Figure 1.3 illustrates how a firm's net income, or profit, is calculated.

As these discussions suggest, there is a strong connection between balance sheets and income statements—a change to one automatically affects the other. Understanding this interaction is crucial to reach a sound conclusion about business performance and profitability.

To recap so far, we have shown that the firm invests in assets that are used to produce goods and services that will be sold to customers, and that this production process has embedded costs. The P&L statement shows the accounting profit generated by the firm's operation. Since investors are paid from such profit, clearly this measure is of interest to investors. However, profit is not the only measure of interest, as it is not always a good proxy for the wealth generated by a given investment. In particular, investors also care about the cash flows of the firm. More specifically, investors consider the amount of cash that they invested and compare this value with the amount of cash that the investment returns to them, or their return on investment. We discuss this measure next.

# Return on Investment

When cash enters the company from sales, management distributes the cash among the firm's various claim holders.6 The first group of claim holders to be paid consists of employees and suppliers. After this group of claim holders has been satisfied, the remaining cash is distributed among financial claim holders. First among such claim holders are debt holders, who are paid in accordance with the seniority of their claim and the terms of the firm's debt contracts. Next in line is the federal tax authority, which has a claim on the firm's profit. Finally, after paying employees, suppliers, debt holders, and the tax authority, the balance is distributed to equity holders, who are also called shareholders. Note that this does not mean (p.10)

Figure 1.4. The Distribution of the Firm's Cash Flows

that the shareholders will receive all of the cash that remains after the firm's other obligations are met. Rather, the company will have set a dividend policy that depends, among other things, on the firm's industry and financial condition. This policy will allocate to equity holders a dividend distribution. The balance is held to be reinvested in the firm.7

Figure 1.4 illustrates the distribution of a firm's cash receipts, and in particular how an investor's return on investment is determined. Note that the arrows show the direction of the firm's cash flows according to the seniority of claims.

From the previous discussion, it is clear how financial investors are paid from the cash flows that the firm generates. The remaining question is whether the payment received is high enough to satisfy investors’ ex ante expected returns. We briefly discuss this issue in the next section.

# Investors’ Expected Return—The Cost of Capital

At the beginning of this chapter, we stated that investors are willing to invest their capital in exchange for a return, where the expected return increases with the risk of the investment. From the previous discussion on the allocation of generated cash flows, it is clear that different claim holders bear different levels of risk. For instance, while employees, suppliers, and debt holders enjoy a promise to be paid according to a schedule of payments, shareholders have no such promise; instead, given their subordinate claims, they are entitled to some return only after everyone else has been paid. As a result, shareholders clearly have higher risk exposure than other, higher priority claim holders.

(p.11) Given that different claim holders have different degrees of risk, how can we characterize the return requirements of different investors? Consider an investor bearing no risk. This investor would be expected to require the risk-free rate of return. Now consider an investor who invests on a risky asset. Given that this investor can always obtain a risk-free return (simply by buying a U.S. Treasury bond), he or she would not be willing to accept a return lower than the risk-free rate. Moreover, the investor will require a premium over the risk-free rate to agree to invest in the risky asset, as otherwise could obtain the risk-free rate at lower risk by investing in the risk-free asset. Note that investment risk varies not only by type of claim on the firm but also across firms, industries, and countries. Thus, expected returns will vary along these dimensions, too.

Based on the previous arguments, we can express investors’ expected return in general form as follows:

$Display mathematics$

where Rf is the return promised by a risk-free investment and risk premium is the extra return that an investor requires for an investment with a given level of risk. However, since debt holders and equity holders take different risks, their risk premium will certainly differ. Thus, when thinking about expected returns, the two most common approaches are to consider either the combined expected return of debt and equity holders as a group or the expected return of shareholders alone.

To consider the expected return of shareholders alone, let the cost of equity be denoted by Ke. We can then say that equity holders’ expected return is given by:

$Display mathematics$

For completeness, with the cost of debt denoted by Kd, we have that the expected return to debt holders is given by:

$Display mathematics$

Notice that since equity holders face more ex ante risk than debt holders, and Rf is the same for both equations, it follows that Risk Premiume > Risk Premiumd and hence Ke > Kd, reflecting equity holders’ higher risk and associated higher expected return.

The expression for the combined expected return of both debt and equity holders is called the weighted average cost of capital (WACC), as (p.12)

Figure 1.5. The Cost of Capital

the expected return is the firm's cost due to investors in exchange for receiving investment capital. WACC is computed as:
$Display mathematics$

where Ke and Kd are as defined previously, E / (D + E) and D / (D + E) are the weights that equity and debt contribute to finance the investment, and t is the marginal income tax rate. Taxes enter the equation so as to allow us to compute the after-tax cost of capital. That is, since interest expenses can be deducted before determining taxable income, each dollar paid to the bank saves t dollars of taxes. As a result, the after-tax cost of debt is Kd × (1 – t).

Figure 1.5 summarizes how we compute investors’ combined expected return, or the cost of capital.

Managers tend to look carefully at the expected returns of their investors in an attempt to improve their ability to meet or beat (in the case of equity, only) these expectations. In the context of this book, which focuses on working capital management, we do not go further into the specific calculations necessary to determine each type of investor's risk premium, one of the most important and debated topics in corporate finance. Rather, we simply take risk premiums as a given, with the understanding that investors are willing to invest in exchange for a compensation that at least meets the minimum return required for the level of risk that investors face.

# Conclusion

In this introductory chapter, we presented a very simple framework of financial accounting, we introduced the two most basic financial statements, (p.13) and we discussed their interaction. As a necessary complement, we also introduced the concepts of expected return and cost of capital.

We acknowledge that the discussion in this chapter has been deliberately light. As the purpose of this book is not to explain in full the mechanics of financial accounting but to shed light on working capital management, the discussion in this chapter is simply intended to review some of the key concepts that serve as a foundation for further analysis. More detailed discussion on these topics will be offered as necessary in the corresponding chapters of the book.

## Notes:

(1.) Obviously, this classification is highly simplified. For now it is worth noting that debt holders are usually divided into banks and bond holders. At this stage, no further distinctions between investors need to be drawn.

(2.) Liquidity has two basic components: time (how fast a given asset can be turned into cash) and cost (how much of a loss of value is incurred in turning a given asset into cash).

(3.) Note that this convention may change from place to place. For example, in the United States and Latin America, the accounts are sorted by decreasing liquidity (most liquid assets at the top), whereas in Continental Europe, the sorting follows the opposite ordering, with fixed assets at the top and more liquid assets at the bottom.

(4.) For now we can say that if the invoice has been paid, then the payment is probably recorded as part of the firm's cash assets, and if it has not been paid, then the payment is still recorded as an asset, but in this case as trade credit to clients.

(5.) Note that sometimes the estimation of sales minus CGS is called the contribution margin. The distinction between the two concepts depends on whether the costs included in CGS are all the variable costs or just the direct costs. This distinction does not affect our analysis, however, and thus we do not dig any deeper into the nuances of CGS. As a quick reference: a variable cost is a cost that varies with the level of production, and a direct cost is a cost that can be directly imputed to a certain product or product line, regardless of whether it is fixed or variable.

(6.) A claim holder is somebody that holds a claim on the cash flows generated by the firm.

(7.) The retained earnings are expected to influence the actual value of a given stock. Therefore, the investors’ return will include these two components: dividends paid and capital gains.