Why CEOs Need Corporate Finance Acumen?

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When defining qualities and traits that make a successful CEO, many would immediately think of managerial skills like leadership, innovative thinking and big-picture oriented.

Yes, these are all must-haves of an executive, however, there’s one important trait which is often overlooked: financial acumen. Having a good knowledge/background of finance is crucial to creating values to the firm.

According to Forbes, many CEOs have a background and/or experience in finance. Specifically, about 22% of F100 CEOs started their career in finance. Jeff Bezos, former CEO of Amazon, Phil Knight, former CEO of Nike, and Jeff Weiner, former CEO of Linkedin are among them.

So what is corporate finance, what are its main principles and why is it so important? Let’s explore them in this blog post by Consultport.

Understanding Corporate Finance

Corporate finance is a discipline that focuses on such areas as financing, capital structuring and investment decisions.

The discipline centers around the management of finances and maximization of shareholder value through financial planning and the implementation of several strategies. Simply put, corporate finance involves the augmentation of the value of a company through financial decisions.

Investopedia describes corporate finance as a “subset” of the finance field. It mainly concentrates on budgeting and the management of capital, debt, equity, assets, and liabilities. The definition of corporate finance can also vary by country.

In England, corporate finance is often linked with transactions that involve the use of capital to develop new projects and acquire other businesses, according to the Institute of Chartered Accountants in England and Wales.

Types of corporate finance activity include mergers and acquisitions, management buy-outs, equity issuance, financing joint ventures, and raising capital.

Meanwhile in America, it is understood in a broader way. It includes not only activities but also decisions and techniques related to the capital allocation. Therefore they can range from project funding and asset investment to cash management.

KEY TAKEAWAYS

Corporate finance is a subset of finance that deals with planning and implementation of strategic plans to augment values for firms.
Financial analysis reveals important performance metrics of a firm: profitability, liquidity and efficiency.
Prudent financial analysis helps CEOs to make “smarter and more strategic” decisions.

Financial Analysis Essentials

Financial analysis involves the analysis and interpretation of a company’s financial performance. The analysis will provide CEOs an insight into the firm’s profitability, its liquidity as well as efficiency.

Looking at financial analysis also enables firms to allocate their resources better, identify risks and take advantage of potential opportunities for growth. Considering all these elements, financial analysis serves as an important input to inform a decision or generate recommendations for the firm.

Now let’s explore the key techniques of financial analysis:

1. Trend analysis

Trend analysis is simply examining financial data over a certain period of time. The periods can be monthly, quarterly, or yearly. From this analysis, firms will be able to pinpoint patterns and changes in performance. Trend analysis also helps the company identify basic changes and detect potential problems as well as good or bad management.

In finance, there are three types of trend analysis:

Upward trend: known as bull market trend. It occurs when the data sets are on the rise. An upward trend of revenue and profitability is the pattern that every business wants to have. However, when it comes to operational expenses, an upward trend may be something that makes the company consider their strategy. This trend can inform the company in many ways. They can adjust its prices to increase the revenue, or find a better supplier to lower the expenses.

Downward trend: known as bear market trend. This trend is often associated with the performance going down.
Horizontal trend: known as stagnation trend. This trend is in between the two previous ones. It neither goes up nor declines. While this is seen as a steady direction, it is difficult for firms to predict the future performance.

three types of trend analysis in finance

2. Ratio analysis:

Using ratios is a basic and fundamental tool of analysis in finance. In the Introduction to Financial Analysis book, however, the author said ratios do not provide a firm an answer. It rather helps it raise questions that it must solve.

In this method, one financial variable is compared to another through many means of comparison:

Vertical: comparing a ratio of a company at two different points of time. For example, a firm may compare its profit margin last year versus this year and investigate the growth or decline.
Horizontal: comparing a selected ratio of two companies at the same point of time. For example, a firm’s efficiency ratio as of January can be higher than that of its competitor. From this, the underperforming company may feel the need to explore the drivers leading to better efficiency of their competitor and develop a new strategic plan to improve its efficiency.

By categories, there are six different types of ratios:

Liquidity ratios: used to determine a company’s ability to settle its short-term debt. It evaluates whether the company can use its current or liquid asset to cover its liabilities. Examples include: current ratio, quick ratio and working capital ratio.
Solvency ratios: used to evaluate a company’s ability to pay off its long-term debt and the interests on its debt. This is also known as financial leverage ratios. Examples include: debt-asset ratios, interest coverage ratios, and debt-equity ratios.
Profitability ratios: shows a business’s ability to generate profits. This is one of the most common metrics of financial health of a firm. Examples include: Profit margin, return on assets, return on equity, return on capital employed, and gross margin ratios.
Efficiency ratios: measures how efficient a company is in managing its assets and liabilities. Examples include turnover ratio, inventory turnover, and days' sales in inventory.
Coverage ratios: assess how well a business can pay its financial obligations. Most common coverage ratios include interest coverage ratio, debt service coverage ratio, cash coverage ratio.
Market prospect ratios: are the most used ratios to forecast earnings and future performance of a company. They include dividend yield, P/E ratio, earnings per share (EPS), and dividend payout ratio.

3. Cash flow analysis

Cash flow is an indicator of a company’s financial stability, which not only the company itself but investors and analysts are interested in.

Cash flow analysis is the examination of the cash that flows in and out of the company. Ongoing positive cash flow may indicate that the company is operating well while prolonged negative cash flow is a sign of financial trouble.

Common indicators of a company’s cash flow:

Operating cash flow/net sales: percentage of a company’s net operating cash flow to net sales/revenue.
Free cash flow: net operating cash flow minus capital expenditures.
Comprehensive free cash flow coverage: percentage of the free cash flow to net operating cash flow.

4. Risk assessment

Risks are inherent in every single business whether it’s start-up or established companies.

The following steps can help executives safeguard their businesses from the negative impacts of financial risks:

Identify the risk: start with listing all possible events or factors that can have a negative impact on the firm’s financial health. This can be done by analyzing financial situations, using historical financial stress events to make forecasts, consulting internal and external experts.
Quantify the risk: evaluate financial risks in quantitative and/or qualitative manners. A firm should take into account elements such as probability of the risk occurrence, impact of the risk and estimated loss from the risk.
Develop and implement strategies to manage the risk: common strategies include risk avoidance, risk reduction, risk transfer and risk retention.

Good Financial Analysis Leads to Smarter Decisions

Financial analysis is a solid foundation for a company to make “smarter and more strategic decisions” based on the financial data, according to Investopedia. In a changing business environment, financial analysis can help firms make important decisions:

1. Investment decisions

Investment is defined as an expenditure made at the present to make future gain. It is a must for a company to develop and stay competitive in the market.

One of the fundamental elements that affects investment decision-making is the risk factor of the investment. A sound financial analysis with good risk assessment is among the musts for executives or managers to make a decision to invest in a project.

2. Financial planning

The planning of corporate finance is about using available financial resources in a strategic manner. It can involve cash requirements on a daily, weekly, monthly or quarterly and yearly basis.

Well-judged corporate financial planning can result in sustainability, viability and activeness of an enterprise in market and business environment.

Analysis of corporate finance is crucial in this planning process as it provides necessary data and insights for the planners.

3. Mergers and Acquisitions (M&A)

A detailed study of various aspects of the target company is a prerequisite for M&A transactions. The analysis of current and projected financial performances are among those must-have steps. Using financial data, trends and predictions, investors can also detect potential issues and risks to ensure successful M&A deals.

Conclusion

Corporate finance is a concrete pillar supporting the firm’s stability and growth. It plays an integral part in the decision-making process of business executives.

Every decision made within a corporate environment takes into account the financial implications. Whether it is shareholder’s dividend issue, investment plan or the management of liabilities and assets, they all involve the consideration of corporate finance.

A firm grasp of the financial situation of the company is a fundamental skill that every CEO should have in an evolving economy.

Here at Consultport, we have a pool of talented consultants who can offer companies world-class services to solve a range of problems. Don’t hesitate to contact us to know more about how our financial consulting team can help deliver values to your firms.

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