INTRODUCTION TO SUBJECT

COMPARISON OF FINANCIAL STATEMENTS >>

Corporate Finance FIN 622

Lesson 01

INTRODUCTION TO SUBJECT

Corporate finance is the study of planning, evaluating and drawing decisions in the course of business. Let's

take a simple example to determine the scope of our subject. This would cover around 85% to 90% of

scheme of studies of corporate finance.

Suppose you intend to kick start a business. Three up-front questions that hit our top of the head are:

What type of investments do we need? In other words, what type of assets will be required to

support the intended business?

Where the money will come from? Sources of investments to be determined in black and white.

How we will finance our day to day monetary matters like purchase of raw materials and payment

of salaries etc?

To answer these question let's explore them individually for twin purpose: to know what is corporate

finance and secondly, to determine the scope of the subject.

Referring to question # 1 Types of investment or assets needed in the business:

The answer to this question can be found by defining Capital Budgeting process.

Capital Budgeting:

It involves planning, analyzing and acquiring capital assets like Plant and Machinery or Land or Building.

These investments take ample amount of resources and therefore, these decisions are irreversible in nature.

That in turn means that once the decision is implemented it would incur heavy losses if we want to un-do it

subsequently. Therefore, making investment in capital assets is a very risky process and must be handled

with care and skill.

SWOT analysis is also very helpful in capital budgeting process.

SWOT stands for:

· Strengths

· Weaknesses

· Opportunities

· Threats

Strengths are connected to Opportunities and in order to tap the lucrative opportunities you need to make

capital investment, which must be handled with due care and skill ensuring effective decision making. This

means that type of assets to be acquired depends on the nature, need and resources of business besides

some other factors. For example, a large airline industry would acquire bigger plane than a smaller airline

which may opt for a relatively cheaper plane.

Taking up the second question in line, that is, "where the money will come from?"

Broadly speaking there are two potential sources for making investments. The first sources emerge from

the contributions of sponsors or directors who commence the business. This portion of investment is

called Capital or Equity contribution.

The other source of investment is from loans and various financial instruments and markets. Banks provide

long term and short loans to the business world and this has been the most important source of business

finance and is being used widely.

Other source of external financing is issuance of bonds and securities in primary and secondary markets.

This process is known as Capital Structure Decisions in which it is determined that how much of the total

cost shall be financed by Equity contribution and Loans.

Moving to third and last question:

To finance day to day financial needs is in fact an issue that fall within the ambit of Working Capital

policies. Following are the typical questions in this context:

· What would be our purchases level for raw materials?

· Do we need to import or are locally available?

· How much finances will be needed to procure raw materials?

· What are our customers or markets?

· How many days credit to be extended to customer and taken from creditor?

Corporate Finance FIN 622

FINANCIAL STATEMENTS & CORPORATE FINANCE WITH SOME IMPORTANT

CONCEPTS:

There are basically three financial statements that every business entity runs periodically. It includes:

· Balance Sheet

· Income Statement

· Cash Flow

Balance Sheet:

This is a statement of resources controlled by and obligations to settle by an entity as on a specified date.

The format of Financial Statements is governed by International Financial Reporting Standard in Pakistan.

However, in US these are governed by the provisions of Generally Accepted Accounting Principles

(GAAP).

Balance Sheet Contents are:

i) Fixed Assets

ii) Current Assets

iii) Current Liabilities

iv) Long Term Liabilities

v) Capital & Reserves

Assets (both fixed and current) are placed in balance sheet in the order of less liquid or illiquid to liquid.

This means that current assets are more liquid than fixed assets. Then question arises "what is liquidity?" or

"what is a liquid asset?"

An asset that can be converted to cash quickly and without loss of value is liquid asset. For example, prize

bond is not a currency but you can get the face or par value of a prize bond when you sell the bond to any

one. But this is not the case when you want to sell your motorcycle or car. Therefore, car or motor cycle is

not a liquid asset but prize bond or gold are highly liquid.

Current Assets and Current Liabilities when clubbed together, give birth to another concept known as

working capital.

Current assets are those that form part of the circulating capital of a business. They are replaced

frequently or converted into cash during the course of trading. The most common current assets are stocks,

trade debtors, and cash.

Current liabilities are those short-term liabilities which are intended to be constantly replaced in the

normal course of trading activity. Current liabilities typically comprise: trade creditors, accruals and bank

overdrafts.

There is another concept of Cash Cycle associated with working capital. Take a compact example to

understand.

You acquire goods or raw materials from vendors on credit. It takes time (say in days) to process or

transform raw materials to finished goods, which are sold to customers on credit. Customers or Debtors

are allowed a time period (in days) to settle or pay their bills and money received from debtors is used to

pay off creditor, who provided goods on credit. Let's assume you allowed your customers 30 days to pay

for goods you sold to them on credit. And on the other hand you sought 35 days cushion from creditors to

pay off purchases of raw materials. In this simple example you were still able to use money for 5 days

before paying to creditors. This means the operating cycle is positive.

Other concepts from financial statements shall be taken up in the next hand out.

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