Corporate Finance Primer: 4 Essential Elements
An article by New York Institute of Finance Corporate Finance instructor Richard Malekian.
In particular, there are four elements within corporate finance that everyone should be mindful of when doing any type of analysis. These four elements are operating flows, invested capital, cost of capital, and return on invested capital. Let’s now take a look at each of these elements.
1. Operating Flows
Operating flows reflect the actual flows experienced by a company as a result of its operations. If one were to ask business professionals what constitutes their company’s operating flows, you will invariably receive a variety of answers. For some, net income is the answer. For others, metrics such as earnings before interest, taxes, depreciation and amortization (EBITDA) or cash flow from operations fit the bill. While each of these metrics has value and provides us with information that is important to us, they don’t fully capture the economics of what is occurring with respect to the operating flows of a business. Net income as a metric reflects both cash and non-cash transactions, as well any interest costs associated with debt financing, and is therefore not an ideal measure of economic operating flows. EBITDA is also not an ideal metric because it eliminates all depreciation and amortization expenses even though these expenses can frequently represent an economic decline in the viability of an asset. It also eliminates all taxes, even though current taxes do represent an economic outflow. Finally, cash flow from operations is equally flawed in that it fails to capture economic outflows such as depreciation and certain types of amortization, while including the impact of financing charges such as interest expense.
So, what should business professionals look at from an operating flow point of view that will best capture the economics of what is happening within a company? The answer is net operating profit after taxes, or NOPAT. NOPAT is a metric that is derived from a company’s income statement, but with certain adjustments. Specifically, non-cash reductions to the income statement (e.g. expenses related to bad debt reserves, LIFO reserves, warranty reserves, etc.) are added back in for NOPAT purposes. Also, unusual non-cash losses are added back (non-cash gains are subtracted), and any reductions due to deferred taxes are similarly added back. Finally, company results are evaluated on an operating basis, prior to any interest expenses, so that a company’s true operating flows can be determined irrespective of the particular debt/equity financing that may have been used. By adopting NOPAT, a business professional will be evaluating a company’s true economic operating results that are unaffected by the particular financing strategy chosen by the company, and that reflect the flows available to both the debt holders and equity holders of a company.
2. Invested Capital
Invested capital is the next essential element to be considered within corporate finance. As with the concept of operating flows, if one were to ask business professionals what constitutes a company’s invested capital, a variety of answers would be forthcoming. For some, total assets constitutes invested capital, while for others it is a company’s equity. Unfortunately, both of these definitions of capital are flawed. Invested capital should consist of long-term investments upon which a return is expected. Part of the financing for total assets comes from non-interest bearing current liabilities such as accounts payable and accrued expenses. As a result, using total assets to represent invested capital will overstate a company’s invested capital level. On the other hand, using equity to represent invested capital will understate a company’s invested capital. A company’s assets are funded by both equity and any interest-bearing debt that the company may have taken on. As a result, both equity and debt should be considered when determining a company’s invested capital. This definition of invested capital also dovetails with our definition of operating flows. The NOPAT flows represent the pre-investment flows available to both the debt and equity holders, while invested capital represents the funding provided to the company by those same debt and equity holders.
3. Cost of Capital
The third essential element in corporate finance is the cost of capital. The cost of capital is one of the most important, yet one of the least understood of all the concepts within corporate finance. Put simply, the cost of capital represents the minimum return required by the two major sources of capital -- debt and equity. Debt and equity holders contribute capital to a business with the hope of earning a return that is commensurate with the risk that these debt and equity holders have taken on. As a result, a company’s cost of capital can be considered a hurdle rate that must be met, and exceeded, in order for a company to say it has created shareholder value. The cost of capital is typically calculated by taking the after-tax cost of debt capital and the cost of equity capital, and weighting those costs by the percentage of debt and equity in a company’s capital structure. This calculation results in a blended cost of capital know as the weighted average cost of capital. The weighted average cost of capital can be used to evaluate ongoing business results, capital budgeting opportunities, and acquisition opportunities by setting the minimum rate of return that must be earned.
4. Return on Invested Capital
The fourth essential element in corporate finance is the return on invested capital. The return on invested capital is calculated by taking the NOPAT in a given period and dividing that amount by the invested capital in place at the end of the prior period. For instance, if a company’s NOPAT was $180 at the end of 2013, and the company’s invested capital was $1,000 at the end of 2012, then the return on invested capital for 2013 would be $180/$1000, or 18.0%. The return on invested capital represents the return that a company actually earned during a given period, while the cost of capital represents the return that the investors required the company to earn. To the extent that the actual return on invested capital exceeds the required return, shareholder value has been created by the company. The actual return has exceeded the expectations of the investors. On the other hand, if the return is below the cost of capital, then the company has failed to meet the minimum investor expectations, and shareholder value has been destroyed. The ability of a company to consistently exceed the cost of capital expectations of its investors will ultimately determine a company’s success or failure.
About New York Institute of Finance
With a history dating back more than 90 years, the New York Institute of Finance is a global leader in training for the financial services and related industries with course topics covering investment banking, securities, retirement income planning, insurance, mutual funds, financial planning, finance and accounting, and lending. The New York Institute of Finance has a faculty of industry leaders and offers a range of program delivery options including self-study, online and in classroom.
For more information on the New York Institute of Finance, visit the homepage or view in-person and online finance courses below: