Executive Summary
The paper discusses different topics related to the field of corporate finance and how the same will impact my future career, during which I plan to work as an equity investor. Beginning with the paper, I first discussed the importance of the financial statements and what information they reveal about the company. However,more than reading these financial statements, it is important that we learn how to study the financial statements using the tool of common-size statements and financial ratios as these tools help us in evaluating the trend in the financial standing of the company. Thereafter, I discussed the importance of portfolio diversification within the subject of risk and return. Learning about the diversification theory, I got to know the importance of including non-correlated stocks in my portfolio to eliminate unsystematic risk from my portfolio. Lastly, I discussed the concept of time value of money, which I will probably use for deciding the investment amount needs and calculating future value of my investments.
1.0 About the paper
Corporate Finance is one of the most important domains in the genre of financial management and is also deep-rooted in our lives. The book, ‘Essentials of Finance’ helped me getting a strong grasp on the various topics related to corporate finance, however, least I had expected that these academic topics will have an influence on my professional career. Even though all of the topics in the book have an influence in its own way, but for this paper, I will discuss five topics, financial statements, working with financial statements, ratio analysis, Risk and Return and Time value of money. Important to note, each of these topics closely aligns with my career objective of being an equity analyst. Therefore, I will discuss each of these topics in the context they are expected to assist me in my professional life.
2.0 Financial Statements and working with financial statements
Financial statements are the documented results of the financial position and performance of the company. According to the provisions of US GAAP, the three types of financial statements, which an entity is required to make, are:
Income Statement
Balance Sheet
Cash Flow
Both income statement and balance sheet are made on an accrual basis, and represents financial performance and financial position of the company, respectively. On the other hand, cash flow statement, which, unlike other two financial statements, is made on the cash basis and offers more concrete information about the financial health of the company. For instance, merely by comparing the net income with the operating cash flow, we can judge the quality of earnings of the company because net income higher than the operating cash flow clearly indicates that the quality of the company’s earnings is poor and sparks the need for cautious overview.
Therefore, an overlook of the financial statements of the company will help me in understanding how strong is the company’s fundamentals because even though I am still in my young age and going by the basic fundamentals of portfolio construction, I should assume high risk, but I would classify myself as a risk averse investor and would thus love to invest in blue chip stocks only, i.e. the one with strong fundamentals and strong record of good historical performance.
2.1 Common Size Financial Statements
Next, another learning in relation to financial statements was their analysis using the common-size statement and ratios. Being an equity investor has always been a harbored ambition of mine, however, having personally experienced the debacle of the financial crisis of 2007-08, and how even ace analysts ignored the fundamentals of financial analysis and got trapped in the herd-behavior of housing bubble, learning more about these financial statements and how to interpret them using the tool of common-size statements and financial ratios,was an important lesson for me, which I will cherish and will stick to throughout my career. It is considerable that the figures in the financial statements are just raw financial figures, and can misguide the invetsors. Therefore, it is important that we transform these financial statements using common-size statements and ratio analysis, and then take the final investment. For instance, consider the common-size income statement for Nike Inc. hereunder:
-Common Size Income Statement
-Common-Size Balance Sheet
As we may note from the above figures, the income statement just reveals that during the year, the revenue figures and the profit figures of the company has increased during the year. However, it is only through the common size statements we get to know the real reason as what factors led to the increase in the profit figures of the company. Referring to the above table, we can see that the revenue figures of the company increased by 10.08% during the year. However, what was more considerable here was the controlled cost structure of the company. Important to note, during 2015, the proportion of costs of goods sold to the revenue figures decreased from 55.23% to 54.03%, thus allowing the gross margins to increase from 44.77% to 45.7%. This was followed by the marginal increase in the proportion of operating expenses from 31.53% to 32.33%, which sustained the positive impact of the increase in the revenue figures.
Therefore, on the basis of common-size statement, we were able to derive that the profit margins were higher not just because of higher revenue figures, but also because of controlled cost structure that helped the company to generate a sustainable increase in the net income. Similarly, the same methodology can be applied to the financial statements of other companies and will help me pick the right stocks for my portfolio.
3.0 Financial Ratios
Just like the common-size statements, even the financial ratios carries significant utility for the investors. For instance, while the liquidity ratio reveals the working capital position of the entity and how capable it is to honor short-term obligations, profitability ratios reveals the profit margin being earned by the company using the available resources. On the other hand,while solvency ratios provide information on the capital structure composition of the company, asset management ratios provides information on the efficiency of the management in utilizing the available asset base. Therefore, it is on the basis of the outcome of the financial ratios, an investor can witness the trend in the financial standing of the company and can thus decide on his investment decision.To illustrate the utility of the financial ratios, I have calculated liquidity ratios of Nike Inc. for the past three years:
-Current Ratio: Current Assets/ Current Liabilities
-Quick Ratio: (Cash+ Receivables)/Current Liabilities
Referring to the above tables, we witness that during the past three year period, the liquidity position of the company is on a declining trend as the proportionate increase in the current liabilities of the company exceeds the proportionate increase in the current assets. For instance, during 2015, the multiple has declined from 2.72 to 2.52 because of a higher proportionate increase in the current liabilities by 26% relative to 16.6% increase in the current assets.
4.0 Risk and Return
Another important topic of corporate finance was studying the relationship between risk and return. Even before studying the topic, I was aware of the direct relationship between risk and returns. However, the topic gave a real insight by introducing the concept of diversification and how the risk can be categorized into unsystematic risk and systematic risk. As learnt from the topic, the risk factor of each stock is divided into unsystematic risk, i.e.diversifiable risk and systematic risk, non-diversifiable risk, and the stocks are only priced for bearing the systematic risk as markets never reward the investor for bearing unsystematic risk.
Therefore, in order to eliminate the unsystematic risk from their portfolio, investors should diversify their holdings across the assets that are less than perfectly correlated as the weighted average risk of such portfolio will be less than that of a single security only. Academicians have also confirmed that it is not required that the investor purchase all the low correlated stocks from the stock market, as even a portfolio of 30 stocks will eliminate the majority of the unsystematic risk.
Therefore, learning about he diversification concept, I will make sure that my investment portfolio is highly diversified with the inclusion of non-correlated stocks.
5.0 Time Value of Money
This subject of corporate finance is embedded most aggressively into our daily life. Important to note, the concept of time value of money states that the value of one dollar is more in present time than the same amount of money being received in the future. Continuing with my future goal of becoming an equity investor holding a diversified portfolio, the first step I need to do is to accumulate the sum before I start trading, and this is where the concept of time value of money will be most useful. Assuming that I want to accumulate $100000 in five years while the interest rate prevailing in the market is 4% with annual compounding. Therefore, using the formula for present value, I can ascertain the amount that I will need to invest :
PV= FV/(1+Interest rate)Period
= 100000/(1.04)5
= $82912.71
Therefore, using the concepts of present value and future value, I can ascertain my investment needs and can also compare the cash flows over different time horizons.
Referencs
Nike Inc. (2015). Annual Report 2015. Nike Inc.
Steve Ross, R. W. (2011). Essentials of Corporate Finance. Cengage Learning.
