Corporate Financial Policy
A corporation's financial policy defines the company's overall approach to managing its financial decisions. A company's financial strategy is comprised of the following: Capital budgeting, financing and dividend policy. While every corporation typically deals with these three areas when setting its financial policies, each organization must examine many factors that are unique to its business and situation before setting up its overall policies. Trends in setting corporate financial policies have been changing over the past decade. While investors and shareholders want to insure that there is capital available to grow the business, shareholders are increasingly comfortable in accumulating debt to do so. In today's fast changing marketplace, corporate managers and investors are looking for short-term gains as opposed to more traditional long-term financial strategies. The financial fitness of an organization is typically assessed from looking at its balance sheet; the ways that companies are willing to manipulate or dirty their balance sheets is discussed. Investors are keen to see a return on their equity investment in the form of dividends (also known as shareholder or investor value). Investors and shareholders have become increasingly active in determining corporate fiscal policy with an eye toward short-term financial rewards for themselves. U.S. corporations and their investors are much more comfortable operating at much higher risk levels than ever before; U.S. corporations have on average the lowest credit rating in history which is another indication of how comfortable today's corporations are at operating in high risk situations.
There are many aspects associated with planning and implementing a corporate financial policy. Historically, corporations have focused on both short-term and long-term planning when determining financial policies. Conventional wisdom indicates that investors favor companies with good fundamentals or a strong balance sheet. Corporations are faced with many decisions related to how to grow and finance their operations. The following are some factors that companies typically take into account when mapping out their financial strategy:
- Since the interest on debt is deductible, does it make sense to borrow more?
- What is the best thing to do with excess cash?
- Should cash be used to finance the business or returned to shareholders?
While these questions are rhetorical in nature, the answers are really dependent upon linking financial strategy and business strategy. In terms of solid planning, companies should be looking into the longer term (typically 3-5 years) for direction. In essence, companies should have solid projections about what their cash flow or debt service will be for the next few years. If cash flow is strong, then companies are in a good position to acquire target companies in their industry, fund capital projects, or even improve existing operations. Cash allows companies much flexibility and security. Some mature companies may not have any acquisition targets and may well decide to distribute cash back to investors or shareholders. A couple of options are buying back stocks that are undervalued or paying dividends with them if they are overvalued (Godehart, Koller & Rehm, 2006). Companies that are less mature or in highly competitive markets may have no choice but to take on debt to stay competitive -- investments in infrastructure or target acquisitions are necessary to capture market share. A company's credit rating has historically been an important factor in securing competitive rates for borrowing. This essay discusses the changing trends in credit ratings in the U.S. and how these changes are affecting corporations. Debt is certainly not all bad, and many companies benefit from interest deductions on debt. Debt also keeps many companies honest by requiring discipline in making interest and principal payments.
Public corporations have long answered to shareholders by developing and executing solid financial policies. Much has been written about federal legislation that has been enacted to safeguard investor equity in corporations. Increasing numbers of public companies are "going private" as a way to escape the demanding regulatory environments imposed by federal legislation. This essay looks at the impact that private equity funds have had in the "going private" movement and the effects that this trend has on corporate financial policy. Investors in public companies have become more involved in setting social and financial policies at their organizations. These so-called activist investors are shaping capital structures by influencing the debt-to-equity ratios of their companies. Finally, this essay looks at the high tolerance for risk that became prevalent in Corporate America in the early 2000s. Access to cheap and abundant capital, emboldened shareholders and investors, and a high tolerance for risk have truly had a profound effect of corporate financial strategies.
Investors typically look at a company's balance sheet as an indication of financial fitness. The company balance sheet illustrates the capital structure of an organization. Capital structure is a term that deals specifically with a company's debt-to-equity ratio. The ratio of debt to equity has always been an important consideration for investors and offers one of the best pictures of a company's leverage.
Managing capital structure is a balancing act that requires financial flexibility and fiscal discipline. Achieving a balance of debt and equity has been one of the biggest challenges to organizations, and it remains a big challenge. The long-term impact of capital structure means managing operating cash flows and cost of capital. The interest exposure on debt is tax deductible, and a company can reduce its after-tax cost of capital by increasing debt relative to equity (Godehart, Koller & Rehm, 2006).
Calculating Debt-to-EquityTotal Liabilities / Total Shareholders' Equity,
where shareholder equity = common stock plus firm profits or losses
(Adapted from McClure, n.d.)
The following is an illustration of the impact that the debt-to-equity ratio can have on an organization. In general, a debt ratio of 0.5 to 1.5 is considered to be a good ratio (McClure, n.d.).
If Company A has long-term debt (in a bond) of $10 million and has $10 million in equity, the debt-to-equity ratio is 1 (10 / 10 = 1). This ratio falls well within acceptable debt-to-equity ratios.
If Company B has long-term debt (in a bond) of $10 million and has $1 million in equity, the debt-to-equity ratio is 10 (10 / 1 = 10). This ratio is way too high for most investors to feel comfortable. This company is debt laden.
It Company C has long-term debt (in a bond) of $10 million and has $20 million in equity, the debt-to-equity ratio is 0.5 (10 / 20 = 0.5). This ratio will be looked upon favorably by investors because the company has little debt compared to its equity.
"Indeed, the potential harm to a company's operations and business strategy from a bad capital structure is greater than the potential benefits from tax and financial leverage. Instead of relying on capital structure to create value on its own, companies should try to make it work hand in hand with their business strategy, by striking a balance between the discipline and tax savings that debt can deliver and the greater flexibility of equity" (Godehart, Koller & Rehm, 2006).
Strong corporate fundamentals are a requisite for investors. Investors have longed used criteria such as solid balance sheets and favorable credit ratings to decide where to invest their dollars. But just how much faith...
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