What is corporate finance and how is it relevant to SMEs?

Revolut Contributor

 · 06/24/2020  · 06/24/2020

Corporate finance is a specific subset of the finance industry. It relates to how companies secure capital, structure that capital, and develop strategies or investment decisions to maximise the economic benefits for their own shareholders as a result.

What is corporate finance?

Various territories define corporate finance in different ways. The US perspective is broad and includes anything from capital structures to allocating dividends or share buybacks.

The UK definition of corporate finance is tighter. This tends to focus on the transactions that executives undertake when they raise capital to expand their existing company, form a new one, or acquire another. Here are three corporate finance examples relevant to SMEs:

  • Raising angel finance or venture capital to evolve a business
  • Restructuring a company by issuing new equity or debt
  • Creating a joint-venture or merging operations with a competitor

What is the role of corporate finance?

The goal of corporate finance is to create value for stakeholders by making these plans work in practice. Smarter corporate financiers might spot a way to boost retained earnings just by looking at a company finance structure and adjusting the invested capital. It’s more likely that these experts will help to fulfil a wider business strategy rather than instigate their own ideas.

For instance, if two brands do not sit well under one umbrella, executives might ask to form a new company for one of these assets, to minimise the risk. If a company needs to grow its market-share rapidly, the owners might seek funding to expand the team or snap-up a rival. The latter option often provides intellectual property or secures access to a scarce resource.

These transactions might involve a technical change of ownership and the restructuring of one or both companies. They could include the purchase or exchange of equity and debt. And so this is the point when corporate finance professionals are hired to provide guidance.

What are the three main areas of corporate finance?

Corporate finance is a chunky topic, but it falls into three loose categories:

  • Capital budgets (i.e. setting long-term goals and allocating financial resources)
  • Capital structure (i.e. deciding if equity, debt, or both make most economic sense)
  • Working capital (i.e. allocating financial resources around day-to-day activities)

Let’s look at an example. Avocado Ltd is a fictional company that makes fruit-shaped furniture in London. It wants to buy Smashing Ltd, a fictional fabric design agency. Avocado commissions an independent audit of Smashing’s accounts. This reveals Avocado will gain £300k of extra revenue each year from selling to Smashing’s existing clients. It also shows Avocado will reduce its own annual operating costs by £50k due to economies of scale.

Smashing is valued at £1m, and Avocado offers a premium of 20% to sweeten the deal. The two sets of directors shake hands. The problem is Avocado only has £500k in cash and must raise £700k (i.e. £1.2m minus the £500k). Avocado reviews its cash flows and takes advice on financing the capital, then chooses to raise the cash from a venture capital fund. Avocado secures the £700k as a loan, knowing that with the £350k boost in operating profits, it can repay the loan in 2-3 years. This way, it does not have to offer any equity as part of the deal.

Why do SMEs need to know about corporate finance?

Along with the potential financial return of any such transactions, it’s equally vital to consider the potential risk of failure. For starters, the true costs of short-term debt or long-term capital.

Larger companies typically have in-house corporate finance teams or nominated advisors, such as an investment bank. SMEs will need input from people who are qualified to help, perhaps by hiring a suitably trained CFO. It’s good to think big but often wiser to plan well.

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