All managers must understand corporate finance to profitably direct their companies.
Corporate finance is a basic component of how a business is run. All managers should keep this in mind to direct funds to the optimal division or product in a company. In addition, managers should understand how their company is financed and whether it has a risk of bankruptcy. Conversely, managers should understand if the equity in the business is undervalued and has the potential to grow.
Return on Investment
The most important reason for managers to understand corporate finance is the concept of return on investment (ROI) over time. This term is calculated by subtracting the gain on investment from the cost and dividing that by the initial cost. Understanding this helps managers to invest funds more efficiently. For example, a product that needs a $10 million investment to generate $1 million in profits is less efficient than one that could generate $500,000 in profits with a $2 million investment cost.
Company Debt
If a manager believes his division is ready for growth and wants to issue debt for the funding, he should understand the return necessary to efficiently produce profits. In a fast-growing technology company with high return-on-investment requirements, issuing debt is often a poor option versus using existing cash. Managers with a good knowledge of corporate finance will have a better understanding of this tradeoff.
Company Equity
Issuing equity is an option that companies use to generate investment funds and is an alternative to debt issuance. Corporate managers should understand equity to better know the capital structure of the firm. For initial public offerings, managers need to understand how new funds will be distributed and how their division will be affected. Equity offerings have a much higher threshold for return on investment because they are a permanent relinquishment of a portion of future earnings.
Company Options
Managers at many companies have equity options in the company. These fluctuate with the market and affect the total capital structure of the firm. Options also affect the income of the firm because they are counted against earnings. In this instance, managers must understand corporate finance for their own personal wealth. Managers seeking to understand and grow their personal balance sheet should understand these financial instruments.
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