Corporate Finance, 4th Edition

Chapter 12Financing

Tell me how you're financed and I'll tell you who you are

When you evaluate how a company is financed, you must perform both dynamic and static analyses.

• As we saw in the previous chapter, when it is founded, a company makes two types of investment. Firstly, it invests to acquire land, buildings, equipment, etc. Secondly, it makes operating investments, specifically start-up costs and building up working capital.

To finance these investments, the company must raise either equity or debt financing. The investments, which initially generate negative cash flows, must generate positive cash flows over time. After subtracting returns to the providers of the company's financing (interest and dividends), as well as taxes, these cash flows must enable the company to repay its borrowings and eventually pay dividends.

If the circle is a virtuous one, i.e. if the cash flows generated are enough to meet interest and dividend payments and repay debt, the company will gradually be able to grow and, as it repays its debt, it will be able to borrow more (the origin of the illusion that companies never repay their loans).

Conversely, the circle becomes a vicious one if the company's resources are constantly tied up in new investments or if cash flow from operating activities is chronically low. The company systematically needs to borrow to finance capital expenditure, and it may never be able to pay off its debt, not to mention pay dividends.

Evaluating these matters ...