Corporate Finance Fundamentals: Key Concepts

Posted on Jun 11, 2025 in Economy

Operating Cycle

The operating cycle is the average period of time required for a business to make an initial outlay of cash to produce goods, sell the goods, and receive cash from customers in exchange for the goods. This is useful for estimating the amount of working capital that a company will need in order to maintain or grow its business.

A company with an extremely short operating cycle requires less cash to maintain its operations, and so can still grow while selling at relatively small margins. Conversely, a business may have fat margins and yet still require additional financing to grow at even a modest pace, if its operating cycle is unusually long. If a company is a reseller, then the operating cycle does not include any time for production; it is simply the date from the initial cash outlay to the date of cash receipt from the customer.

The following are all factors that influence the duration of the operating cycle:

  • The payment terms extended to the company by its suppliers. Longer payment terms shorten the operating cycle, since the company can delay paying out cash.
  • The order fulfillment policy, since a higher assumed initial fulfillment rate increases the amount of inventory on hand, which increases the operating cycle.
  • The credit policy and related payment terms, since looser credit equates to a longer interval before customers pay, which extends the operating cycle.

Thus, several management decisions (or negotiated issues with business partners) can impact the operating cycle of a business. Ideally, the cycle should be kept as short as possible, so that the cash requirements of the business are reduced.

Examining the operating cycle of a potential acquiree can be particularly useful, since doing so can reveal ways in which the acquirer can alter the operating cycle to reduce cash requirements, which may offset some or all of the cash outlay needed to buy the acquiree.

Dividend Policy Fundamentals

A dividend policy is the approach a company takes to decide how much of its profits should be distributed to shareholders as dividends and how much should be retained for reinvestment. This policy helps maintain a balance between rewarding investors and ensuring the company has enough funds for future growth.

Types of Dividend Policies

  1. Stable Dividend Policy – A fixed amount or gradually increasing dividend.
  2. Constant Dividend Payout Ratio – A percentage of profits paid as dividends.
  3. Residual Dividend Policy – Dividends paid after funding necessary investments.
  4. Hybrid Dividend Policy – A mix of stability and residual payments.

Determinants of Dividend Policy

Several factors influence how a company structures its dividend policy, including:

  • Profitability – Higher profits allow for generous dividend payouts.
  • Growth Opportunities – Companies needing capital for expansion may retain earnings.
  • Liquidity – Availability of cash affects dividend distribution.
  • Market Trends – Industry expectations and stock market conditions matter.
  • Tax Considerations – Tax regulations may impact dividend payments.
  • Investor Preferences – Some shareholders prefer stable dividends, while others favor capital gains.
  • Debt Levels – Firms with high debt may prioritize repayments over dividends.
  • Legal Regulations – Compliance with financial laws influences payouts.

EBIT-EPS Analysis: Financial Planning Tool

EBIT-EPS analysis gives a scientific basis for comparison among various financial plans and shows ways to maximize EPS. Hence, EBIT-EPS analysis may be defined as ‘a tool of financial planning that evaluates various alternatives of financing a project under varying levels of EBIT and suggests the best alternative having the highest EPS and determines the most profitable level of EBIT’.

Concept of EBIT-EPS Analysis

The EBIT-EPS analysis is the method that studies the leverage, i.e., comparing alternative methods of financing at different levels of EBIT. Simply put, EBIT-EPS analysis examines the effect of financial leverage on the EPS with varying levels of EBIT or under alternative financial plans.

It examines the effect of financial leverage on the behavior of EPS under different financing alternatives and with varying levels of EBIT. EBIT-EPS analysis is used for making the choice of the combination and of the various sources. It helps select the alternative that yields the highest EPS.

We know that a firm can finance its investment from various sources such as borrowed capital or equity capital. The proportion of various sources may also be different under various financial plans. In every financing plan, the firm’s objectives lie in maximizing EPS.

Advantages of EBIT-EPS Analysis

We have seen that EBIT-EPS analysis examines the effect of financial leverage on the behavior of EPS under various financing plans with varying levels of EBIT. It helps a firm in determining optimum financial planning having the highest EPS.

Various advantages derived from EBIT-EPS analysis may be enumerated below:

Financial Planning

Use of EBIT-EPS analysis is indispensable for determining sources of funds. In case of financial planning, the objective of the firm lies in maximizing EPS. EBIT-EPS analysis evaluates the alternatives and finds the level of EBIT that maximizes EPS.

Comparative Analysis

EBIT-EPS analysis is useful in evaluating the relative efficiency of departments, product lines, and markets. It identifies the EBIT earned by these different departments, product lines, and from various markets, which helps financial planners rank them according to profitability and also assess the risk associated with each.

Performance Evaluation

This analysis is useful in comparative evaluation of performances of various sources of funds. It evaluates whether a fund obtained from a source is used in a project that produces a rate of return higher than its cost.

Determining Optimum Mix

EBIT-EPS analysis is advantageous in selecting the optimum mix of debt and equity. By emphasizing the relative value of EPS, this analysis determines the optimum mix of debt and equity in the capital structure. It helps determine the alternative that gives the highest value of EPS as the most profitable financing plan or the most profitable level of EBIT, as the case may be.

Limitations of EBIT-EPS Analysis

Finance managers are very much interested in knowing the sensitivity of the earnings per share with the changes in EBIT; this is clearly available with the help of EBIT-EPS analysis, but this technique also suffers from certain limitations, as described below:

No Consideration for Risk

Leverage increases the level of risk, but this technique ignores the risk factor. When a corporation, on its borrowed capital, earns more than the interest it has to pay on debt, any financial planning can be accepted irrespective of risk. But in times of poor business, the reverse of this situation arises which attracts a high degree of risk. This aspect is not dealt with in EBIT-EPS analysis.

Contradictory Results

It gives a contradictory result where, under different alternative financing plans, new equity shares are not taken into consideration. Even the comparison becomes difficult if the number of alternatives increases, and sometimes it also gives erroneous results under such situations.

Over-capitalization

This analysis cannot determine the state of over-capitalization of a firm. Beyond a certain point, additional capital cannot be employed to produce a return in excess of the payments that must be made for its use. But this aspect is ignored in EBIT-EPS analysis.

Indifference Points

The indifference point, often called a break-even point, is highly important in financial planning because, at EBIT amounts in excess of the EBIT indifference level, the more heavily levered financing plan will generate a higher EPS. On the other hand, at EBIT amounts below the EBIT indifference points, the financing plan involving less leverage will generate a higher EPS.

Concept

Indifference points refer to the EBIT level at which the EPS is the same for two alternative financial plans. According to J. C. Van Horne, ‘Indifference point refers to that EBIT level at which EPS remains the same irrespective of debt-equity mix’. The management is indifferent in choosing any of the alternative financial plans at this level because all the financial plans are equally desirable. The indifference point is the cut-off level of EBIT below which financial leverage is disadvantageous. Beyond the indifference point level of EBIT, the benefit of financial leverage with respect to EPS starts operating.

Graphical Approach

The indifference point may also be obtained using a graphical approach. In Figure 5.1, we have measured EBIT along the horizontal axis and EPS along the vertical axis. Suppose we have two financial plans before us: Financing by equity only and financing by equity and debt. Different combinations of EBIT and EPS may be plotted against each plan. Under Plan-1, the EPS will be zero when EBIT is nil, so it will start from the origin.

Financial Break-even Point

In general, the term Break-even Point (BEP) refers to the point where the total cost line and sales line intersect. It indicates the level of production and sales where there is no profit and no loss because here the contribution just equals the fixed costs. Similarly, the financial break-even point is the level of EBIT at which, after paying interest, tax, and preference dividend, nothing remains for the equity shareholders.

Working Capital Management Essentials

The term ‘working capital management‘ primarily refers to the efforts of the management towards effective management of current assets and current liabilities. Working capital is nothing but the difference between the current assets and current liabilities. In other words, an efficient working capital management means ensuring sufficient liquidity in the business to be able to satisfy short-term expenses and debts.

In a broader view, ‘working capital management’ includes working capital financing apart from managing the current assets and liabilities. That adds the responsibility for arranging the working capital at the lowest possible cost and utilizing the capital cost-effectively.

Objectives of Working Capital Management

The primary objectives of working capital management include the following:

  • Smooth Operating Cycle: The key objective of working capital management is to ensure a smooth operating cycle. It means the cycle should never stop for the lack of liquidity, whether it is for buying raw material, salaries, tax payments, etc.
  • Lowest Working Capital: For achieving the smooth operating cycle, it is also important to keep the requirement of working capital at the lowest. This may be achieved by favorable credit terms with accounts payable and receivables both, faster production cycle, effective inventory management, etc.
  • Minimize Rate of Interest or Cost of Capital: It is important to understand that the interest cost of capital is one of the major costs in any firm. The management of the firm should negotiate well with the financial institutions, select the right mode of finance, maintain optimal capital structure, etc.
  • Optimal Return on Current Asset Investment: In many businesses, you have a liquidity crunch at one point in time and excess liquidity at another. This happens mostly with seasonal industries. At the time of excess liquidity, the management should have good short-term investment avenues to take benefit of the idle funds.

Importance of Effective Working Capital Management

Although the importance of working capital is unquestionable in any type of business, working capital management is a day-to-day activity, unlike capital budgeting decisions. Most importantly, inefficiencies at any levels of management have an impact on the working capital and its management.

Following are the main points that signify why it is important to take the management of working capital seriously:

  • Ensures Higher Return on Capital
  • Improvement in Credit Profile & Solvency
  • Increased Profitability
  • Better Liquidity
  • Business Value Appreciation
  • Most Suitable Financing Terms
  • Interruption-Free Production
  • Readiness for Shocks and Peak Demand
  • Advantage over Competitors

Decisions in Working Capital Management

If anybody describes the benefits of working capital management in terms of money, it would most likely be the cost of capital that a business pays on the investment in working capital. The amount of this cost would depend on two things, namely, the quantum of working capital required and the cost of working capital.

Working Capital Management Policies

Working capital management policies deal with the quantum factor. These policies, in essence, are different levels of the trade-off between liquidity and profitability. Theoretically, the following three types of policies are explained, whereas there can be a number of policies depending on where the trade-off is struck between the liquidity and profitability.

  • Relaxed Policy / Conservative Policy: This policy has a high level of current assets maintained to honor the current liabilities. Here, the liquidity is very high, and the direct impact on profitability is also high.
  • Restricted Policy / Aggressive Policy: This policy has a lower level of current assets. Here, the liquidity levels are very low; therefore, the direct impact on profitability is also low.
  • Moderate Policy: It lies between the conservative and aggressive policy.

Advantages of Working Capital Management

  • Working capital management ensures sufficient liquidity when required.
  • It evades interruptions in operations.
  • Profitability Maximized.
  • Achieves better financial health.
  • Develops competitive advantage due to streamlined operations.

Disadvantages of Working Capital Management

  • It only considers monetary factors. There are non-monetary factors that it ignores, like customer and employee satisfaction, government policy, market trends, etc.
  • Difficult to accommodate sudden economic changes.
  • Too high dependence on data is another downside. A smaller organization may not have such data generation.
  • Too many variables to keep in mind, such as current ratios, quick ratios, collection periods, etc.

Walter’s Dividend Policy Model

According to the Walter’s Model, given by Professor James E. Walter, dividends are relevant and have a bearing on the firm’s share prices. Also, the investment policy cannot be separated from the dividend policy since both are interlinked.

Walter’s Model shows the clear relationship between the return on investments or internal rate of return (r) and the cost of capital (K). The choice of an appropriate dividend policy affects the overall value of the firm. The efficiency of dividend policy can be shown through a relationship between returns and the cost.

  • If r > K, the firm should retain the earnings because it possesses better investment opportunities and can gain more than what the shareholder can by reinvesting. The firms with more returns than a cost are called the “Growth firms” and have a zero payout ratio.
  • If r < K, the firm should pay all its earnings to the shareholders in the form of dividends, because they have better investment opportunities than a firm. Here, the payout ratio is 100%.
  • If r = K, the firm’s dividend policy has no effect on the firm’s value. Here, the firm is indifferent towards how much is to be retained and how much is to be distributed among the shareholders. The payout ratio can vary from zero to 100%.

Assumptions of Walter’s Model

  1. All the financing is done through the retained earnings; no external financing is used.
  2. The rate of return (r) and the cost of capital (K) remain constant irrespective of any changes in the investments.
  3. All the earnings are either retained or distributed completely among the shareholders.
  4. The earnings per share (EPS) and Dividend per share (DPS) remain constant.
  5. The firm has a perpetual life.

Criticism of Walter’s Model

  1. It is assumed that the investment opportunities of the firm are financed through the retained earnings and no external financing such as debt or equity is used. In such a case, either the investment policy or the dividend policy or both will be below the standards.
  2. The Walter’s Model is only applicable to all equity firms. Also, it is assumed that the rate of return (r) is constant; however, it decreases with more investments.
  3. It is assumed that the cost of capital (K) remains constant; however, it is not realistic since it ignores the business risk of the firm, which has a direct impact on the firm’s value.

NOTE: The cost of capital (K) = Cost of equity (Ke), because no external source of financing is used.

Leverage: Operating & Financial Decisions

Leverage refers to the employment of assets or sources of funds bearing fixed payment to magnify EBIT or EPS, respectively. So, it may be associated with investment activities or financing activities.

According to its association, we find mainly two types of leverages:

  1. Operating leverage
  2. Financial leverage

The combined effect of operating and financial leverage is measured with the help of combined leverage.

Operating Leverage

Operating leverage is concerned with the investment activities of the firm. It relates to the incurrence of fixed operating costs in the firm’s income stream. The operating cost of a firm is classified into three types: Fixed cost, variable cost, and semi-variable or semi-fixed cost. Fixed cost is a contractual cost and is a function of time. So, it does not change with the change in sales and is paid regardless of the sales volume.

Variable costs vary directly with the sales revenue. If no sales are made, variable costs will be nil. Semi-variable or semi-fixed costs vary partly with sales and remain partly fixed. These change over a range of sales and then remain fixed. In the context of operating leverage, semi-variable or semi-fixed cost is broken down into fixed and variable portions and is merged accordingly with variable or fixed cost.

Operating leverage is measured by computing the Degree of Operating Leverage (DOL). DOL expresses operating leverage in quantitative terms.

The higher the proportion of fixed operating cost in the cost structure, the higher is the degree of operating leverage. The percentage change in the earnings before interest and taxes relative to a given percentage change in sales and output.

Therefore,

DOL = %Change in EBIT / %Change in Sales OR (∆EBIT / EBIT) / (∆SALES / SALES)

Financial Leverage

Financial leverage is mainly related to the mix of debt and equity in the capital structure of a firm. It exists due to the existence of fixed financial charges that do not depend on the operating profits of the firm. Various sources from which funds are used in financing of a business can be categorized into funds having fixed financial charges and funds with no fixed financial charges. Debentures, bonds, long-term loans, and preference shares are included in the first category, and equity shares are included in the second category.

Financing decisions favor employing funds having fixed financial charges because it can be used as a lever. Financial leverage results from the existence of fixed financial charges in the firm’s income stream. With the use of fixed financial charges, a firm can magnify the effect of change in EBIT on change in EPS. Hence, financial leverage may be defined as the firm’s ability to use fixed financial charges to magnify the effects of changes in EBIT on its EPS.

The higher the proportion of fixed charge-bearing funds in the capital structure of a firm, the higher is the Degree of Financial Leverage (DFL), and vice versa. Financial leverage is computed by the DFL. DFL expresses financial leverage in quantitative terms. The percentage change in the earnings per share to a given percentage change in earnings before interest and taxes is defined as Degree of Financial Leverage (DFL).

A firm is said to be highly financially leveraged if the proportion of fixed interest-bearing securities, i.e., long-term debt and preference share capital, in the capital structure is higher in comparison to equity share capital. Like operating leverage, the value of financial leverage must be greater than 1.

Capital Structure Theories

Net Income Approach and Net Operating Income Approach were proposed by David Durand. According to the NI approach, there exists a positive relationship between capital structure and valuation of a firm, and a change in the pattern of capitalization brings about a corresponding change in the overall cost of capital and total value of the firm.

Thus, with an increase in the ratio of debt to equity, the overall cost of capital will decline, and the market price of equity stock as well as the value of the firm will rise. The converse will hold true if the ratio of debt to equity tends to decline.

This approach is based on three following assumptions:

  1. There are no taxes;
  2. Cost of debt is less than cost of equity;
  3. The use of debt does not change the risk perception of investors. This implies that there will be no change in cost of debt and cost of equity even if the degree of financial leverage changes.

Thus, a firm can achieve optimal capital structure by making judicious use of debt and equity and attempting to maximize the market price of its stock.

Net Operating Income Approach (NOI)

According to the Net Operating Income Approach, which is just opposite to the NI approach, the overall cost of capital and value of the firm are independent of capital structure decisions, and a change in the degree of financial leverage does not bring about any change in the value of the firm and cost of capital.

The market value of the firm is determined by the following formula:

The crucial assumptions of the NOI approach are:

  1. The firm is evaluated as a whole by the market. Accordingly, the overall capitalization rate is used to calculate the value of the firm. The split of capitalization between debt and equity is not significant.
  2. Overall capitalization rate remains constant regardless of any change in the degree of financial leverage.
  3. Use of debt as a cheaper source of funds would increase the financial risk to shareholders who demand a higher cost on their funds to compensate for the additional risk. Thus, the benefits of lower cost of debt are offset by the higher cost of equity.
  4. The cost of debt would stay constant.
  5. The firm does not pay income taxes.

Thus, under the NOI approach, the total value of the firm, as stated above, is determined by dividing the net operating income (EBIT) by the overall capitalization rate, and the market value of equity (S) can be found out by subtracting the market value of debt (B) from the overall value of the firm (V).

Traditional Approach

While the above two approaches represent extreme views about the impact of financial leverage on the value of a firm and cost of capital, the Traditional Approach offers an intermediate view which is a compromise between the NOI and NI approaches.

Further, the traditional approach differs from the NOI approach because it does not hold the view that the overall cost of capital will remain constant whatever be the degree of financial leverage. Traditional theorists believe that up to a certain point, a firm can, by increasing the proportion of debt in its capital structure, reduce the cost of capital and raise the market value of the stock.

Beyond that point, further induction of debt will lead the cost of capital to rise and the market value of the stock to fall.

The traditional view regarding optimal capital structure can be appreciated by categorizing the market reaction to leverage in the following three stages:

  1. Stage 1: The first stage starts with the introduction of debt in the firm’s capital structure. As a result of the use of low-cost debt, the firm’s net income tends to rise; the cost of equity capital (Ke) rises with the addition of debt, but the rate of increase will be less than the increase in the net earnings rate. The cost of debt (Kd) remains constant or rises only modestly. The combined effect of all these will be reflected in an increase in the market value of the firm and a decline in the overall cost of capital (Ko).
  2. Stage II: In the second stage, further application of debt will raise costs of debt and equity capital so sharply as to offset the gains in net income. Hence, the total market value of the firm would remain unchanged.
  3. Stage III: After a critical turning point, any further dose of debt to the capital structure will prove fatal. The costs of both debt and equity rise as a result of the increasing riskiness of each, resulting in an increase in overall cost of capital which will be faster than the rise in earnings from the introduction of additional debt. As a consequence of this, the market value of the firm will tend to depress.