Corporate Valuation Modeling: A Step-by-Step Guide

CHAPTER 4

Capital Structure and Balance Sheet

Even with strong revenue, a firm can experience financial stress and possible bankruptcy if its assets, liabilities, and capital structure are poorly selected or structured. Management has the ability to select or partially control nearly all items that relate to the sources and uses of funds in the firm. On the asset side, the more obvious items are large capital expenditure projects such as building a new warehouse; a more obscure one could be directing in-store advertising toward more cash versus credit sales. As for the liabilities and capital structure, management is responsible for determining how to fund assets. They have the ability to select different types of debt and equity or work with other entities to structure financing to fit the company’s needs. All of the financing comes at a cost, which revenue must be able to cover in the long term.

Companies can have innumerable variations of assets, liabilities, and capital structure. There is an expansive spectrum of combinations. On the extremes, a manufacturing firm may have multiple warehouses and machinery and be financed mostly with equity, while a financial services company may have assets consisting of complex financial instruments and equally complex financial products making up its capital structure. To make sense of all of these possibilities, accountants created a financial statement known as the balance sheet. This financial statement is an organized account of ...